Private equity returns

There’s no doubt that private markets investments are hot. We receive updates on capital raisings and new funds almost daily. And at investment industry conferences product providers are talking up private equity, private debt and venture capital investments. Partly this an extension of the “there is no alternative” narrative: equity valuations are high and bond yields are rising, so you have have to look elsewhere for higher returns. Partly it’s due to fabulous returns that are attributed to private markets. Figures of 20% per annum are often quoted for private equity funds, which are the dominant segment of the private markets investment universe.

As asset allocators, we believe in risk premia. We think investors should get paid for the risk that they take and are much more attracted to asset classes and segments of the market where we can measure or estimate how much investors are getting paid for taking on risk than ones where guesswork is required.

When we look at private equity in this light we can make a case for why it should have superior returns:

  • the investments are in smaller companies than listed equities, with higher risks
  • private companies are not subject to the same level of scrutiny and oversight as public companies, meaning that smart investment managers ought to have more opportunities to find hidden gems or bargains

The negatives for private equity investment, relative to public markets, are the other side of these risk factors:

  • private equity investments require much greater oversight than public market investments, so the fees are much higher, and almost always include large performance fees in addition to high base fees
  • private equity investments are illiquid, so the investor needs to commit their capital for a long period of time and doesn’t get to determine when their money is invested and when it is returned to them (and so also won’t be able to compound returns by reinvesting distributions in the way that they can reinvest dividends of public companies)

So the question for an asset allocator is: does the extra expected return for private equity investments compensate investors for the higher fees and poor liquidity?

Historical returns

At time of writing, the most up-to-date information that we have on private equity returns is preliminary data for the fourth quarter of calendar year 2021, which was released last week by Pitchbook. (Pitchbook’s data covers about 85% of the private equity universe, so it’s the closest thing to a benchmark in the space. All returns below are after fees.) In itself this is a bit of a red flag: if it takes three and a half months to get preliminary returns across the asset class then we would have to have concerns about transparency and managing exposures in our portfolio.

But at a headline level the returns look stellar for the last few years. 2015 and 2018 vintage funds are posting returns that are 7% and 15% higher than the S&P 500 over the same period. (Private equity funds are predominantly US-based and invested in US companies, so we’ve used the US index here.) Older funds are less impressive, but still the prospect of an asset class that can return substantially more than equities is very attractive. Unfortunately, this is misleading. These returns are the internal rates of return (IRRs) for the private equity funds. But private equity investors (“limited partners” in the jargon of these funds) don’t get the IRR because, unlike public market funds, with most private equity funds you cannot invest or withdraw capital when you want to, so a notional compound rate of return is not valid.

The “KS-PME” (Kaplan Schoar Public Market Equivalent) calculation is an attempt to place private and public equity funds on a more level playing field. Basically, it takes the actual schedule of investments into and distributions out of a private equity fund and compares the total return of the fund with the same cashflows invested in a public market instead. It’s usually presented as a multiple but in the chart below we’ve converted it to an annualised percentage by which the average private equity fund outperforms public markets (in this case the S&P 500). While still positive, the outperformance is much lower than the notional outperformance of the IRRs.

If we look at the long term history for this measure, we can see that the average outperformance has been around 1.5%. And funds launched around the GFC have underperformed public markets on average. If we exclude the last 7 years (so we’re focussing on funds that have realised most of the return on their investment), the average is closer to 1%. That’s still a net benefit, but it’s much lower than the figures quoted in most funds’ marketing literature. Given that most private equity funds have base fees of 1.5% to 2% and 20% performance fees above a modest hurdle rate on top of that, it also suggests that most of the value generated by private equity managers has gone to the managers, not the investor.

This raises the question of why IRRs consistently give a more positive picture than more sophisticated calculations. The chart below helps explain this. It shows the average fund value and cumulative distribution of the total amount invested. We’re comparing across fund vintages, rather than following the evolution of all funds over time (which would be a more exact comparison), but still we can observe similar trends across many years of private equity funds. There’s an initial surge in the value of the average fund in the first few years, then a long slow process where that notional value is converted into cash and returned to investors.

Unlike public equity investments, which continue to grow over time and allow you to reinvest dividends, the typical private equity fund doesn’t seem to experience much growth after four or five years, even though most of the capital is still invested. It takes over ten years for the average fund to realise about 90% of its total value, and investors can expect little growth in the second half of that period.

Broadly speaking, most private equity funds have a few investments that drive their returns – maybe one or two holdings that double or triple in value, with the bulk of the investments delivering public market-like returns before fees and a tail of underperforming companies that don’t grow. This is consistent with the pattern above, where rapid revaluation of the best companies drives the initial surge in value and then the slow process of selling the less successful investments drags on long term returns. Private equity managers also have incentives to revalue investments upward early as well: funds’ base fees are a percentage of the total value of the fund, and most fund constitutions give them performance fees based on the rate of return for each investment, not the fund as a whole. If the value of the fund goes up quickly, the manager gets more fees than if the value increases steadily over time.

The KS-PME analysis above takes that liquidity profile as a starting point. It assumes that a public market investor is happy to be partly invested for much of the period. In reality, public markets investors can be fully invested at all times, which is a luxury that private markets investors don’t have. So an alternative is to calculate the total money return of the private equity fund. This is what the returns would be if a private equity investor kept their capital to invest and returns from the fund segregated in a separate account for the whole period, and we calculated the returns for the account over the full period. The chart below shows that these returns are much lower.

The analysis above is somewhat unrealistic, because in reality investors can invest their committed capital in liquid investments while they’re waiting for the fund to call on it and can reinvest their proceeds in other investments once they are paid out. But it’s noteworthy that the liquidity effects on return are quite large, even for the 2018 vintage which has returned very little capital to date. The KS-PME for this vintage is 2.7% per annum more than the S&P 500, but the annualised total return of the average fund in this vintage is less than the index, because much of the capital has not been invested for the full period.

Finally, we need to be mindful of the fact that this analysis is based on the average fund, but the dispersion of returns in private equity funds is very large. In fact, a few funds with stellar returns have a significant influence on the average, and the return of the median fund is lower than the average across measures and time periods. In order to achieve average returns reliably, investors would need exposure to several different managers to diversify the risks of the underlying investments.


Historical returns analysis provides a solid foundation for understanding the returns available from private equity funds.

  • IRRs quoted by funds are heavily skewed by the timing of valuations and cashflows, and are not a meaningful comparison with public market investments nor a useful guide to the returns investors can expect. Don’t use them.
  • Private equity funds take five to ten years to return cash to investors. Growth is rapid at at the start of the investment, and much slower as the value of the assets are realised, so it’s unwise to assess returns over shorter time periods.
  • Private equity funds have, on average, delivered superior returns to public markets. A premium of around 1% seems to be achievable after fees.
  • But to achieve these higher returns, investors would need to
    • be prepared to wait for 10 years to get their money back
    • have a sufficiently large allocation that they can invest in several different funds to spread the risk
    • actively invest the committed funds before investment and the distributions after investment in liquid growth assets to reduce the drag of low returning cash on the portfolio

Most of our clients and investors have a shorter time horizon than this and don’t have portfolios large enough to allocate the minimum investments required in several funds, but we can see why large institutional investors with long time horizons might allocate part of their portfolios to private equity investment programs.

Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.

This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.

Taxation warning: Any taxation considerations are general and based on present taxation laws and may be subject to change. Aequitas is not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and investors should seek tax advice from a registered tax agent or a registered tax (financial) adviser if they intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law.

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