Private Equity Groups and Total Stock Market

[Paullmas]

If certain companies, and hence, certain parts of the market, are held by private equity groups, then parts of the market are not available to the public. Therefore, when one purchases total stock market index funds, there are companies that missing from one's portfolio. Since one is to believe private equity firms are purchasing companies to beat market averages (otherwise why buy these companies) how does this impact risk and returns over both short and long time spans, if any?

[arcticpineapplecorp.]

the argument has been made in the past by Rick Ferri (at his core 4 portfolios):

Privately held companies tend to be much smaller than publicly traded ones, and they are bought and sold at lower multiples based on known private equity transactions. Over time, the returns of private equity funds are comparable to small-cap value indices. There is a growing body of academic research supporting this view.

source: https://core-4.com/total-economy-core-4-portfolio/

so if you want private equity but want mark to market and greater liquidity (which private equity does not provide) then hold some small cap value index fund in your portfolio.

[alex_686]

This is deeply debated and a ongoing subject in my field. The data is very thin and incomplete.

I can make a solid argument for adding PE to a portfolio. However there are lots of qualifications that I would have to add.

That being said, a total market fund is fairly efficient, giving good returns for the risk given. The next step up is fairly high.

To make this actionable, why are you trying to do?

[exodusNH]

If certain companies, and hence, certain parts of the market, are held by private equity groups, then parts of the market are not available to the public. Therefore, when one purchases total stock market index funds, there are companies that missing from one's portfolio. Since one is to believe private equity firms are purchasing companies to beat market averages (otherwise why buy these companies) how does this impact risk and returns over both short and long time spans, if any?

The fees kill you, unless you're putting in $10M+. One ex-Vanguard CXX even put the number at $1B.

The vaunted 2&20 really winds up being 2&50 / closer to 8%. They take their 2% regardless of how they're doing AND you don't get credit for the losers. So, you wind up with the loss and they take 20% of the profits on the winners.

There can be other less trackable inefficiencies as well. E.g., the PE group buys a hotel and replaces all the mattresses. The mattresses are purchased from a partner's brother-in-law. Maybe they are a deal. Maybe they are 1% more than what could have been the best price.

For the average investor, PE is essentially "returns smoothing as a service" since they don't regularly publish valuations (so you don't get to see crazy daily swings that cause so much hand-wringing ) and you don't get anyway to judge whether the valuations make sense.

And on top of all of that, your money is typically locked up for a long time.

[Intrepyd]

In his awesome book “Investing Amid Low Expected Returns,” Antti Ilmanen argues that private equity does not outperform public equity, and their performance is perfectly explained by well publicized and publicly available factors (value, momentum, profitability, etc). In fact, there is data indicating that an illiquidity discount actually exists in private equity, not an illiquidity premium. The argument is that investors pay for the privilege of not having the returns marked to market, which causes an artificial smoothing of private equity returns—something investors seem willing to pay for.

[afan]

Private equity is a very expensive way to invest. The fees are enormous. So high that most studies conclude one is better off without them. There is no performance persistence, so knowing that a particular sponsor has done well in the past tells you nothing about how they will do in the future. The way PE results are reported are so different from those of public stocks or funds that it is very difficult to compare the two. And they are risky.

I think there is a very good argument that PE pays well for the sponsors (due to the fees) but not for the investors.

In my opinion, nowhere close to worth it, but each to their own.

If you are curious, there was a good Rational Reminder podcast on the subject, along with references.

[Elbowman]

Since one is to believe private equity firms are purchasing companies to beat market averages (otherwise why buy these companies) how does this impact risk and returns over both short and long time spans, if any?

I'm sure they try, but what makes you think they succeed at effectively another form of stock picking? Public companies make acquisitions as well, are they worse at it then PE?

[alex_686]

If certain companies, and hence, certain parts of the market, are held by private equity groups, then parts of the market are not available to the public. Therefore, when one purchases total stock market index funds, there are companies that missing from one's portfolio. Since one is to believe private equity firms are purchasing companies to beat market averages (otherwise why buy these companies) how does this impact risk and returns over both short and long time spans, if any?

The fees kill you, unless you're putting in $10M+. One ex-Vanguard CXX even put the number at $1B.

The vaunted 2&20 really winds up being 2&50 / closer to 8%. They take their 2% regardless of how they're doing AND you don't get credit for the losers. So, you wind up with the loss and they take 20% of the profits on the winners.

There can be other less trackable inefficiencies as well. E.g., the PE group buys a hotel and replaces all the mattresses. The mattresses are purchased from a partner's brother-in-law. Maybe they are a deal. Maybe they are 1% more than what could have been the best price.

For the average investor, PE is essentially "returns smoothing as a service" since they don't regularly publish valuations (so you don't get to see crazy daily swings that cause so much hand-wringing ) and you don't get anyway to judge whether the valuations make sense.

And on top of all of that, your money is typically locked up for a long time.

The average fee is 1.4% of the assets and 14% of the return over the hurdle rate. i.e. if the benchmark is the S&P, they would get 14% of the returns above the risk-adjusted return that the S&P generated.

i.e. the contract should be structured to reward hard work, and not for the PM to load up on risk and throw darts at the wall.

Maybe it isn’t great but it not as bad as you make it out to be.

Note, they normally use some custom benchmark index, not a investable index like the S&P. But I am not going down that path.

[mikejuss]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

[exodusNH]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

[mikejuss]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

Huh [shaking head in incredulity].

[exodusNH]

If certain companies, and hence, certain parts of the market, are held by private equity groups, then parts of the market are not available to the public. Therefore, when one purchases total stock market index funds, there are companies that missing from one's portfolio. Since one is to believe private equity firms are purchasing companies to beat market averages (otherwise why buy these companies) how does this impact risk and returns over both short and long time spans, if any?

The fees kill you, unless you're putting in $10M+. One ex-Vanguard CXX even put the number at $1B.

The vaunted 2&20 really winds up being 2&50 / closer to 8%. They take their 2% regardless of how they're doing AND you don't get credit for the losers. So, you wind up with the loss and they take 20% of the profits on the winners.

There can be other less trackable inefficiencies as well. E.g., the PE group buys a hotel and replaces all the mattresses. The mattresses are purchased from a partner's brother-in-law. Maybe they are a deal. Maybe they are 1% more than what could have been the best price.

For the average investor, PE is essentially "returns smoothing as a service" since they don't regularly publish valuations (so you don't get to see crazy daily swings that cause so much hand-wringing ) and you don't get anyway to judge whether the valuations make sense.

And on top of all of that, your money is typically locked up for a long time.

The average fee is 1.4% of the assets and 14% of the return over the hurdle rate. i.e. if the benchmark is the S&P, they would get 14% of the returns above the risk-adjusted return that the S&P generated.

i.e. the contract should be structured to reward hard work, and not for the PM to load up on risk and throw darts at the wall.

Maybe it isn’t great but it not as bad as you make it out to be.

Note, they normally use some custom benchmark index, not a investable index like the S&P. But I am not going down that path.

I do trust your numbers. The ones I mentioned were based on these podcasts.

Rational Reminder did a deep dive here: https://youtu.be/VcZzRoKwe6g?si=Y5TISoWsdxB8zftO This was the one that demonstrated that 2% was anywhere from 8-12%.

Former Vanguard CIO discussed it here: https://youtu.be/Qq69bTBWnQE?si=X6w1-I0ZHXRJyxOa This is where he mentioned the $1B value.

And they recently briefly touched on it here: https://youtu.be/NLS1Ol4dkWc?si=FfzqPX1vY_KFSYmh And here is the 2&50. It echoed much of the same that was discussed in the first video.

[alex_686]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

Huh [shaking head in incredulity].

On a more serious note, why does one invest in a mutual fund? A mutual fund is a investment structure, PE is a investment structure. Nobody invests because of the investment structure.

Just like there are many different flavors of mutual funds, there are many different flavors of private equity. Some promise stellar returns like a lotto ticket, others promise something slower and steadier.

There are parts of the market where large public companies just don’t thrive.
So often a promise of higher returns than a similar public companies with a low correlation.

[alex_686]

I do trust your numbers. The ones I mentioned were based on these podcasts.

Rational Reminder did a deep dive here: https://youtu.be/VcZzRoKwe6g?si=Y5TISoWsdxB8zftO This was the one that demonstrated that 2% was anywhere from 8-12%.

Former Vanguard CIO discussed it here: https://youtu.be/Qq69bTBWnQE?si=X6w1-I0ZHXRJyxOa This is where he mentioned the $1B value.

And they recently briefly touched on it here: https://youtu.be/NLS1Ol4dkWc?si=FfzqPX1vY_KFSYmh And here is the 2&50. It echoed much of the same that was discussed in the first video.

Anything that isn’t a video? I don’t have time to wade through all of this. Sigh.

I tend to favor the written word, preferably something dense.

For context I have worked on the fringes of PE, hedge funds, and private REITs. More familiar with academic literature and white papers here.

[mikejuss]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

Huh [shaking head in incredulity].

On a more serious note, why does one invest in a mutual fund? A mutual fund is a investment structure, PE is a investment structure. Nobody invests because of the investment structure.

Just like there are many different flavors of mutual funds, there are many different flavors of private equity. Some promise stellar returns like a lotto ticket, others promise something slower and steadier.

There are parts of the market where large public companies just don’t thrive.
So often a promise of higher returns than a similar public companies with a low correlation.

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

[Makaveli]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

Huh [shaking head in incredulity].

On a more serious note, why does one invest in a mutual fund? A mutual fund is a investment structure, PE is a investment structure. Nobody invests because of the investment structure.

Just like there are many different flavors of mutual funds, there are many different flavors of private equity. Some promise stellar returns like a lotto ticket, others promise something slower and steadier.

There are parts of the market where large public companies just don’t thrive.
So often a promise of higher returns than a similar public companies with a low correlation.

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

PE may not be a good investment from the outside.
If you’re on the inside (employee at PE company) and can invest your own dollars heads up with the parent company, then it’s a different story.

[alex_686]

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

Because it isn’t a inherently bad product. Nor a good one. It is a complex thing that covers multiple asset classes. It has its uses.

Lets not use a overly broad brush to tar everything here nor invent boogie men to scare the children.

[mikejuss]

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

PE may not be a good investment from the outside.
If you’re on the inside (employee at PE company) and can invest your own dollars heads up with the parent company, then it’s a different story.

This is interesting. I have no reason to doubt you. But could you post some verifiable stats on what the ROI is for those who work in PE and invest in their own companies?

[mikejuss]

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

Because it isn’t a inherently bad product. Nor a good one. It is a complex thing that covers multiple asset classes. It has its uses.

Lets not use a overly broad brush to tar everything here nor invent boogie men to scare the children.

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

I'll ask you too: do you have any stats you can share about private equity returns?

[alex_686]

I'll ask you too: do you have any stats you can share about private equity returns?

Used to, when I worked in that field. Now I have moved on to something more exotic. I would suggest a trip to a good academic library associate with a good MBA program. They should have the data.

But even then, as I suggested above, the data isn’t real great. I mean, I can say that about almost ant investment data. Currently I an having fun with the holes in Treasury market data.

Reading the tea leaves then, PE isn’t a complete disaster nor a sure win. There are cycles which favor PE, then punish them. Some classes of PE can do well while others do poorly.

If a mutual fund is a 4 door sedan that us used for a uber, then some PE funds are a custom tour bus that you rent out to rock-n-roll stars while others are F-250s with a cherry picker on the back. Its hard to make a straight comparison. (I know people who do both and make good money, but it isn’t exactly a turn key operation)

Like I mentioned above, I can make a modest case for PE. Highly dependent on the portfolio’s goals. Highly dependent on the PE funds.

[alex_686]

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

The fee structure isn’t that bad.

You do want that 2% fee - which you may have negotiated down to 1%. The underlying asset is complex. If the investment stumbles - and many do - you do not want the fund to cut back on operations. i.e. skimp on accounting, risk management, insurance payments, etc.

The 20% (or maybe only 10%) only kicks in if you clear the hurdle rate. i.e. you pay only if the manager added real value.

Or at least in theory. Some contracts are put together better than others. Practices vary.

And the quality of the stats are pretty bad. PE funds don’t have to publicly report their returns, prices lag, return methods vary. This is true also of hedge funds and REITs.

[mikejuss]

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

And the quality of the stats are pretty bad.

So on what basis are you arguing that PE is worth investing in?

[mikejuss]

I'll ask you too: do you have any stats you can share about private equity returns?

Now I have moved on to something more exotic.

As in even more private equity?

[mikejuss]

I'll ask you too: do you have any stats you can share about private equity returns?

But even then, as I suggested above, the data isn’t real great. I mean, I can say that about almost ant investment data.

Is the data on S&P 500 index-fund returns bad?

[alex_686]

I'll ask you too: do you have any stats you can share about private equity returns?

Now I have moved on to something more exotic.

As in even more private equity?

Nope, opposite direction. But I am at a point that my wife can’t describe what I do for a living. It is a very obscure niche.

[exodusNH]

I do trust your numbers. The ones I mentioned were based on these podcasts.

Rational Reminder did a deep dive here: https://youtu.be/VcZzRoKwe6g?si=Y5TISoWsdxB8zftO This was the one that demonstrated that 2% was anywhere from 8-12%.

Former Vanguard CIO discussed it here: https://youtu.be/Qq69bTBWnQE?si=X6w1-I0ZHXRJyxOa This is where he mentioned the $1B value.

And they recently briefly touched on it here: https://youtu.be/NLS1Ol4dkWc?si=FfzqPX1vY_KFSYmh And here is the 2&50. It echoed much of the same that was discussed in the first video.

Anything that isn’t a video? I don’t have time to wade through all of this. Sigh.

I tend to favor the written word, preferably something dense.

For context I have worked on the fringes of PE, hedge funds, and private REITs. More familiar with academic literature and white papers here.

I know it's a lot, but the interviewees are published academics. The first one in particular is a tenured professor of financial economics at Oxford, which he achieved at 39/40. He specializes in PE, and is the author of "Private Equity Laid Bare." He's got a bachelors of economics, a masters of economics, a masters of mathematical finance, and a Ph.D in finance.

I think Rational Reminder posts transcripts on their main site, https://rationalreminder.ca/.

[alex_686]

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

And the quality of the stats are pretty bad.

So on what basis are you arguing that PE is worth investing in?

We often have to make decisions involving incomplete data. For example, returns on housing data has holes that I can drive a truck through. Yet I can make a decent argument on why people should invest their capital into a home. Or even rental units. Ir even real estate.

A bit more specific to your point, the PE funds being peddled today are different than the PE funds of 30 years ago If that is the case than I certainly can’t use the historical data straight.

Investing isn’t like the hard sciences.

[mikejuss]

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

And the quality of the stats are pretty bad.

So on what basis are you arguing that PE is worth investing in?

We often have to make decisions involving incomplete data. For example, returns on housing data has holes that I can drive a truck through. Yet I can make a decent argument on why people should invest their capital into a home. Or even rental units. Ir even real estate.

A bit more specific to your point, the PE funds being peddled today are different than the PE funds of 30 years ago If that is the case than I certainly can’t use the historical data straight.

Investing isn’t like the hard sciences.

This is hardly a ringing endorsement. I appreciate your honestly. Bottom line, I'd say PE is way too murky to confidently invest in.

[alex_686]

I'll ask you too: do you have any stats you can share about private equity returns?

But even then, as I suggested above, the data isn’t real great. I mean, I can say that about almost ant investment data.

Is the data on S&P 500 index-fund returns bad?

Yes. I mean, what could you possibly use it for? Could you be more specific?

We can go into how the weights are off from the free float calculations or why certain companies are or are not included (Tesla being a great example).

End of day prices are really wonky, with surprising fat tails. I have gone deep in other threads about the difference in mutual fund and ETF pricing. (I have stuck the NAV of a fund. I have been in a room full of accountants trying to figure out what the end of day price of a stock is).

We have moved from one secular period to another around 2020. i.e. a change in the fundamentals of the underlying economy. So one really shouldn’t link the pre 2020 data with the current.

Would you like me to go on?

[Paullmas]

I'll ask you too: do you have any stats you can share about private equity returns?

Now I have moved on to something more exotic.

As in even more private equity?

Nope, opposite direction. But I am at a point that my wife can’t describe what I do for a living. It is a very obscure niche.

Plastics?

[Paullmas]

The reason for the question was I was reviewing the composition of the funds I am holding. And noted some big companies that should be doing well now (but could not check as no longer listed) and certainly not in the composition. Found out they were now in private equity hands and that got me wondering.

[Valuethinker]

It seems many people above do indeed believe private equity is an inherently bad product. The fee structure looks pretty obviously bad to me.

And the quality of the stats are pretty bad.

So on what basis are you arguing that PE is worth investing in?

We often have to make decisions involving incomplete data. For example, returns on housing data has holes that I can drive a truck through. Yet I can make a decent argument on why people should invest their capital into a home. Or even rental units. Ir even real estate.

A bit more specific to your point, the PE funds being peddled today are different than the PE funds of 30 years ago If that is the case than I certainly can’t use the historical data straight.

Investing isn’t like the hard sciences.

AFAIK because of tax rules American individual investors struggle with PE investments. Unless you are wealthy enough to have good tax advisers who can slug through all the reporting.

In Britain we have Closed End Funds that invest in Private Equity (either directly or more likely as part of a fund-of-funds). Returns have been good (with wide dispersion) but ultra cyclical. Fees are high to very high (if I can believe the expense ratio disclosures now legally required - I have questions about the basis). Many of the funds are trading at c 40% discounts to NAV, suggesting widespread disbelief in private portfolio valuations of the constituent funds.

Our tax system does not flow through capital gains. So as long as the fund doesn't pay a dividend, it doesn't create a taxable event. And if it does pay a dividend (most due) that may be classified as Eurobond interest income (higher rate of tax) or as dividends (was a lower rate of tax).

[Valuethinker]

The reason for the question was I was reviewing the composition of the funds I am holding. And noted some big companies that should be doing well now (but could not check as no longer listed) and certainly not in the composition. Found out they were now in private equity hands and that got me wondering.

We had discussions a few years ago on this Forum.

The number of listed companies in the USA has been on a decline since the late 1990s. Something like a halving of total listed companies.

Many of these are now in the hands of PE funds. It's become a whole new sector of the financial economy.

You also have things like Private Credit funds which are in some ways disintermediating banks -- and also give exposure to this "hidden economy".

How this all plays out I don't know. It means that the listed US stocks may be less and less representative of the total investing universe.

Nonetheless equity index funds offer the best low cost way of "owning the market". But you won't find Koch Industries in there (world's largest private sector oil refiner?). Nor Ineos (one of the world's largest private chemical companies, founded in UK but HQ'd in Switzerland). Nor the Portfolio of CVC, Cinven etc (to name top European PE managers), Advent International.

[nisiprius]

One rationale for a total market index fund is that, under the usual set of idealized assumptions, the market portfolio (the collection of all stocks traded in a stock market) is "mean-variance efficient." It has the highest risk-adjusted return, as measured by the Sharpe ratio. This provides a reason for using a cap-weighted total market portfolio.

Some of the idealized assumptions include rational participants, an efficient market, etc. But an important one is that it be a market, within which investors can trade easily and frictionlessly.

This assumption does not carry over into collections of separate markets. By definition private equity does not trade in any stock market.

It also does not carry over into "the economy."

To decide whether it makes sense for something that is not clearly a market, you need to ask how closely it approaches the "frictionless trading" assumption. For example, the US stock market is not really a single market. The first web search hit I got says there are 13. The NYSE and the NASDAQ are merely the two biggest. However, in practice, trading is so fast and so low-cost that it behaves essentially as one market.

Notice that this is not true for international stocks. There is no such thing as "the global stock market," there are about a dozen national stock markets (counting those with have capitalizations over $1 trillion). They trade in different currencies, so there is definitely friction from currency conversion.

And it is not true for private equity.

Private equity is not "missing" from the Vanguard Total Stock Market Index Fund because it is not a part of any unified market together with stocks.

[cableguy]

People that invest in PE, and probably should invest in PE, are people that can buy $2M boats, belong to multiple private clubs, have multiple homes, etc. Most likely net worth is $50M+. Stay away from PE if you aren't in this club. Its risky business. Yes it can be rewarding....but you can also lose your shirt. My opinion...

[Valuethinker]

People that invest in PE, and probably should invest in PE, are people that can buy $2M boats, belong to multiple private clubs, have multiple homes, etc. Most likely net worth is $50M+. Stay away from PE if you aren't in this club. Its risky business. Yes it can be rewarding....but you can also lose your shirt. My opinion...

If you invest as a Fund Limited Partner (I believe the typical minimum ticket is $5m but I could be wrong) then you do have diversified exposure - -typically say 20 companies in a portfolio (for a 4-5 year active investing period, with returns coming from years 2 to 10 of the fund life, typically). Most buyout funds return 1-2x investments (3-4x is possible).

Venture Capital funds are much higher risk than Buyouts. Plenty of Venture funds do not pay back the investors' capital.

Caveats:

- you are paying very high fees for the privilege - "2 and 20". For the high performing venture funds (Swensen takes you through why you will probably never be an investor in that club) even higher fees, also typically for funds that invest in startups (which are much more labour intensive for the VC manager)

- buyouts have economic and credit cycle cyclicality. Barbarians at the Gate is about the takeover by KKR of RJR-Nabisco, in 1989/90. That investment nearly finished off KKR as a firm. The Texas Utilities investment led to something like a $20bn (equity) writeoff after 2008.

The theory is it gives you diversified returns, but the underlying correlation with the equity market cycles is there. Anti Illmanen is probably a good go-to person to read on all this.

[Makaveli]

The bottom line--per many of the posts above--is that private equity is not a good investment. So...what are you talking about? You seem to be missing the point here.

PE may not be a good investment from the outside.
If you’re on the inside (employee at PE company) and can invest your own dollars heads up with the parent company, then it’s a different story.

This is interesting. I have no reason to doubt you. But could you post some verifiable stats on what the ROI is for those who work in PE and invest in their own companies?

Only a few sample points, myself and two other colleagues at PE firms.

Nothings final until the exit yet we’re in a great place at the moment. Likely 3x ROI. One colleague isn’t doing as well, probably 1x or less. The other is doing well, 2-2.5x.

The upshot is that this route allows for investment where I have a direct influence in decisions (upper management) which gives me a sense of control (albeit truly not much). I realize this also increases concentration. Hence allocating 20% of my NW not 80% (what other colleagues have done).

[garlandwhizzer]

Broadly based portfolios of publicly traded stocks have a rather narrow range of return outcomes regardless of whether you use S&P 500, SC, MC, Value or Growth. SCV which is supposed by the research community to be the secret sauce has outperformed TSM by only 1% or less and that's using DFSVX, the premier SCV fund by reputation, as the representative of SCV instead of the mean or average SCV fund. This since 1993, 30 years ago. Not much difference and DFSVX had deeper drawdowns, greater volatility and a lower Sharpe ratio.

All non-beta strategies go through alternating periods of outperformance and underperformance that have up-cycles and down-cycles and after multiple decades it turns out that it is critical to be invested in something but it doesn't make a lot of difference which strategy you pick as long as it is low cost and widely diversified in publicly traded stocks. A lot of advertising and financial media dollars are spent to obscure this fact and to push investors into more costly approaches. Publicly traded stocks are heavily scrutinized by professionals and alpha when it appears gets arbitraged away quickly.

Private equity on the other hand is much more expensive, much more illiquid, and produces an extremely wide range of long term return outcomes. There are a few very big winners that you hear about and a lot more that substantially underperform beta after costs. It is a much more risky proposition to invest in either hedge funds or private equity IMO. Separating future winners in PE from future losers is an art, not a science, and very few PE managers are consistently good at that art and when they are good you pay for it with increased fees. The chance that readers of this forum are proficient at that art is very close to zero IMO. It's hard to know how either PE or hedge funds perform as a group because, unlike publicly traded stocks, they do not have to report quarterly or annual results. Winners often choose to report, losers almost never and many losers disappear as do many of the worst performing actively managed stock funds.

Allocating substantial money to PE or a hedge fund is iMO more like gambling than long term investing because of the wider range of outcomes incerased costs and illiquidity. I personally avoid Vegas, so I avoid them.

Garland Whizzer

[Jack56]

Lots of PE companies are publicly traded and if you hold the market index you will hold them and participate in any possible outperformance. If you believe that PE will outperform the market, dubious in my opinion, you can overweight that segment by buying individual PE managers -- their fees and hence the manager's revenues will have a performance elelement. There may even be an ETF devoted to them.

[garlandwhizzer]

There is an incredible amount of money from government and private pension funds flowing into both private equity and hedge funds now. This is because there is a large and growing mismatch between generous promised retirement benefits and their fund current assets given realistic expected forward returns on bonds and stocks. The numbers simply don't work given current assets from employee contributions, expected returns over the time horizon, and payment obligations at retirement. What to do?

Private equity, hedge funds, and other alternates to the rescue! They promise the chance for substantially greater than market returns long term. It is an easy decision for pension fund managers to make. They can avoid both of two very politically difficult options. Either substantially increase employee contributions, or substantially decrease retirement distributions for those employees later. Either of those likely result in loss of job for the pension managers, so that decision is a no-brainer.

This enhanced return optimism of PE is based on a substantial amount of literature suggesting that PE in particular has outperformed over the last 20 or so years even after costs. Almost all of this literature is authored and/or promoted by those who financially benefit from it, and is therefore in my view suspect. Reporting standards in hedge funds and PE are much looser than in publicly traded stock and bond funds and etfs. I am sure that there are big time winners in both hedge funds and PE. I am also sure that there are lots of losers after fees which can be quite large in this arena (1% - 2% + 20% profits).

I personally believe that true consistent investment skill is rare and even when found often does not persist. Is outperformance due to luck or skill? And will it persist for the next decade? Skill is iffy. On the other hand investment costs and fees are totally consistent, very real, and set a high hurdle to overcome. This is particularly so now, with so much pension money flowing into the private/alternate space. All spaces these days have limited potential alpha due to ever more heavily scrutinized markets by professionals. Not much left in publicly treaded markets. I believe there is more potential alpha in private firms than in publicly traded firms which have very strict quarterly reporting standards. There are some diamonds in the rough in private firms. One the other hand, more and more professional scrutiny goes into the private market as all this pension money flows into PE and hedge funds. Can PE/hedge fund managers harvest sufficient alpha to overcome their much higher cost structure and deliver improved returns for investors going forward? I do not know but personally I doubt it if you look at the group as a whole. There will be PE winners and losers but separating them prospectively is a big problem, just as it is with actively managed mutual funds and etfs.

Garland Whizzer

[Kbg]

I think it is also hard to ignore that the "most" successful companies on the planet generally end up in the top 10-25 holdings of a large cap index for long periods of time and in an open and transparent manner. PE vs. not PE is at its essence a rehash of the active vs. passive fund manager debate which this board is well familiar with.

The next huge thing/industry in the future, whatever it might be, will also eventually find its way into your pocket via an index. Cap weighted indexes are a very powerful concept.

I'm sure there are highly skilled managers in the PE space making boatloads of money for their clients...but can I pick or get entry to them? The odds are unfavorable. However, with a large cap index I can be certain that I will own a little bit of the best companies on the planet in the fastest growing sectors no matter what they may be now or in the future. The odds of that are 100%.

[unwitting_gulag]

Maybe I'm garbling/conflating several concepts here, but by "private equity" I understand (using that term loosely) the following:

1. Somehow, perhaps from the golf-course or a cocktail party, an individual is approached with a solicitation to invest in a start-up.

2. This individual does background research, called "due diligence", on the company and its principals.

3. If the due-diligence comes up favorably, the individual stakes a sum, typically several $M or tens of $M, at some agreed-upon valuation, to invest into the company. In exchange, besides his or her portion of equity, the individual gets a seat on the board, and sometimes even a C-suite position in the company.

4. The company then goes through several rounds of raising more funds, ideally each at successively higher valuation, while maturing its R&D, and bringing products to market.

5. Upon showing some established amount of revenue, the board then votes that the company approach an investment bank, either to act as broker or facilitator of private sale to some other company, or to go IPO.

6. Our hero then cashes out.... or, perhaps more likely, there's failure in step (4), and the investor's return is -100%.

Given the above, the only time that Wall Street enters the picture is step (5). Until then private equity is literally that - private.

[arcticpineapplecorp.]

If private equity is such a rip-off--and I don't doubt it is--why do so many rich people invest in it?

Exclusivity.

the allure of exlusivity.

they put a velvet rope outside the club to make those that get in feel special and those they keep out to feel envious.

[alex_686]

Maybe I'm garbling/conflating several concepts here, but by "private equity" I understand (using that term loosely) the following:

That is one flavor of PE, both in the initial and mid stages.

But the majority of action is elsewhere.

There is a fair slug of small and medium sized companies that are involved. Too big for a family, too small for Wall Street. I know a few family businesses where the 3rd generation non-managers wanted to cash out but the family managers wanted to stay in.

Another popular line are the turn around firms.

I am more familiar with the private REITs, a adjacent area. Apartment buildings sold to a dental practice’s retirement plan is the meme.

[Valuethinker]

Maybe I'm garbling/conflating several concepts here, but by "private equity" I understand (using that term loosely) the following:

1. Somehow, perhaps from the golf-course or a cocktail party, an individual is approached with a solicitation to invest in a start-up.

2. This individual does background research, called "due diligence", on the company and its principals.

3. If the due-diligence comes up favorably, the individual stakes a sum, typically several $M or tens of $M, at some agreed-upon valuation, to invest into the company. In exchange, besides his or her portion of equity, the individual gets a seat on the board, and sometimes even a C-suite position in the company.

4. The company then goes through several rounds of raising more funds, ideally each at successively higher valuation, while maturing its R&D, and bringing products to market.

5. Upon showing some established amount of revenue, the board then votes that the company approach an investment bank, either to act as broker or facilitator of private sale to some other company, or to go IPO.

6. Our hero then cashes out.... or, perhaps more likely, there's failure in step (4), and the investor's return is -100%.

Given the above, the only time that Wall Street enters the picture is step (5). Until then private equity is literally that - private.

That's Venture Capital. That's probably only 10-15% of the institutional money out there.

The majority of Private Equity is actually buyouts -- Leveraged Buy Out or LBO. Typically of mature companies, sometimes public, that have stable cash flows that can support raising of large amounts of debt from banks and CLO funds (indirectly). They may also subsequently issue junk bonds. This is where Mitt Romney made his fortune - as a founding partner of Bain Capital.

RJR Nabisco was the 2nd biggest buyout in history and was something like $60bn. Barbarians at the Gate is a masterful history of the deal. It nearly crippled the PE firm - KKR.

The largest I think was Texas Utilities - an electricity generator in Texas. It was done before 2008, and then with the Great Recession electricity and gas prices crashed, their hedges ran out, they couldn't service the debt. $20bn of equity in a something like $80bn deal (I am pulling these numbers entirely from memory so beware). Wiped out entirely.

Needless to say those are merely the big deals (that get a lot of publicity & coverage) and there are many many smaller deals that are quite successful.

Equity Office Properties (the largest REIT) was bought by Blackrock before the 2008 Crash and they exited successfully. So there's an example where it was a really bad sector to buy into (financial services is a big proportion of total office space rental), but due to skilful management by the PE fund, a good return was made for investors.

Mattress companies, the entire industry was owned by Private Equity players at one point.

[Paullmas]

One rationale for a total market index fund is that, under the usual set of idealized assumptions, the market portfolio (the collection of all stocks traded in a stock market) is "mean-variance efficient." It has the highest risk-adjusted return, as measured by the Sharpe ratio. This provides a reason for using a cap-weighted total market portfolio.

This assumption does not carry over into collections of separate markets. By definition private equity does not trade in any stock market.

If the public market was composed of a single company stock, say AAPL, and I invest in total market index, I really would not be diversified. That is my concern. As well as politics, though that is not mentionable here but true. Knowing or guiding what future regulations and laws are passed could leave certain investors holding a bag of grossly underperforming investments and other large investors holding a bag of golden goose eggs.

Appreciate the insights as well as confirmation that this is a valid concern and will become more so every year. However, there is no avoiding this risk, unless one gets into the group of large investors.

[exodusNH]

If the public market was composed of a single company stock, say AAPL, and I invest in total market index, I really would not be diversified. That is my concern. As well as politics, though that is not mentionable here but true. Knowing or guiding what future regulations and laws are passed could leave certain investors holding a bag of grossly underperforming investments and other large investors holding a bag of golden goose eggs.

But the US market isn't a single company. It's about 7500. The top few players ALWAYS dominate the market. It's how it's always been; the market has still been a fantastic investment overall.

Appreciate the insights as well as confirmation that this is a valid concern and will become more so every year. However, there is no avoiding this risk, unless one gets into the group of large investors

I don't think the concern is warranted. And even if it were warranted, the only way around it is to have $100M-$1B to invest in PE. If you have $100M in investible cash, you'd not worry about it since you could live off of 0.5% annual interest.