Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.
Although its definition is muddled, private equity most commonly refers to a managed pool of raised or borrowed funds. These funds are explicitly used for obtaining an equity ownership position in smaller companies with growth potential. Private equity firms encourage investment from wealthy sources by boasting greater return on investment (ROI) than other alternative asset classes or more conventional investment options.
- Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020.
- Between 2000 and 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital.
- When compared over other time frames, however, private equity returns can be less impressive.
- A high degree of risk tolerance and the ability to handle substantial illiquidity are necessary for success in private equity markets.
Historical Returns of Asset Classes
The U.S. Private Equity Index provided by Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020. During that same time frame, the Russell 2000 Index, a performance tracking metric for small companies, averaged 6.69% per year, while the S&P 500 returned 5.91%.
It is clear that an investor taking a risk with private equity would have received a much higher return than those who chose the more conventional route of investing in an ETF that tracked a popular index. Furthermore, the Cambridge Associates U.S. Venture Capital Index averaged just 5.06% per year between 2000 and 2020.
When compared over other time frames, however, private equity returns can be less impressive. For example, venture capital was the top performer between 2010 and 2020, with average annual returns of 15.15%. Furthermore, the S&P 500 slightly edged out private equity, with performance of 13.99% per year compared to 13.77% for private equity in the 10 years ending on June 30, 2020. On the other hand, that was still better than the 10.50% average annual return of the Russell 2000 during that time.
Differences in Valuation of Public and Private Equity
While it is generally easy to determine the price and performance of publicly-traded companies and funds, private equity and venture capital present additional issues. For public companies, one can simply observe market prices and measure the changes in prices to obtain the historical returns.
There are a variety of methods for valuing private companies. One approach is comparable company analysis, but that only works if there are public companies similar to the private company in question. It is also possible to calculate the book value of private companies if their balance sheets are available.
The best estimates of private company valuations are usually made by private equity firms. Firstly, they need accurate estimates in order to know how much to pay when they invest in private companies. After buying in, private equity firms will also need a steady stream of reliable data, such as balance sheets, for decision making and providing information to their investors.
The major issue with using valuation metrics, such as book value, for comparing private equity returns with public equity is that they behave quite differently than market prices. For example, book value is much less subject to short-term swings in market prices. One would therefore expect private equity to underperform public equity during bull markets and outperform in bear markets. It can be argued that this is somewhat artificial. It might be more accurate to compare the performance of private equity to the change in the book values of public companies instead of their market prices. However, these differences tend to even out in the long run.
Comparisons of public and private equity returns tend to be more accurate over longer time frames.
Drawbacks of Private Equity
Although private equity can be a lucrative investment option for high-net-worth individuals, it is not the only alternative asset class that provides attractive returns. Investors interested in private equity, venture capital, or other alternatives should be aware that their potential for higher returns also comes with higher risk. A high degree of risk tolerance and the ability to handle substantial illiquidity are necessary for success in private equity markets. In some cases, it can take a year or more to sell investments in private equity.