The private equity industry justifies its high fees to institutional investors in part by claiming that PE allocations improve a portfolio’s diversification.

While there may be individual PE firms that can deliver this kind of uncorrelated outperformance, there is significant evidence that the industry in the aggregate provides few services for its investors that cannot be obtained elsewhere at far lower cost.

Diversification has often been called the one free lunch in economics.

That is because the tradeoff between risks taken and returns earned can be improved by adding cash flows to a portfolio that have a positive expected value and are uncorrelated to each other.

For an extremely simple example, you can imagine a world with two assets.

Investors who have a buy-and-hold strategy with asset A earn 3% (above t-bills) every odd-numbered month (January, March, etc.) and lose 1% (relative to t-bills) every even-numbered month, while investors who own asset B lose 1% every odd-numbered month and gain 3% in every even-numbered month.

Either asset by itself generates a decent return over time, but a portfolio that combines both is much better because the gains of one asset more than cancel out the losses of the other.

Of course, in the real world it is impossible to achieve this kind of perfect diversification.

One reason is that you cannot know how an asset will perform in advance. Yes, there are plenty of data out there about historical correlations, but correlations are not constant.

Back to private equity.

It so happens that Fidelity, the mutual-fund company, offers something that sounds quite similar to PE (buy smaller companies with lots of debt), but without the 2% management and 20% performance fees.

The best part is that the 10-year returns of this product (15.8% annualized), which I am not endorsing in any way shape or form, are significantly higher than the 10-year returns  generated by the PE industry on behalf of their limited partners after fees (13.7% annualized), according to Cambridge Associates.

Intriguingly, the differential in performance is extremely close to what you would get if you took the numbers from Fidelity and subtracted out private equity fees. This would be tolerable for investors if PE firms compensated for their underperformance by providing diversification benefits.

However, it does not seem that this is the case. Both the mutual fund and the PE industry did well and did badly at the same times over the past decade.

One defense offered by the PE industry is that their performance is less volatile than that of a mutual fund.

This may be true in theory (performance fees reduce measured volatility but not in a way that is helpful to investors.)

In practice, however, the supposedly lower volatility provided by private equity does not really exist. The problem for investors in PE funds is that they cannot easily cash out of their position. This illiquidity means that investors are still exposed to wild swings in value if they ever try to sell their stakes early.

During the crisis, the Stanford University endowment needed cash and was forced to sell its PE holdings at steep discounts.

Putting it all together, it is difficult to see why sophisticated investors choose to allocate such large shares of their portfolios to active managers that fail to outperform cheap replicas.

It seems like an interesting area of study, doesn’t it??

Source: THE ECONOMIST – Free Exchange Economics

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As a professional service firm with international operations, we specialise in managing complex change solutions for different companies. apcore guides clients through Organisational Changes, Innovation Management and New Business Model Designs, as well as implement Innovative Management Strategies and Internationalisation processes thanks to our expertise and experience in various sectors.
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