Despite the promise of outsized returns and diversification, private equity often serves the fund managers better than the investors.
The Allure of the Illiquidity Premium
The pitch for private equity is theoretically elegant: by locking up capital in opaque, hard-to-access markets, investors should be compensated with an 'illiquidity premium.' Proponents argue that skilled managers can add value by bringing new information to private companies, justifying fees that often reach six or seven percent annually. This narrative has become so persuasive that even stalwarts of low-cost indexing like Vanguard have begun offering private equity access to their clients, framing it as a tool for long-term excess returns and expanded market coverage.
However, evaluating these claims requires moving past the marketing gloss. Private equity performance is typically reported using Internal Rate of Return (IRR), a metric that is not comparable to the time-weighted returns most investors see in their brokerage accounts. IRR is easily manipulated and does not represent actual investment growth. To truly understand the asset class, we must look at the Public Market Equivalent (PME), which compares private equity results to a benchmark index assuming identical investment timing. When we apply this rigorous lens, the 'outperformance' begins to evaporate.
Benchmarks and the Reality of Returns
Historical data shows that while private equity once delivered significant premiums, those days may be behind us. For fund vintages between 1996 and 2005, private equity did indeed outperform the S&P 500. But when compared to more risk-appropriate benchmarks—specifically small-cap value indexes—that lead narrows significantly. Since 2006, the data suggests that private equity in aggregate has performed about the same as, or even trailed, public small-cap equities. This is a critical distinction: if you can achieve the same return in a liquid, low-fee public index, the case for private equity collapses.
The industry also suffers from a 'billionaire factory' phenomenon. Research by Ludovic Phalippou highlights a striking disconnect: while private equity as an asset class has failed to deliver much value to investors after fees since 2006, the industry has minted dozens of new billionaires among the fund managers themselves. The skill in the industry is real, as evidenced by high gross returns, but the structure of the market ensures that the benefits of that skill accrue to the managers rather than the limited partners.
The Venture Capital Selection Trap
Venture capital (VC) presents an even more complex challenge due to its skewed distribution of returns. While the average VC fund might show a respectable PME, the median fund—the one in the middle of the pack—often significantly underperforms public equities. This indicates that a few 'home run' funds drive the entire asset class's averages. For the average investor, these elite funds are effectively out of reach; they have limited capacity and maintain exclusive relationships with existing institutional partners.
This creates a severe adverse selection problem. If you are being offered a spot in a venture capital fund, it is likely because the most sophisticated investors have already passed on it. Unlike public markets, where you can simply 'buy the haystack' through an index fund, you cannot easily capture the broad private market. In venture capital, if you aren't in the top-tier funds, you aren't just getting average returns—you are likely underperforming a basic stock portfolio.
The Diversification Illusion
One of the most persistent myths in private equity is that it provides diversification because its returns don't move in lockstep with the stock market. On paper, private equity looks remarkably stable, showing lower volatility and low correlation to public equities. However, this is largely an accounting mirage. Because private assets are not priced daily on an exchange, managers use cost-based or fair-value accounting that smooths out the bumps. This 'return smoothing' hides the underlying economic risk, which is often identical to that of leveraged small-cap stocks.
Research has shown that when private equity funds are forced to use more transparent fair-value accounting, their reported correlations with public markets spike. While this smoothing effect might help an investment manager keep their clients calm during a market crash, it doesn't represent a fundamental reduction in risk. It is simply a delay in reporting reality. Investors who prize this 'volatility dampening' are essentially paying high fees for the privilege of not knowing the true value of their assets in real-time.
Replicating the Strategy
If the goal of private equity is to capture the premiums associated with small, undervalued companies, investors can often do so more effectively through 'homemade' strategies. Studies have shown that a portfolio of low-priced, small-cap public equities, potentially combined with modest leverage, can replicate or exceed the returns of private equity funds. This approach offers several advantages: lower fees, daily liquidity, and the elimination of the manager selection risk that plagues private markets.
As of early 2022, the expected real return for U.S. buyout funds, net of fees, was estimated at roughly 5.9%. When compared to a global portfolio of public stocks tilted toward similar risk premiums, the returns reach parity. Given the lack of evidence for a distinct illiquidity premium and the high probability of being stuck with a mediocre manager, the private equity pitch loses its luster. Unless an investor has the rare ability to negotiate down fees or gain access to the most exclusive venture funds, the public markets remain the superior venue for building wealth.