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.
Key Takeaways
- 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 an average annual return 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 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.
FAQs
Key Takeaways
How much does private equity return compared to other asset classes? ›
According to Cambridge Associates, for the 20-year period ended in June 2020, PE had average annual returns of 14.65% compared with the S&P 500, which had average annual returns of 5.91% over the same period. However, these high averages are not the case every year.
How is private equity different from other investments? ›
Key takeaways
Public equity refers to ownership in publicly traded companies, which are available to anyone with an investment account. Private equity has historically higher returns but isn't available to everyone and has downsides that include higher risk, higher fees, and lower liquidity.
How does private equity make returns? ›
Private equity firms buy companies and overhaul them to earn a profit when the business is sold again. Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.
What is the return of the private equity index? ›
Annual returns
So far in 2024 (YTD), the S&P Listed Private Equity index has returned an average 7.79%.
What is the return rate for private equity? ›
Over a 21-year time period ending June 30, 2021, private equity allocations by state pensions produced a 11.0% net-of-fee annualized return, exceeding by 4.1% the 6.9% annualized return that otherwise would have been earned by investing in public stocks.
Does private equity have better returns? ›
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.
Why do investors prefer private equity? ›
Low correlation to other asset classes: In terms of performance, Private Equity funds are less volatile than listed markets. Diversification: You can diversify away from more traditional asset classes.
How does private equity investing compare with public market investing what are the similarities and differences between the two? ›
Public investors build wealth by accumulating stocks. By contrast, private equity investors get paid through distributions. Since investors who invest in public stocks can easily trade shares on public exchanges, they have the advantage of liquidity over private equity investment.
How is private equity different from traditional investments? ›
Private equity (PE) is ownership of (or an interest in) an entity that is not publicly traded. Often, it is high net worth individuals and/or firms that purchase shares of privately-held companies or acquire control of publicly-traded companies (and possibly take a public company private).
Performance in private equity investing can be measured using the internal rate of return (IRR), the multiple of money (MoM), and the public market equivalent (PME).
How are private equity returns different from venture capital? ›
Value Creation / Sources of Returns: Both firm types aim to earn returns above those of the public markets, but they do so differently: VC firms rely on growth and companies' valuations increasing, while PE firms can use growth, multiple expansion, and debt pay-down and cash generation (i.e., “financial engineering”).
How is private equity return calculated? ›
RVPI = NAV / LP Capital called - Distribution to paid-in (DPI) represents the amount of capital returned to investors divided by a fund's capital calls at the valuation date. DPI reflects the realized, cash-on- cash returns generated by its investments at the valuation date.
What are average PE returns? ›
Average annual returns for PE can range from 10% to 20%, but this can differ significantly based on the fund's strategy, vintage year, and economic conditions. Investment Horizon: PE investments typically have longer investment horizons, often spanning five to ten years or more.
What is the target return for private equity funds? ›
Target private equity returns vary depending on the specific investment strategy and whether the investment is direct or through a fund structure, but typically they will be around 2.0x-5.0x capital returns within five years. Often there will be an opportunity for upside.
Is there persistence in private equity returns? ›
In buyout, historical data suggests a similar pattern of persistence. Seventy percent of funds that followed a first-quartile performer generated an above-median return. Other studies have, however, demonstrated a waning of this pattern of persistence in more recent vintages.
How much does private equity return compared to the S&P 500? ›
Not including fees, the median private equity return for the six largest publicly traded private equity managers in the first quarter was 2.4%, compared with 7.5% for the S&P 500 index, the report said.
What is the 2 20 rule in private equity? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
Is return on equity higher than return on assets? ›
This equation tells us that if a company carries no debt, its shareholders' equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same. If that company takes on financial leverage, ROE would rise above ROA.
What is the average preferred return in private equity? ›
Stated as a percentage or equity multiple, preferred return is often favored by investors since the sponsor's “promote” or profits participation is subordinated up to a specific return threshold, generally 8 to 10 percent.
