A Private Equity Blog

A vignette into the aberrant thoughts of a private equiteer

Blog > Anti-PE > Private equity returns are misleading – Part II

Private equity returns are misleading – Part II

View Comments

Wake Up & Smell...It seems I’ve ruffled a few feathers with my previous post, Private equity returns are misleading (lots of emails and even a few comments over at Seeking Alpha). The main point of contention is that limited partners (LPs) don’t hold committed capital as cash from day one. Someone even suggested it was ludicrous to make this assumption and that the premise of my argument collapses as a result.

However, that’s not the point I was making. Of course LPs time their cash flows across their portfolios, which is probably the reason why so many have defaulted on capital calls recently. If anything, this supports my argument rather than refutes it. So let me make my points a little clearer (I concede my last post was a little rushed):

If you hold all of the committed capital in cash from day 1, then you are exposed to the normal risk of a private equity investment. However, the return of the investment must take into account the risk-free rate on the cash for the entire period it is held in cash (before it is called).

If you do NOT hold all of the committed capital in cash from day 1, then you increase the risk of the investment. If you default on a call, you destroy massive amounts of value (except in rare cases). Therefore, the risk you are exposed to is not just the risk of the private equity investment and hence the return should be considered in light of the higher overall risk. Even then, any loses or gains from activities designed to meet capital calls should be accounted for in the overall return.

I’m certainly not suggesting private equiteers are misleading LPs, but more that we all mislead ourselves through blinkered analysis. Investment returns must be risk-weighted to mean anything and to be compared like-for-like. It’s convenient for most of us to forget the risk of default, even in the wake of the GFC when such ludicrous assumptions led to cataclysmic outcomes.

twitter: @privateequiteer |

Posted in Anti-PE, Firm & Fund, Theories & Ideas

«
»
  • Hey Aakar. Great stuff. What was the reason for starting with 10.4%? Is that an average return for VC for a particular period? The reason I ask is that most private equiteers would suggest much higher returns for their funds (of course reality doesn't always meet expectation).

    Either way, a 12.5% drop is still significant. Great to see the numbers to quantify the concept.
  • Here's my take at an example of what the effect of holding cash might have on the performance of a pe or vc fund: http://bit.ly/75sNdi I realize there's a lot more that goes into to figure out the true impact but at the core, there is definitely a difference, and I think it is material enough to impact investors - IF they were to hold committed capital as cash.
  • Great paper.

    It also brings up the point you mentioned... the reinvestment rate and IRR calculations.

    Makes you wonder what PE returns would be in an apples vs apples comparison with stocks or property or whatever else.

    Though each of those classes has its own similar nuances that need even more modelling and subjective assumptions.
  • Alex
    http://faculty.fuqua.duke.edu/~charvey/Teaching...

    You might find this paper of interest (though it's quite old) - I think it articulates several of your main points.
  • I thought you were arguing my side at first, but then I thought you might of had a point that the hedge of default risk shouldn't be taken into account.

    Anyway, it's all academic really, unless you're an LP or asset manager. We just try to do the best we can. Though it's nice to know if we're actually outperforming other asset classes.
  • vlade
    Hmm.. Seems I should improve my writing quite a bit, as I was in fact arguing your side. Looking at my entry again, I'm not surprised, as it's barely in English.

    What I meant is that there's a liquidity risk - and it's up to the investor to decide whether they are willing to hedge (and remove the risk, receiving known return), or not (and take the risk, but potentially earning less than in perfect hedge situation).

    Maybe other way is to look at it as an opportunity cost vs risk. If you hedge perfectly, you incur opportunity cost, but have no risk. If you don't hedge perfectly, you have liquidity risk, but you invested your cash in something.
    What you invested in is limited by your liquidity requirements though, so you still incur some opportunity cost - limiting your investment choices is not costless.
  • Hi vlade. So are you saying it's immaterial and therefore not relevant in analyzing returns?

    I would have thought that it's immaterial when you're comparing investments that have exposure to the same risk, but not otherwise. For example, if comparing investments in two stocks, they both have systematic risk, therefore you shouldn't work in the cost of a delta hedge into the equation.

    However, if comparing an investment in a stock to an investment in gold, you should account for the storage cost of gold in the returns, because it's required for the gold and not the stock. If you didn't account for the storage cost, then you'd be favoring the investment in gold.

    Not sure if that makes sense... or whether it's even a valid argument.

    So my thinking with private equity, as an asset class, is that we can't just say "private equity outperformed public markets by X%" because there is a bias. In the case of holding the committed cash, the bias is ignoring the lower return on that cash. In the case of not holding the cash, the bias is towards no account for the risk and potential loss of a default.

    I'm still not convinced of my own argument, but know that intuitively there may be something there.
  • vlade
    As a derivative person, I agree with the fact that there's an extra cost. You have a risk of future cashflows at unknown time. So you have a liquidity risk. A perfect hedge for the liquidity risk is keeping money at overnight (you can of course get better hedges if your period between the call and need to stump the money out is known, and even better if it can be done only on certain dates).
    Whether you take the hedge or not is immaterial - if you don't hedge (or hedge imperfectly), you take on some risk. The price of that risk is basically the made of what you do, the perfect hedge, and what would happen if you would need to put out the money and you didn't have them. So if you want to separate the fund return, you have to deal with it as if you peferectly hedged + actuall return of the fund. Again, whether you do it or not is immaterial (same as you can decide to delta hedge your position or not - which affects your portfolio return, but not return of any single instrument).
blog comments powered by Disqus