E267: Why 95% of LPs Misread Private Market Returns

Speaker 1 Greg, so you spent your career researching the markets as a distinguished professor of finance at UNC.

Speaker 1 To start from a research lens, why do you believe that alternatives investing is such a fertile ground for research?

Speaker 2 From a academic research perspective, it's just woefully under-researched compared to public markets.

Speaker 2 We've been doing a lot of work the last 10 or 15 years relative to prior to that, not just because alternatives have gotten to be more popular, but because we've finally gotten our hands on data that we think is research quality data.

Speaker 2 So we're able to answer a lot of what people would think are sort of low-hanging fruit type questions. But

Speaker 2 it's still very much a green space for academic research.

Speaker 1 So, the lack of research is why there's a lot of opportunities for research. Absolutely.

Speaker 1 So, clearly, the private world is growing significantly, both in terms of AUM as well as significance. Why has so little research gone in the space?

Speaker 2 There's always a lag for academic research. It takes a while for people to kind of catch on, to realize that something's important.

Speaker 2 So, you didn't really see serious academic research in the public market space until the 60s and 70s, even though obviously public markets had been around for a long time.

Speaker 2 What's really happened the last 15 years is in addition to getting access to more data, people have appreciated that these are real markets.

Speaker 2 More capital is getting allocated, and there's a real interest among our stakeholder base to learn more about them and do that through sort of an objective academic lens versus an industry, more marketing-oriented lens.

Speaker 1 And you just released your annual paper on private markets performance.

Speaker 1 Maybe you could explain why is it so difficult to answer a seemingly basic question, which is, do private investments outperform public investments on a risk-adjusted return?

Speaker 2 The real reason for this is because we don't observe returns for private assets. You observe things that sort of look a little bit like returns.

Speaker 2 You can use net asset values to sort of calculate things that look like returns, but those are not market prices. And we know that net asset values are smoothed.

Speaker 2 So in addition to just basically having it be difficult to get the data in the first place, the data that you get doesn't lend itself to the type of analysis that's usually done to calculate risk-adjusted returns.

Speaker 1 I previously had Professor Steve Kaplan on the podcast and he's created this Kaplan-Shor index. Tell me about that index and why is it so widely used in academia today?

Speaker 2 The Kaplan-Shor PME, public market equivalent, that's essentially the

Speaker 2 most widely used measure for doing risk-adjusted returns. The idea is pretty simple.

Speaker 2 It's trying to capture how would you have done in a particular investment versus if you had taken the same capital and committed it to a public benchmark.

Speaker 2 So for example, instead of investing in a buyout fund, you were to have the capital calls for that buyout fund instead invested in the S ⁇ P 500, let's say.

Speaker 2 So it gives you a pretty good apples-to-apples comparison in terms of what the performance in the private fund was versus whatever you think the appropriate public benchmark was.

Speaker 1 And how does that work? Maybe double-click on that because one is liquid, one is illiquid, one has capital calls. How do you smooth out those?

Speaker 2 It's actually a pretty simple calculation. I teach my students how to do it in a spreadsheet.

Speaker 2 You create a total return index with the public benchmark, and then you use that as the discounting factor in just a present value calculation.

Speaker 2 So, instead of using like a fixed interest rate or cost of capital, you actually use what the market returns were for each of the cash flows that that fund is experienced. So, you would discount,

Speaker 2 for example, all of the distributions back to the present using the kind of market return, and then divide that by a discounted value of all of the capital calls.

Speaker 2 And that ratio is essentially a market-adjusted multiple.

Speaker 2 So for example, a number like 1.2 would be equivalent to earning 20% more in the private fund than if you had invested in the public benchmark. So it's very intuitive.

Speaker 2 I mean, you can just think of it as a market-adjusted multiple.

Speaker 1 When you think about this index comparing private to public investments, what have been some insights that have come from this index?

Speaker 1 What are some lessons that institutional investors can learn from this public market and private market comparison?

Speaker 1 And how should institutional investors change their behavior in terms of how they invest?

Speaker 2 So, this big study that we just released, and it's freely available on our website for anybody that wants to look at it.

Speaker 2 We took what we think is the most comprehensive data set, the Burgess MSCI data set. We took it across all types of funds.

Speaker 2 So, not just private equity funds, we also look at real estate and infrastructure and private credit funds. And

Speaker 2 we have more than 30 years worth of data for a lot of

Speaker 2 these fund types, equity funds in particular. And we calculated what the risk-adjusted return was using things like the Kaplan-Shore PME.
We used some more sophisticated models too.

Speaker 2 And I think sort of the headline for equity is that buyout funds have done quite well on a historical basis, even after you risk adjust them, depending on what period you look at and what benchmark you use, things in the sort of 2% to 5% range better than the public markets.

Speaker 2 And interestingly, buyout funds have a market beta that seems to be about the same as the market. Like you would sort of think buyouts would be riskier because they tend to be at high leverage.

Speaker 2 But empirically, if you just let the data tell you what the beta is and you do that using a range of different models, you pretty much always get a beta of one.

Speaker 2 So that's saying that buyouts are about the same risk level. Is beta just shorthand for volatility?

Speaker 1 In other words, higher return, but same volatility around the return or is there more to it?

Speaker 2 No. So beta is essentially how much market risk you have.
So like the total volatility of a fund is going to be higher because there's going to be some idiosyncratic risk as well.

Speaker 2 So beta is just, you know,

Speaker 2 that's essentially what is the scaled correlation with the market index that you're using. And so to say that the beta is one just means that the market itself has a beta of one.

Speaker 2 It just means it's exactly the same amount of market risk as the market itself.

Speaker 1 I've been kind of trained to think about volatility and high volatility is good because it's higher returns, but obviously it's bad because the volatility of health and you're trying to smooth that out.

Speaker 1 How do you use beta in order to build the right portfolio?

Speaker 2 So this kind of goes back to like old-fashioned market widths portfolio optimization.

Speaker 2 And optimal portfolio theory tells us is that it isn't the total risk that matters because you can diversify away the idiosyncratic risk. What matters is only the market risk or the beta.

Speaker 2 And so, you know, importantly, beta is the thing that you should get compensated for.

Speaker 2 Like, if you have something that's really, really risky, but it's a diversifiable risk, you shouldn't earn a premium for that diversifiable risk. It's just the risk you can't diversify away.

Speaker 2 And that's what beta measures.

Speaker 2 So when you're thinking about, you know, sort of doing a discounted cash flow type of calculation, what matters is the beta of the asset, not the total risk of the asset.

Speaker 1 So in another way, if you do find an asset that's highly volatile, but with a beta of one, that's a superior asset within a total portfolio versus one that has lower returns with a beta of one.

Speaker 2 Absolutely. Yeah.
And so I think what's interesting about this, oh, that alpha, is that the definition?

Speaker 2 Alpha, so you can think of alpha as just being what's the total return that you earned minus what you would have earned in a similarly risky, you know, sort of market adjusted.

Speaker 2 If the beta is more than one, you got to lever up the market benchmark in order to properly compensate for the risk that you're going to.

Speaker 2 In this case, it would be so if it the same buyout returning two to five hundred percentage points that is the alpha yeah that is the alpha and it's you know and and it's pretty easy to calculate for buyouts because you can just take the difference between the market benchmark and index of buyout funds that we're looking at and in the case of our study what's also interesting is if you look at venture it's a very different story so venture has a beta that's much higher than one right so there the the kind of return hurdle is quite a bit higher because you need to be compensated for more risk.

Speaker 2 So even though venture has had higher returns on average than buyout funds, on a risk risk-adjusted basis, there's less alpha, essentially zero alpha in venture.

Speaker 1 What kind of data are we talking about?

Speaker 2 Well, it depends on the model. The lowest estimate that we've got is about 1.4

Speaker 2 for U.S. venture.
Higher estimates are in the range of like 2.3. So, you know, it's meaningfully higher regardless of what method you use.

Speaker 1 Do you still think that it's a good idea to invest into venture when you have access, when you have access to top quartile, or is that also something that you're challenging?

Speaker 2 This doesn't say anything about what any individual investor's experience is going to be.

Speaker 2 So if you have access to the best funds or you are able to select better funds, then yeah, your returns are going to be better than that average.

Speaker 2 We just simply take the pooled experience of all funds that we have data for to say what is the asset class as a whole done.

Speaker 2 So yeah, if you have access to the top venture funds, then you're going to earn positive alpha with very high probability because there's a lot of return persistence among those top funds or you can figure out who the next great VC is.

Speaker 2 That's a good investment for you. But if you're just throwing darts to pick your VC funds, you're not getting paid anything on a risk-adjusted basis.

Speaker 1 At the risk of asking a dumb question, let's say that you have a beta of two, and let's say you have diamond hands. You are completely cold calculated.

Speaker 1 You don't run for the streets when 95% of people do over a long enough period. Should you care about beta? And if so, why?

Speaker 2 The way that finance thinks about things is in terms of probabilities.

Speaker 2 And so, you know, if you have a really, really long horizon and you can never get cashed out, then that kind of positive, you know, long-run return experience will be good for you.

Speaker 2 But history is littered with long-run bad performance. I mean, think about investing in Japanese stocks in 1990, right?

Speaker 2 During the dot-com bubble, there was a 10-year period where stocks underperformed cash when the dot-com bubble burst.

Speaker 2 So you can have very long periods of time where even risky assets that have traditionally done quite well will underperform.

Speaker 1 And again, I'm ignoring behavioral finance, which for those that listen to podcasts know that I believe it's much more powerful than regular finance because people are ultimately human beings.

Speaker 1 But let's just ignore behavioral finance for a second. Is the practical risk there that there's a risk of ruin?

Speaker 1 In other words, if you have a 2% beta and it goes down 20% for multiple years, you could literally be wiped out?

Speaker 1 Or what is the practical risk of these long time periods in the market where high beta assets are performing poorly?

Speaker 2 If you were to be invested in a high beta asset and you were not diversified, there is something that would be like a risk of ruin because

Speaker 1 you could be down 80, 80 90 potentially um and certainly people that actually lever portfolios blow themselves up that happens uh you know in the hedge fund um world pretty regularly why warren buffett says which is why charlie munger says leverage is one of the three things that could ruin your career said another way if buyout is a one beta and you wanted to take a similar risk to let's say venture let's just say it's 1.75 x beta one could actually lever up their buyout investment and they would have the equivalent amount of risk that's one way to think about it.

Speaker 2 And at least historically, you would have had a better risk return profile doing that rather than investing in venture directly.

Speaker 2 Again, if you sort of had the combined experience of investing in all venture funds.

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Speaker 1 So within your research, you found 200 to 500 basis points, 2% to 5% outperformance on buyouts. It's obviously a non-trivial dispersion.
What accounts for some of that dispersion?

Speaker 1 And what are some practical tips that institutional investors can take away in order to build out maybe something that gets closer to that 400 or 500 basis point outperformance?

Speaker 2 So it depends on time period.

Speaker 2 So some of the time periods have been better than others. We kind of look at three 10-year sub-periods.
It depends on what benchmark you use.

Speaker 2 And the benchmark can make a lot of difference, especially over a shorter window.

Speaker 2 It actually turns out that if you use a small cap versus a large cap benchmark, it doesn't matter a lot over the full 30-year period. But certainly.

Speaker 2 more recently having a large cap benchmark has been a tougher hurdle because large caps have outperformed small caps the last 10, 15 years or so. And then also geography matters quite a bit.

Speaker 2 So one thing that we found is that despite underperforming on an unadjusted basis, non-US private equity has actually done better on a risk-adjusted basis.

Speaker 2 And so what we mean by that is like compare U.S. funds to a U.S.
benchmark and compare European funds to a European public benchmark. Because foreign stocks overall have underperformed U.S.
stocks,

Speaker 2 you get a little bit better relative return when you're looking internationally.

Speaker 2 So actually, venture internationally has done okay

Speaker 2 because the foreign markets haven't done very well. So what looks looks sort of like underperformance in just unadjusted terms is actually better relative performance.

Speaker 1 And you care about these relative outperformance in markets because when you're building your portfolio, your diversified portfolio, you invariably want exposure to certain parts of the world or certain markets in the world.

Speaker 1 So, that relative outperformance is relevant versus just the absolute performance.

Speaker 2 There's different ways to think about it. One is if you have an asset allocation model, and part of that is saying you want to be in global stocks.

Speaker 2 I mean, I think of buyouts and venture as just you know, another form of equity.

Speaker 2 And so you might think I'm going to have a split of my foreign equity that's more tilted towards private markets if I think they're going to perform better.

Speaker 2 Whereas in the U.S., maybe I'm more tilted towards public markets. So you can think about it in that sense.

Speaker 2 But the other one is if you're just wanting to know, like, do foreign buyout funds or venture capital funds add value? The answer is yes, if you use the proper benchmark.

Speaker 2 Whereas you might think the answer is no if you were to, say, use a U.S. benchmark to evaluate foreign managers.

Speaker 1 And practically that assumes that you would have exposure to not just U.S., which so it's a context of a public portfolio that you could even make a relative statement on the private portfolio.

Speaker 2 So I think if you're going to be allocated to global stocks and private is an option for you, you want to think like, where is it that I'm going to get the best relative performance in global equities?

Speaker 2 And I think at least historically, you've gotten kind of even better relative performance outside the U.S. than in the U.S.

Speaker 1 So let's talk about fund size. What does your research say about large buyouts, small buyouts, and does that play a factor in returns?

Speaker 2 So we did a study that we released last year that again sort of used this really large comprehensive data set over a very long period of time to look at this question around scale.

Speaker 2 And what we found was that the average return for smaller funds was higher than for big funds, but that that was driven by dispersion.

Speaker 2 It was driven by the fact that there's just a much bigger right tail in smaller funds than you see in the large funds.

Speaker 2 So essentially, you're averaging in some really seller performers among small funds to get to that higher average.

Speaker 2 If you instead look at the median performance, there's basically no difference in the median fund across size groups.

Speaker 2 So, you know, if you if you want to sort of go fishing in the most productive pond for buyout funds or venture funds, this is true for venture as well.

Speaker 2 The best place to go is the small end of the market. You need the skill to identify who those top performing are going to be.
Just a random draw doesn't do it for you.

Speaker 2 And because these are private funds, you can't sort of buy an index. You can't buy everything.

Speaker 2 So you need to feel confident that you have the skill to wade through what's a pretty large set of managers

Speaker 2 on the small end and find the ones that are going to be those top performers, because that's what drives the higher average.

Speaker 1 So in smaller funds, you want to be selective.

Speaker 2 And larger funds it's hard to do well it's hard to do poorly yeah i think the practical implication is it's probably not worth your time doing a lot of due diligence on the big uh the big funds because they are you know the return uh experience is pretty similar there's just not that same level of dispersion so you know maybe if you're going to have some you know mega funds you know throwing darts is fine but you definitely don't want to do that at the lower end of the market you want to use your due diligence budget to go um try to find some smaller managers that are going to be real winners one of the other areas of research that you focus on is persistence of returns, which is if one manager does well, how likely is he or she going to do in their next vintage?

Speaker 1 In venture, persistence has remained to be present, meaning that if you pick a manager that does well, he's more likely than on average to do well again.

Speaker 1 In buyouts, that persistence has lowered significantly over the last 15 to 20 years. Why is that?

Speaker 2 It's an interesting question. There's some research that sort of documents it

Speaker 2 pretty reliably. I'd say that what was significant persistence up until about 2010 vintage or so has pretty much gone away

Speaker 2 at the GP level.

Speaker 2 But interestingly, what's happened is people have started to analyze the deal partners' performance and found that there is persistence if you actually look at the individuals who are doing deals.

Speaker 2 And these, what explains that difference is that people are moving around firms. And you can imagine a story where what's happened was people cut their teeth and were doing really well at

Speaker 2 a big buyout shop,

Speaker 2 but they weren't the founders and the partners. They weren't getting the economics they thought they deserved.
And so then they went off on their own or joined another firm or something.

Speaker 2 And so they kind of took that talent with them, whatever ability it was they were using to create value. And so the persistence followed them versus staying with the original GP.

Speaker 1 What's kind of a mind twist here is that if you follow the incentives, the most rational thing is that for that manager that has unique deal flow or unique ability pick is for him or her to leave, but it's also for that GP within that firm to let that person leave because there doesn't seem to be a correlation between the performance as well as their ability to accumulate assets.

Speaker 1 So both actors could be acting in completely rational ways. And the rational thing is for the person to leave and start a firm.

Speaker 2 Especially when you think that some of these very large firms are essentially asset gatherers now and earning the bulk of their profits through fees versus carry.

Speaker 1 And just to add another layer of incentives there, the LP's incentives, which many times in public pensions, I think it's 5.3 years or something, they're average in that position.

Speaker 1 Their incentives is actually to chase these brands and to chase these asset gatherers as stamps on their resume rather than actually bring long-term asset appreciation to their underlying asset manager.

Speaker 1 So it's these perverse incentives across the entire spectrum.

Speaker 2 If you're working at a public pension, you know, it's, it's the, you know, IBM issue, right? Nobody gets fired for

Speaker 2 buying IBM

Speaker 2 is the old saw. And it's the same thing with like these major GPs.
So, you know, it's very low risk for people who have little upside in their careers

Speaker 2 to

Speaker 2 sort of take the big established brands. And I think the other challenge is if you look at public pensions in the U.S., I mean, so many of them are under-resourced and understaffed.

Speaker 2 They just don't have the bandwidth or resources that it takes to go out and do diligence on, you know, a large number of relatively small or new GPs.

Speaker 2 And they rely on consultants who are also going to bias towards the big name brand folks. So I think there are clearly inefficiencies in the system and

Speaker 2 how it gets sorted out. I don't know.
I mean, there's other more sophisticated folks that are sort of investing in the smaller funds, obviously. And so I think those are going to tend to be

Speaker 2 endowments and foundations and other sorts of commercial entities, sovereign wealth funds that do have the resources to do that research.

Speaker 1 When we last chatted, one of my takeaways from our conversation is that venture is about being picked. And in other words, the founder picks the VC and buyout is about picking.

Speaker 1 So there is actually this skill of picking where venture, I would argue, the skill is actually getting picked. To what extent do you agree to that?

Speaker 2 The evidence does suggest that VC is more of a relationship type of business and having that reputation,

Speaker 2 having the access and the network, that's where the value is going to be created. Not that they don't do anything on the kind of operational advising side.

Speaker 2 I mean, I think there are firms that add a lot of value through that, but it is more of this kind of relationship-oriented business.

Speaker 2 And that is why I think the performance persists in venture, because people, the founders want to be with the top VC firms and the VC top VC firms get to see the best deal flow.

Speaker 2 And so it sort of makes sense that that network is going to stay intact. Whereas I think buyout is very different.

Speaker 2 I mean, if you think about

Speaker 2 the larger end of buyout space, I mean, effectively most stuff is being sold through auctions now.

Speaker 2 And so like, you need to really think, why am I going to be the best bidder, the highest bidder for this asset?

Speaker 2 You need to have some sort of skill that revolves around value creation in order for you to justify

Speaker 2 why you're going to be the highest bidder. Essentially, what's your comparative advantage to add value? Otherwise, there's going to be a kind of a winner's curse in the big buyout space.

Speaker 2 And I think when you move down a lower middle market, then it is very much about

Speaker 2 building a process for identifying companies where, first of all, you find the companies, because in some cases it's just you need to go out and beat the bushes to find viable investments.

Speaker 2 But then what does your playbook look like for adding value? And is it compatible with the types of companies that you're able to identify?

Speaker 1 To double-click the term they use, comparative skill in large buyout, which is all the large buyouts have similar playbooks.

Speaker 1 In order to outperform that large buyouts, you need to have something very different. And the research seems to suggest that something doesn't really exist on average.

Speaker 2 The returns are definitely more compressed on the high end.

Speaker 2 So, you know, if you were talking about alphas in the neighborhood of like two to 500 basis points, for the large funds, it's going to be more like 200 basis points, right?

Speaker 2 It's going to be on the lower end.

Speaker 1 It is alpha in all in large buyouts versus the public markets, but not necessarily between the different managers. The Mac 7 last several years has just done incredible.

Speaker 1 QQQ outperformed most venture funds.

Speaker 1 If you assume that this was a once-in-a-generation thing where the large, large caps outperform, does that make an even stronger argument for private equity buyout or is that already priced in?

Speaker 2 It's interesting to just think about what's happened in the last few years with the MAG 7.

Speaker 2 Basically, if you weren't in those seven stocks, your return experience was very different, even in public markets, right?

Speaker 2 And so we've done our benchmarking against sort of a value-weighted total market portfolio. That's kind of our preference.

Speaker 2 If you were to do this benchmarking on sort of a size match, so you say use small cap stocks or a small cap value for buyouts, which sometimes people do, then the numbers actually look a lot better historically.

Speaker 2 But recently, I mean, everything has lost in Mag 7, right? Just about, I mean, except maybe gold or Bitcoin or something.

Speaker 2 But I mean, if you think about equity investments, private or public, been extremely difficult. What does this mean for investors in private equity?

Speaker 2 And I think there's kind of two kind of bookend answers to that. And the truth is probably somewhere in between.
One is that

Speaker 2 private markets had its day.

Speaker 2 We're not going to see the same kind of returns going forward that we've seen in the past.

Speaker 2 The opportunities and large cap growth. And so why even bother with private equity? Because

Speaker 2 it's performance the last three to five years has been subpar compared to public markets.

Speaker 2 The other, and maybe you'll like this being the behavioral person, the other explanation is that we're in the midst midst of a bubble, right, in public markets, and the Mag 7 are going to come back down to Earth.

Speaker 2 And so staying invested in private markets is the right thing to do.

Speaker 2 In fact, it's probably a preferable thing to do if there's a bubble that's going to deflate because they haven't experienced that kind of bubble run up the same way that the Mag 7 has.

Speaker 2 And I think there is a historical precedent for this.

Speaker 2 If you look at the relative performance of private markets in the early aughts when the dot-com bubble was bursting, that was the best relative returns ever for private markets. The alphas

Speaker 2 that we calculate, these kind of PME type of market-adjusted returns, were double-digit percentage for the vintages from like 2000 through 2005.

Speaker 1 Because the pets.com, the web vans were public companies, so they just got clobbered. And the private versions of them performed much better on a relative basis.

Speaker 2 Yeah. It's not true of venture, but for buyouts, the performance was okay for those vintages, but the public markets were so bad that the relative performance was fantastic.

Speaker 1 The prevailing wisdom is to look at it as a class as if the valuations are constant. So early stage, it's as if you're always investing $20 million valuation or say Series A had $75 million.

Speaker 1 But of course, that's absurd because if you take into extreme, if everybody leaves Series A, the valuations go down. And if everybody goes in, the valuations go up.

Speaker 1 And we've seen both sides of the story.

Speaker 1 So there is a game theory aspect to it, which is oftentimes the best time to be in asset classes is when everybody's away from them.

Speaker 1 Now, that's not always the case because sometimes you have, for example, private equity buyout. They have a lot of dry powder.

Speaker 1 So even though a lot of people aren't necessarily net new investors there, they still have a lot of money from the previous cycle. So it doesn't always work as a heuristic.

Speaker 1 But I do think there's this bias to look at asset classes as if the valuation is fixed, which doesn't make sense.

Speaker 2 I think that's right. And I think we have seen what looks to be a pretty big divergence between public and private market valuations right now.
And I mean, private market valuations are depressed.

Speaker 2 That's why exit activity has been so low. People just don't like what they can sell stuff for right now.
At the same time that in the Mag 7, valuations are just off the charts.

Speaker 2 This isn't like advocating for private equity, but if I was forced to

Speaker 2 put all of my money in either the Mag 7 or a diversified private equity portfolio, I would definitely pick the diversified private equity portfolio because it is more diversified.

Speaker 2 If you could put me in 20 different buyout funds right now, go to the secondary market and buy some with different vintages and different strategies, that just feels like a much more prudent investment than even the SP 500 that's now a third Mag 7 value.

Speaker 1 Yeah, the SP 493, as some people call it. Right.
Well, Greg, this has been an absolute masterclass. Thanks so much for jumping on.
Look forward to continuing this conversation live.

Speaker 2 It's my pleasure. Thanks for having me.
Thank you.

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