The title of this piece comes from a recent Josh Brown article titled, Delusions and Entitlement (he deserves full credit for this quip).
In his post, Josh said the following:
“There’s this idea floating around out in the ether that, for some reason, public equity markets are expensive but private market valuations will serve as an effective diversifier. As if acquisition multiples aren’t sky high both absolutely and relative to history. As if there isn’t a trillion dollars soaking everyone and everything within the asset class. As if there aren’t a thousand and one funds and a hundred thousand professionals who all read the same case studies and interned in Boston. As if there weren’t an army of private equity junior associates literally cold-calling small businesses to buy out, from coast to coast. As if the chase for cash flows to harvest isn’t every bit as intense off the exchanges as it is on them.”
At the end of his article, Josh then links to my recent post, Fake News (thanks again, Josh).
Fake News talks about a Private Equity (PE) return metric (Internal Rate of Return or IRR) that is commonly pitched and used to promote PE outperformance as compared to public markets.
Josh correctly says that even though IRR is commonly quoted, it is not the “true return that investors have received on their invested cash.”
As he does so well, Josh also calls it like it is and bluntly says to the purveyors of returns that “no client received”:
I wasn’t planning on posting something again so quickly about how some PE pitches present returns in a manner that can be misleading (click here for more on why I’m using this strong word – it includes links to a solid McKinsey paper that includes arguably stronger words such as “dangerous”).
But, then I received something that made me realize how much I appreciated Josh’s blunt words.
It was a well-distributed Q4 2018 Market Insights book from a leading private bank and asset manager that included the chart below:
The illustration could easily be used to make a make a compelling case for PE. The sources are impressive and it was even quoted in a leading publication with a similar headline.
There’s only one problem.
“No Client Received the Above Return.”
I referenced this quote earlier and used it in my Fake News post (another link to it can be found on the right-side bar of this blog). It is a direct cut and paste of fine print that I found at the very back of a 50 page plus pitch book that was also touting PE outperformance as compared to public markets.
No client received the PE return in the chart above, either, and even more troubling…
This firm didn’t provide this disclosure.
They also didn’t disclose the following from the PE index provider in making their comparisons to public market returns:
“Due to fundamental differences between the two calculations, direct comparison… to [public market returns] is not recommended.”
What are the PE Buyout & Growth Equity Index returns that the firm used in the comparison to public markets, even though the index provider states that it isn’t recommended?
IRRs, which at least one top academic from Oxford University has labeled #IRRelevant (for more on this pick up a copy of this book, Private Equity Laid Bare and note Chapter 11).
As a reminder, the big problem with IRR is that it assumes that investments will achieve the same returns as earlier investments. Realized cash distributions are assumed to keep earning the same returns in the future for the complete life of the fund or private investment. Translation: even though we all know it can be misleading and is forbidden by regulators when talking about public market returns, IRR assumes that past performance will equal future performance. These are indeed not returns that any investor has received.
On other pages of the Market Insight deck, the firm also compares the volatility of PE to public markets in a manner that makes PE look less volatile. They state that PE volatility has been 10% vs. 15-20% for public markets.
Maybe this should be called low volatility that no PE investment has experienced.
PE volatility is a complicated story, but as a concise summary, a quote from my friend Wes Gray seems appropriate (click here for more).
As Wes so aptly put it:
“When reporting returns, [PE] funds manage prices, allowing them to understate their true market exposure…, which artificially lowers measured volatility.”
Wes goes on to quote a line from Pioneering Portfolio Management, the book from David Swensen, the Chief Investment Officer of Yale, that arguably made PE investing so popular.
“…the low risk evident in data describing past returns from private investing constitutes a statistical artifact…If two otherwise identical companies differ only in the form of organization—one private, the other public—the infrequently valued private company appears much more stable than the frequently valued publicly traded company.”
I’m not suggesting with any of this that some PE deals are not attractive. Some are.
As in my last piece, I’m also not listing the names of the firm I’ve referenced. The point is not to call out any specific firm, as these practices are widespread.
I’m just hoping, for the good of the industry and investors, that the people and firms who pitch PE returns that no investor receives and volatility that no investment experiences will…
For more related to this, see the new post from my friend, Blair duQuesnay