Investing in private assets can lead to higher returns when compared to public markets, at least over the longer term. In this last of our three-part overview* on private asset investing drawn from our recent paper, we look at how private asset outperformance – the illiquidity premium – can be seen as compensating investors for their willingness to lock up capital for five to 15 years, the usual lifecycle of private equity and private debt investments.
Private equity firms, in particular those involved in buyouts, appear to have had persistently higher returns than the US S&P 500 equity index over the past 30 years, net of fees. One recent study shows that US private equity buyouts, including management fees, outperformed the S&P 500 by 2.3% to 3.4% a year between 1986 and 2017.
This outperformance appears to persist even when the public equity indices are adjusted to better reflect the nature of the companies targeted by private equity, for example, by using small capitalisation benchmarks.
The study covering the 1986-2017 period showed that US private equity buyouts outperformed the Russell 2000 index, comprising 2,000 small-cap US companies, by 2.3% to 4.3% a year. This is even more remarkable when considering that the Russell 2000 does not include management fees.
Leverage, small-cap and value exposures
Despite such results, the question of whether typically higher leverage private equity outperforms public equity remains hotly debated. Yet the same study cited above shows that when comparing the performance of US buyouts to a leveraged Russell 2000 at 1.2 times, the excess returns remain positive.
In assessing the performance of private equity versus public equity returns, numerous studies use Public Market Equivalent (PME) as a metric. One study based on PME finds that all US buyout vintages between 1994 and 2014 outperformed the S&P 500. The results were similar when using the Russell 2000 index. For global private equity, another study reached a similar conclusion: buyout pooled returns outperformed the MSCI World index on a PME basis in 19 out of the 20 measured vintage years (1999–2018).
Should private equity buyout benchmarks include a tilt towards value stocks because buyout targets tend to trade at lower valuation multiples than the market? Research shows that US buyout funds have historically outperformed public market indices even after adjustments for leverage (beta), and small-cap and value exposures.
Paying an illiquidity premium
When high-quality capital is scarce, private equity firms typically pay an illiquidity premium to investors less sensitive to liquidity shocks, that is, targeting investors who can provide long-term capital and have a higher tolerance to illiquidity, thereby potentially realising higher returns.
While the academic literature on private debt is scarcer, it too tends to show evidence of an illiquidity premium relative to other forms of debt.
One study looked at the performance of private debt funds by collecting timed cash flow data on 448 funds listed in Preqin with vintage years from 1986 to 2018. The average of those vintages of private debt funds realised a 9.2% internal rate of return net of fees for investors between 1996 and 2020.
The study compared the performance of the private debt funds with those of public investment-grade (IG) and high-yield (HY) bond benchmark indices using the public market equivalent method. Here, private debt outperformed the IG and HY benchmarks by 8% and 6%, respectively, over the period of retention of the fund, i.e., about 0.9% and 0.7% a year, respectively, assuming an average life of nine years for each vintage.
It seems clear that private assets tend to outperform public assets, often with lower risk. This is supported by various studies and research papers, and our own analysis of benchmarking performance data. This outperformance can be seen as an illiquidity risk premium – basically compensation to investors for the risk of holding illiquid assets over prolonged periods.
For more on investing in private assets, visit our private assets page