Is Private Equity a Low-IQ Approach to Finance?
I am faced with an intellectual dilemma and trying to resolve it. For me, it revolves around intellectual honesty above anything. I can't help but think that Private Equity is a lot of trite mish-mash with the industry growth stemming from statistical artifacts, leveraged beta, errors in institutional investor beliefs about persistence, high expected returns, diversification benefits, etc. (things that don't actually exist). I think PE is the goose that laid the golden egg on this forum, but it seems to me that not enough people comment about how benighted PE really is in the grand scheme of things.
In my mind, leveraged buyouts, at their heart, are no different from stock-picking ( I get the extra diligence and operational changes that goes into PE relative to public markets investing.). But at its heart, it is levered stock picking with massive illiquidity and no creative hedging options. I call it illiquid, long-only, levered, stock-picking (or ILL Stock-Picking, for short). Right now, I am seeing fundamental L/S equity investors get hammered time and again for lack of alpha generation. Yet, somehow ILL Stock-picking a la Blackstone and Apollo is the holy grail of alpha?
I compare this with alternative methods of investing/finance (stat arb, momentum, HFT.. even high-sample size areas like mortgages or commodities) and can't help but think that those forms of investing are more intellectually honest and not as riddled with empirical errors. Simulataneaously I notice that Blackstone is over twice as large by AUM as the next biggest quant fund and scratch my head. I understand that quant strategies may be harder to scale, but it seems like a labor market breakdown to funnel top talent and money to investment programs with questionable alpha generation.
Here is some scientific work to back-up the concerns I'm raising:
- Does Private Equity generate Alpha? - Here is how Eugene Fama, 2013 Economics Nobel Prize winner, would respond:
"We ... emphasize that if private equity managers have skill in choosing good investment projects and bringing them to fruition, the result is a return due to the human capital of the private equity managers. Labor economists would argue that this return goes to the human capital, that is, the managers. Talented private equity managers are the scarce resource here, not investors' capital. As a result, the fees of managers should be set so that private equity investors just get expected returns that compensate them for the high risks of the investments."
"Finally, because the returns to private equity investments have large idiosyncratic random components (in addition to high market sensitivity), a wide range of outcomes is likely purely by chance. It is then predictable that the lucky managers are anointed by investors and the media, and they are flooded with new money from investors, even when past performance is due to luck."
- Historical Performance - "Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective. Institutional interest in private equity has increased despite its mediocre performance in the past decade versus corresponding public markets, and weak evidence on the existence of an illiquidity premium. Although this demand may reflect a (possibly misplaced) conviction in the illiquidity premium, it may also be due to the appeal of the smoothed returns of illiquid assets in general."
- Performance Persistence - "The conventional wisdom for investors in private equity funds is to invest in partnerships that have performed well in the past. This is based on the belief that performance in private equity persists across funds of the same partnership ... Post-2000 we find little evidence for persistence in buyout funds, except for the lower-end of the performance distribution"
- Ex-Ante choice of top-performing PE Firms - If you are betting on pre-identifying good funds to join, then take a look at David Swensen over at Yale. He has been unable to meaningfully outperform the Cambridge Associates average PE return for the past 20 years. For reference, Yale's 20 year historical return on its leveraged buyout investments is 12.1%, while the 20-year PE industry average return, during the same period, according to Cambridge Associates is ~12.32% (this could be survivorship bias, but still quite embarassing if you ask me). If Swensen cannot outperform the PE index despite probably having access to "top decile managers", then why do you believe you can pick a PE firm that will generate gargantuan returns without it being a statistical artifact?
Yale Returns: https://static1.squarespace.com/static/55db7b87e4…
- Is Private Equity Due Diligence Cognitively Feasible? - Here is an interesting paper than comments on attention and judgement. I am skeptical that the 100+ page CIM/IC materials can be cognitvely processed correctly.
"What do we notice and how does this affect what we learn and come to believe? I present a model of an agent who learns to make forecasts on the basis of readily available information, but is selective as to which information he attends: he chooses whether to attend as a function of current beliefs about whether such information is predictive. If the agent does not attend to some piece of information, it cannot be recalled at a later date. He uses Bayes' rule to update his beliefs given attended-to information, but does not attempt to fill in missing information. The model demonstrates how selective attention may lead the agent to persistently fail to recognize important empirical regularities, make biased forecasts, and hold incorrect beliefs about the statistical relationship between variables. In addition, it identifies factors that make such errors more likely or persistent. "
- Executive Pedigree - "Our findings suggest that the 'best and brightest' do not appear to have a statistically significant edge when it comes to managing public companies. An elite pedigree-the type of pedigree favored by head hunters and corporate boards-is not predictive of superior management. One of the central rationales for Michael Jensen's campaign (increasing CEO pay by tying it to share price performance) appears, in retrospect, to have little empirical support. These credentials, however, are significantly overrepresented in the CEO biography database. The elite credentials thus benefit the individual, but there is little evidence that these credentials benefit shareholders."
In a word, I am hoping someone can systematically address the concerns I have raised through a rigorous scientific treatment - showing studies with alternative results and a narrative tying those results together to explain how PE got this big. I, for one, cannot see a narrative that explains PE's modern-day zeitgeist.