Private equity is widely regarded as a source of diversification and long-term outperformance. As a consequence, allocation to private equity in institutional portfolios has grown and is now significant. For example, private equity is the second most prevalent alternative asset in pension fund portfolios after real estate.

The authors focus specifically on buyout funds, which represent about 40% of the private equity universe, with the aim to establish how much value investments in buyout funds really add to portfolios.

On the face of it, investments in buyout funds add substantial value, with a body of evidence pointing to their significant long-term outperformance over the main public equity indices. But buyout targets tend to be relatively small, so it is more relevant, say the authors, to compare the performance of buyout funds with that of small cap indices. This comparison proves unfavourable for private equity: A previous study shows that the average buyout fund underperforms small-cap and value indices by some 3.1% a year over the life of the funds. This finding led the authors to wonder whether investors allocating to buyouts could actually be incurring an opportunity cost.

The key questions the authors seek to answer are: Are buyout investors adequately compensated for the risks they are taking? And would investors be better off investing in public markets, which provide more liquidity and, possibly, superior returns?

The authors conducted a bottom-up analysis of buyout transactions to try to fully break down the risks that buyout funds are taking. They found that, compared with public equities, buyout targets are, on average, smaller, their leverage is higher, and their sector focus is narrower than comparable publicly listed companies.

First, the average equity size of buyout investments is well below the minimum market capitalisation of public companies included in small-cap indexes. Second, buyout transactions have an average net debt-to-enterprise value of about 65%, which is considerably higher than the leverage of comparable publicly listed companies. Third, buyout funds invested almost 30% of their committed capital in consumer discretionary, which is 13% more than the weighting of consumer discretionary in the S&P 600 Index. At the same time, financials, information technology, and health care are significantly underweighted relative to the S&P 600 Index.

This initial analysis shows that it does not make sense to compare the performance of buyout funds directly with that of public equities. So, the authors decided to construct a public equity index with similar characteristics to the buyout universe and then use this index to assess whether buyouts still outperform.

At first sight, buyout funds outperform public equities by some margin. The authors found that, on average, the outperformance of buyout funds over the S&P 500 Index is 22% over the life of the funds. But compared with a public equity index with similar risk characteristics to the buyout universe, the outperformance is reduced by more than half—to just 10%.

The comparison becomes even more interesting when buyout performance is weighted according to the size of the vintage. Why? Because “value weighting,” as the authors describe it, takes into account the fact that buyout fund investments vary significantly by vintage. Early vintages tend to be smaller but have higher returns. In contrast, later vintages tend to be much larger but have lower returns, primarily because over time, competition for buyout assets has increased and buyout targets have become better managed, thus making it harder for private equity firms to generate value out of their investments. The authors point out that value weighting more accurately reflects the actual aggregate returns of buyout investors.

Using value weighting, the authors find that buyout funds do not outperform public equities whatsoever.

These findings could potentially deter some investors from allocating to buyout funds, thereby impacting fundraising by the private equity industry. After all, without clear evidence of outperformance, investors may be less likely to accept the illiquidity of buyout funds and undertake the extensive due diligence and governance processes that are required to invest in private equity.

However, the authors contend that even without significant risk-adjusted outperformance, buyout funds still serve a valuable role in portfolios. First, buyouts provide small-cap equity exposure and broaden the opportunity set beyond the public equity universe. Second, thanks to the dispersion of returns in buyout funds relative to public equities, investments in buyout funds present an attractive opportunity to exercise manager selection. Third, buyout funds may grant direct access to private investments, which can increase returns for investors.