Our last note identified three reasons, beyond return expectations, for investors to invest in private equity. We focused on these three reasons because for both theoretical and empirical reasons, there is no separate "private equity premium" for investors to exploit. Investors in private equity should avoid being seduced by stories of high expected returns because fundamentally, private equity is just like every other active management strategy.

However, many otherwise sober-minded investors still allow expectations of high private returns to drive their private equity allocations. The line of argument is as follows: first, these investors represent so-called “patient capital” with long investment horizons. Second, relative to public equity, private equity has an illiquidity premium. Thus, because these investors represent patient capital, they can allocate capital and reap the long-term illiquidity premium. There are empirical and theoretical reasons why investors should be skeptical of this line of reasoning.

To understand why, let’s return to the simple framework from our earlier note. Behind this framework is the following premise: an investment in private equity is an investment in equity (1) The idea that changing the financing structure of a claim on corporate cash flows should make a difference to long-run returns, in addition to the change in financing structure itself, shouldn’t be controversial. But for some inexplicable reason it still is. . If we accept this basic premise, then our framework suggests the following: private equity returns (and fees) implicitly have four main components:

• Return smoothing

• Small cap and value exposure

• Leverage, and

• General partner alpha

Exhibit 1 applies this structure to look at aggregate private equity returns (2) The private equity return was derived from the Burgiss US LBO Total Return Index values reported in Figure 2, page 43 in Stafford (2020) ("Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting"). versus the smoothed returns to the Navega Liquid PE Index - a leveraged small cap and value index. All returns are evaluated net of fees. The exhibit shows that historically, simply levering a small cap value index produced the same average return (net of fees). This analysis shows that aggregate private equity returns have been driven by the combination of leverage and exposure to the small cap premium. In practical terms, investors need to form views on the level and direction of the long-term small cap value premium. As pointed out in earlier note, the small cap value premium reflects exposure to long run macroeconomic risk.

Exhibit 1 - Private Equity and Leveraged Small Cap Value Index Net of Fees Returns

A second important point emerges from the figures in Exhibit 1: historically, the aggregate alpha from private equity to investors has been basically zero. In practical terms, this point means that investors should treat their private equity managers just like any other active manager and evaluate these managers in terms of their skill in producing alpha, not solely the production of total returns.

Theoretically there are three reasons that we should not be surprised by these results. First, it is a matter of simple arithmetic that the net alpha produced by active managers is less than zero. Simply adding the cap-weighted returns on all managers (passive and active) yields the overall market return. After subtracting fees, we get that the aggregate net alpha is less than zero. The case of private equity returns is no different.

Second, in a capital market equilibrium there can be no distinct aggregate private equity premium — beyond what is captured by the small cap premium and after adjusting for leverage. To see this, consider the following simple thought-experiment: suppose all public equity was converted to private equity overnight, including the required change in financing structure. Would this mean that expected returns on the former public equity, accounting for the change in financing structure, suddenly increased from one day to the next simply because it is held in a  less liquid investment vehicle? We are highly skeptical. (3) Assuming greater leverage (i.e ratio of debt to equity) in private equity, expected returns increase, but only due to the greater leverage employed, not because the equity is held in a less liquid investment vehicle. .

Finally, the idea that in the long run private equity receives a liquidity premium beyond what is priced into the bond premium and underlying cash-flows' long-term growth risk also strikes us as a stretch. Precisely, investments in private equity represent “patient capital” and are held over long horizons. In other words, the capital allocated to private equity in these long run investors’ is not required to finance short-term liquidity and spending needs. Thus, private equity held over these long investment horizons is not exposed to illiquidity risk. Rather, as highlighted earlier, it is exposed to the same long horizon risk as its public equity counterpart, in turn primarily driven by changes in real economic growth trends according to our models. In other words, there is no illiquidity premium in private equity, rather, the private equity premium entirely reflects exposure to long horizon real economic growth risk.

In our view there are four implications for investors. First, they should think very carefully about what specific investment problem they are trying to solve with their private equity allocations. Second, they should critically evaluate the costs of all potential investment solutions to those problems. Third, they should evaluate the expected alpha from their private equity managers versus alternative sources of alpha, and carefully consider the relative costs of each alternative. Finally, they should identify the skills that differentiate private equity managers in alpha production, and evaluate their managers on the basis of those skills — in other words, investors should pay for alpha, not beta.