Investors beware: Private equity funds don’t always live up to their reputation

According to a new study in The Journal of Finance, private equity has average returns roughly equal to the S&P 500 (net of management fees). This contradicts the myth that private equity outperforms the public market benchmarks by 4%-6% annually. However, there is large variation in performance across private equity partnerships. We also find that there is a significant amount of persistence in private equity, not only among successful funds but also for the unsuccessful ones. Successful private equity groups tend to continue to be successful, while poorly performing investments tend to continue to perform poorly.

This persistence result is very different from the results for other asset classes like mutual funds and hedge funds where persistence, if it exists at all, is modest or minimal. Moreover, the study demonstrates a cyclical pattern to investment flows into private equity. Investment flows into the industry tend to increase after periods of good private equity performance and decreases after poor performance. Subsequent returns to private equity are lower after periods of large investment inflows and vice versa for out flows. Interestingly the study finds that returns of established funds with good track records are much less affected by the industry cycles than the returns of young funds (especially those that enter in boom times).

This study has important implications for investors. Because there is such a large range of performance among various firms, investors need to be selective to find funds that have proven consistently successful. The wise investor will not simply assume that these investments will do significantly better than investments in public markets.