Private Equity vs. Index Funds
This past week, I posted a blog about how the presentation of private equity returns can sometimes be quite misleading.
I will admit that the title was a little click baitish (Fake News), but the post was meant to draw attention to a practice that is worrying to many:
The marketing and reporting of a type of return that “no client received.”
Josh Brown, Wes Gray, Dan Rasmussen and many others forwarded it along and it certainly did get attention. As I write this, the post has been read over 7,500 times and picked up by blogs such as Abnormal Returns, the Irrelevant Investor, the Evidence Based Investor and by the Financial Times. Thank you all.
Some people poked a little at a few word choices, but comments were generally very positive.
One that I particularly enjoyed was a challenge from Wes Gray. He proposed that we offer a bet similar to one that Warren Buffett made in 2007.
For those who didn’t follow it, Buffett wagered that a simple S&P 500 index fund would outperform a group of hedge funds hand-picked by a leading alternative asset manager. At the end of 10 years, simple outperformed complex and Buffett won $1 million dollars, which he gave to Girls Inc., a charity that provides after-school care and summer programs for girls ages 5-18.
Wes and I have discussed this and are now formally throwing down the gauntlet.
We can’t put up $1 million dollars, but we will together put up $1 dollar, up to a maximum of $1,000, for each person that takes the other side of our bet. If we win, we’ll donate our take to the same Girls Inc. charity (yes Warren, we hope you pick this up and help us raise the stakes). If we lose, we hope the winners will support Girls Inc. too, but we are open to other non-profits.
Our wager is as follows:
We wager that, over a 15-year period, the return of a simple, liquid index fund strategy (the “Public Market Benchmark”) will outperform a basket of top private equity funds (the “Private Equity Basket”).
Like private equity fund pitch books, “important disclosures and terms” are outlined below (comments are welcome, and the terms are subject to change with notification and approval of all counter-parties).
Important Disclosures and Terms
Private Equity Basket
- A dollar weighted basket of the 10 largest funds raised for the vintage year 2018
- To raise large sums of money, funds need to win mandates from the largest asset owners (public pension funds, top endowments, etc.), which have preferred access and large and sophisticated staffs dedicated to finding the best of the best.
- We will post the final list in early 2019 once all data on the largest funds becomes available.
Public Market Benchmark
- The Vanguard Extended Market small and mid-cap index ETF (VXF) with 1.5X leverage
- Solid academic studies have shown that Private Equity provides exposure that is similar to small to mid-cap equity markets. Beyond this, private equity funds add a significant amount of leverage, which over time has the ability to significantly enhance returns. We think we are being very conservative by adding only 50% leverage but, as we mention above, feedback is appreciated.
- We also acknowledge that the best public benchmark would be focused on capturing the value effect, where the value effect that drives PE returns is best captured via the enterprise multiple metrics (which have been shown to be highly effective in public markets). The inclusion of a unique value style would complicate the analysis, however, so we’ve opted to keep it simple with a more broad index.
- We will assume that our leverage costs are Fed Funds plus 50 basis points
Measuring the Returns
- Coming up with a true apples to apples return comparison of Private Equity (PE) as compared to public markets is tricky, but as many have highlighted, even though many firms continue to present them, IRRs clearly don’t cut it.
- Public market return comparisons should be easy, but they aren’t. We have some problems with how comparisons are often made (they tend to be based on figures that do not reflect how investors actually invest and don’t fully consider opportunity costs), but to try to reduce more debate, we will use a KS-PME performance measurement calculation using fully liquidated Distributions to Paid-In or DPI (part of why we need to wait 15 years – until all investments have been sold it is hard to know exactly what true cash on cash returns have been).
As was mentioned in the Fake News post, “some private investment opportunities can provide investors with solid returns” and we are not trying to knock down the many good private equity managers that exist.
What we are trying to do is to point out the dangers of becoming anchored on commonly marketed and reported IRRs, which are returns that “no client [has] received.” (for more examples of this read, Stop It!)
Related to this, I received some comments in response to the Fake News post that large investors don’t use IRRs, but at least one of the largest pension funds in the nation states the following in their PE fund performance evaluation disclosures:
“Performance will be calculated… with primary emphasis being placed on internal rate of return.”
Finally, we don’t mind losing this bet. It could be good if we did (the beneficiaries of billions in public pension plan assets are counting on their private investments to outperform public markets).
So, let us know.
Who wants to take us on!
For more thoughts from Wes Gray and Preston McSwain click the following links: