If you’ve been reading this newsletter for some time you might have noticed we are not big fans of private equity. We’ve been very critical of performance, specifically performance reporting (IRR is close to useless in our opinion). Well today we want to put some #s behind our criticism.
TL;DR:
- Using performance #s from Blackstone we see a majority of their PE funds have underperformed a simple S&P 500 investment.
- Using cash flow level data for Bain Capital funds, you’re better off investing in a simple S&P 500 ETF.
- All this without taking into account that PE funds use leverage and are significantly riskier than public markets.
Blackstone (BX) is a $125Bn publicly traded alternative asset manager. They recently had their 3Q earnings call and they put out a presentation which has a couple of slides with their funds’ historical performance. This gives us a chance to look at the data and analyze how good their returns have really been. This is obviously one small sample of the entire PE universe and doesn’t represent the entire private equity universe but it will give us a glimpse of how performance isn’t what it seems (also if BX is $125Bn company they must have done something right). Also, they just give us IRRs and MOIC, to really analyze then in detail we would need to have cash flow level data. Of course they don’t provide that so we have to make a couple of simplifying assumptions.
The presentation has net IRRs and net MOICs for 15 private equity funds. For this analysis we’re going to focus on the subset that started on or before 2016 so that we only look at funds which have either already wound down or are close to doing so. To do the comparison we’re looking at returns for the S&P 500 (which isn’t exactly comparable, but it’s good enough). Since we don’t have cash flow data, what we did was look at the MOIC (MOIC measures how many $ you got out for every $ you put in), vs. how much you would have made if you had invested in the S&P 500. We’re assuming a fund life of 10 years.
Out of the 10 funds that match this description, only 3 outperformed the S&P 500 over the same time period, in other words a hit rate of only 30%. Ok well maybe those 3 funds that outperformed were huge winners? Nope, if you had invested equal amounts in every single fund you would have made 2.14x your money (essentially the average MOIC over the funds). If you would have done the same thing on the S&P 500 you would have made 2.2x your money. And this doesn’t even account for the fact that PE uses leverage in their funds. If we had invested in the S&P 500 with a modest amount of leverage (25%), we would have made 2.73x our money!
To give you an example of why IRR is so misleading let’s take BXs first fund, BCP 1 which started investing in Oct 1987. It had a net IRR of 19% and a MOIC of 2.6x. The S&P 500 over that same time period had a CAGR of 17.15% and a MOIC of 4.87x. So how can it be that BCP 1 had a higher return but a lower MOIC? This is the fundamental flaw of IRR. IRR assumes that when you get distributions back from funds, you can keep reinvesting them at the same rate (which is almost never true). Therefore, this inflates IRRs and makes them NOT comparable to CAGRs. A CAGR is a compounded annual growth rate. Therefore if you see a CAGR of 10%, it means that if you invested $100 for 1 year you ended up with $110. If you invested for 2 years you have $121 ($100 * 1.1 * 1.1 = $121), 3 years you have $133.1 and so on. This is the magic of compounding, you earn returns on your returns. That extra dollar in year 2 is the 10% return on the $10 you made the first year. With compounding you start making money at an accelerated rate; year 1 $10, year 2 $11, year 3 $12.1. PE doesn’t allow you to compound since you cannot reinvest your gains.
Granted this isn’t the perfect way of doing this analysis. In reality PE funds don’t give all the money back at the end so you could reinvest that money. For the BX funds we don’t have cash flow data so we cannot calculate that. However, we do have cash flow level data for a couple of Bain Capital funds which have done much better than BX’s funds (full disclosure we were investors in these funds).
We chose the best performing fund, Bain IV and an ok fund, Bain VI. These two funds had net IRRs of 55.61% (amazing compared to any BX fund which highest was 39%) and 12.35%, and MOICs of 3.7x and 1.74x respectively. Over the same time period, the S&P 500 returned 4.49x and 2.44x. So again, these funds underperformed a simple investment in the S&P 500.
Since we have cashflow level data we can do some interesting calculations. The simplest way to adjust IRRs is to change the fatal flaw; assuming you can reinvest at the same rate. There is a formula called modified IRR (=MIRR() in Excel), which lets you specify your financing rate (how much you earn on the committed but not yet called money), and the reinvestment rate (at what rate you can reinvest the money that has been distributed).
Taking Bain IV and using MIRR with a financing rate of 4.52% (average 3 month treasury returns over the period) and a reinvestment rate of 11.89% (average S&P 500 return over the period); the return goes all the way down to 10.13%. And Bain VI (using 3.65% and 6.95%, relevant returns over that time period), the IRR drops from 12.35% to an MIRR of 5.44%.
And the cherry on the cake of all this is that we did this analysis just looking at returns, we haven’t even mentioned anything related to risks, leverage, liquidity etc. So do PE managers generate value? For sure they do, here we’re looking at net returns; but they typically charge 2% management fee and 20% performance fee and have a bunch of fund expenses baked in. They underperform the market, but on a gross basis (if you add back all the fees and costs), they do outperform; it’s just that they keep all the outperformance for themselves.
There’s a saying which is very apt to apply here. To clarify, the general partner (GP) in the fund is the manager of the fund they manage the fund, charge fees, etc. The limited partners (LPs) are the investors which provide the money. The saying goes: “at the start of a PE fund the GPs come with the experience and the LPs come with the money, by the end, the GPs leave with the money and the LPs with the experience”.
