E196: Professor Steve Kaplan: Do Privates Really Outperform the S&P 500?

0:00Why is Yale and Harvard getting out of private equity? That's a good question. I am not entirely sure, but I think it's a combination of things. I think, first of all, they are, you know, Harvard and Yale both have some liquidity issues. They probably felt they were a little too illiquid. And so by selling some of their private equity portfolio, they get more liquidity. I would guess, too, they looked at their portfolio and they saw some funds that they were either not too happy with or were happy to get out of. And third, I think the bid-ask spreads, I imagine, in the secondary market were tight enough that selling, they were able to sell it at what they thought were reasonable values.

0:56So I'd say those are probably the three things that have led to the sales. If Yale gave you a call, let's say Matt Mendelsohn, the CIO, gave you a call and said, how should I get liquidity in my portfolio? What would you advise? Yale, I think, allocates too much to hedge funds. Hedge fund performance has not been great over time relative to other things. So first of all, I get to reduce my hedge fund exposure. I also would say the same thing about infrastructure and real estate. So I would take my allocations a little different from Yale in order to get some liquidity. And then I'd be, go ahead.

1:42One of your research papers took a look at buyout, private equity returns between 2000 and 2017, and found that on average, buyout outperformed by 4 % versus S &P 500. Tell me about that research and how did you go about ascertaining that performance? This is all ongoing and I'm going to give you the most up-to-date numbers in a second. But the research started many, many years ago. No one really knew anything about private equity performance. And Antoinette Shore, who is at MIT, and I wrote one of the first papers looking at private equity performance. It was 2005. And we used data from venture economics.

2:27And we came up with a measure that is called the Kaplan-Shore public market equivalent that allows you to compare apples to apples, private equity, whether it's buyout and venture, with whatever index you choose. We chose the S &P 500. It turned out the venture economics data were bad. And I'm going to come back to that later when we talk about Ludo. Since then, I've been using the Burgess, now MSCI data, which are the absolute best data on private equity performance. They're much better now. Burgess gets their data from limited partners, usually institutional. So it's pension funds, sovereign wealth funds, endowments.

3:15And because those data sources are LPs, there's not a selection bias. They're getting the data from the buyout funds, the venture funds, whatever it is. And Burgess takes the data and then we have access to it. So this is now very, you know, it's data that are as clean as you can get. They're still not perfect because you don't know everything that's out there. But this is the best data there is. And so the most recent data, if you look at buyout funds in North America from 2000 to 2019 vintages, and those are good vintages because the data are through the Q1 of 2025. So the 2019 funds are at least five years old.

4:06And if you look at how those funds have done as of today and the more recent funds, there's still some, you know, they're not fully realized. It could move a little bit because of, you know, net asset values. But they are currently running at 360 basis points above the S &P 500 over that period. And or everything raised 2000 to 2019 as a 125 is 360 basis points over the S &P 500, which is, you know, spectacular. And it's why so much money went into private equity. If you then compare it to the Russell 2000, which is maybe a better benchmark for private extra buyout funds because they're not buying big companies, they're buying mid cap, it's 460 basis points.

5:04So the performance has been very good. Private markets, because there's lack of standardization and there's all sorts of biases, you mentioned one of these biases, LP derived data from GP derived data. There's also all sorts of marketing biases, standardization biases. It's actually incredibly valuable to have standardized data. So you created this Kaplan-Shore index. Tell me about what that index is and how did you normalize data from private equity to the S &P? There are two ways to look at it. One is sort of cumulatively, which would be sort of like a market adjusted multiple of the fund. So what it basically does is says, OK, if the private equity fund calls capital, let's say it calls a hundred million dollars, we put a hundred million dollars into the S &P 500 that day.

6:01And then over the life of the fund, when the fund, when that money comes back, let's say we get a$300 million realization five years later, we compare that$300 million to what you would have returned if you put the$100 million in the S &P 500. So if the S &P 500 went from 100 to 200 over that period and you got 300, that's a PME of 1.5. You have beaten the S &P 500 by 50%. The S &P 500 went to 400. Well, now it's 300 divided by 400. Your PME is 0.75. You have underperformed the S &P 500 by 25%. So the public market equivalent is basically saying apples to apples. You put your money in the S &P 500, you put it into the private equity.

7:02If it's greater than one, you've done better than the S &P 500. And that number for private equity for those vintages I mentioned is 1.13. So it's 13 % cumulatively better than the S &P 500. and the S &P 500 went up quite a bit over this period. You can then annualize it to something called a direct alpha, where you're basically taking that 13 % over the life of the fund and doing an IRR on the excess. And that's the 360 basis points that I mentioned earlier. Something like 15 % versus 11 % would be a back of the envelope guess on that. When you look at the data 2000 to 2019, how much roughly is the S &P growing on a yearly basis versus buyout over 19 years?

7:56So I would say it's sort of 15 versus 11. So you would have done, and that's about the 400 basis points that I mentioned. So using the rule of 72, it's roughly doubling every five years versus doubling every six and a half years, which doesn't sound like a big difference, but it certainly compounds dramatically. It certainly compounds. 360 basis points a year is a big difference. Out of curiosity, do you also add dividends into the S &P 500 as well? Yeah. So the S &P 500, you absolutely have to do that. So the S &P 500, it includes dividends, which are roughly 2 % a year. And the buyout fund performance would include all distributions.

8:42So it's really, it's an apples to apples comparison, which is why it's, and it's very simple to calculate actually, which is why it's such a nice, we thought it was a nice metric to use. One of your colleagues at Oxford, Ludo Filippo, is this private equity critic, just stating his bias. And he believes that a lot of these metrics are gamed, IRs can't be eaten, and there's a lot of gamification from the private equity industry. Why is he wrong? He's wrong in that he's actually misleading on a number of things, and he's wrong on a number of things. And he's actually been wrong for quite some time.

9:27I'll say something nice about him later, that there's some things that he's right about. So these numbers that I gave you are based on cash flows. So these are not IRRs. These are not things you can't eat. These are based on cash flows with the exception of the unrealized investments that are still in the funds. 2017, 2018, 2019 vintages, those aren't fully realized. So the numbers I gave you could move a little bit because we're basing what's left in the portfolio on the marks. But everything else is realized. I mean, this is 2000 to 2015. These things are very realized. And those are the numbers.

10:17And those have been the numbers. So to say, some people say there's volatility, people playing games with volatility, playing games with IRR. Those numbers I gave you, those are quite real. So that's number one. To say they're not real is wrong. And Ludo doesn't say that. The second thing that he's done on a number of occasions is not done in apples to oranges calculations. So what he'll do in a lot of these things is he'll put private credit, he'll put real assets in with the buyout and the venture, and then he'll compare them to the S &P 500. Well, buyout and venture absolutely compare to the S &P 500.

11:07Private credit? Are you kidding? That shouldn't have an S &P 500 type return. And then real assets and real estate and infrastructure, I think you can debate. But if you take out the private credit, the real assets, the infrastructure, these results are super strong through the 2019 vintages. So he sometimes mixes apples to oranges. And in several of his things, he used the least favorable time periods to private equity. And but if you use this long period, 2000 to 2019, what I just told you is what you get. So there's there's just no way to say buyout performance hasn't been very good through those vintages.

11:57Now, where where he may turn out to be right, which is, you know, we'll see are the more recent vintages. So 2020 to 2022 vintages, which invested a lot of money in the craziness and around the pandemic where prices got very high. Those vintages right now have PMEs of about 0.98 and the direct alpha of minus one percent versus the S &P. So they're they're coming in S &P like at the moment and they could end up lower. Um, what's interesting is they're still beating the Russell. So the Russell, they're beating the Russell by like the PME is 1.22. That means cumulatively 22 % better and an 8 % annualized outperformance.

12:49So if you think the Russell is the right benchmark, you know, those vintages are going to be okay. If you think it's the S &P 500, maybe, maybe not. So maybe, uh, Ludo will be right. But what I'm doing and have done consistently is apples to apples, look at the time periods, be very clear about what you're looking at. And that's what I've done. The other place where I think he's, again, I think I agree, is real estate and real assets have not performed so well. And on an absolute basis and relative to the S &P and infrastructure, probably not as well. So if I were advising an endowment, I would steer clear or not do very much of infrastructure or real estate.

13:46And I would stick to what I think is real private equity. And you advise that because real estate has worse performing returns. So even if it adds some more diversification, real estate and infrastructure on a expected value, you're actually lowering your returns. What about diversification? The diversification is the infrastructure. Infrastructure, I think, is the jury is out. The returns have been low. If you look at it relative to the S &P, the returns have been low. If you look at it relative to some infrastructure index of public companies, it looks better. And so you kind of have to decide what you're doing with infrastructure.

14:30Are you looking for return or are you looking for diversification? The real estate even sort of underperforms the, you know, the real public real estate indexes. So the real estate has really not been a great place in private equity. I also, the other thing I think about is you're paying these fees, which are not trivial, whether it's two and 20 or one in 10, depending on the asset class. And you're paying those fees because the PE firms are adding value. And so where are they going to add value? On the buyout side, they're doing it right. And a lot of these companies, the private equity funds try to do it right.

15:22They're adding real operational value to these companies. Infrastructure, I think it's a little harder, but you might be able to. Real estate, what are you doing? You're buying low, selling high. I'm not sure how you add value to a building over somebody else. So I think the value added is potentially much higher on the buyout and venture capital side. So there's some hope or expectation that they'll earn their fees. I think it's harder in some of the other asset class. When the Kaplan Shorter Index is comparing buyout to S &P 500, you're doing on a net basis. So what the LP would get, not what the private equity funds.

16:10Absolutely. Yeah, and that's very important. It's net of fees on the private equity side. And on the S &P side, actually, we use the S &P. So if you think there's a little bit of fee or a little bit of friction, we're kind of biased against the private equity by just using the S &P 500. Although you buy an ETF, the fees are very low. I'm not some kind of private equity or venture apologist. I try to look at the market, although I have a bias. I do think it performs better. It's good to see that the data shows that. But it seems to be the wrong way just because S &P has had a five-year run. If you really double-click on that, that's the Magnificent Seven, the Tesla, Microsoft, Apple, Meta.

16:56And maybe now they're slightly overperforming by 2%. It doesn't mean that it was a better decision at the time of investment. How far back does this data go? And how conclusive is it over a multi-decade timeline? You're absolutely right. And that's why the Russell is interesting, right, because the S &P has crushed the Russell. And going back to Fallopoo and what, you know, also some other people say about private equity, they used to say in, you know, 2005, 2010, oh, buyout investing, that's small cap value. If I just, you know, leverage small cap value in the public markets, I'd outperform. Well, small cap value has been terrible the last 15 years and it's been crushed by the Russell.

17:47Russell value has been worse than Russell, which has been worse than S &P 500. So you kind of have to think about what the right comparison is. And then I think you are getting diversification, which I think is your point, that when you invest over the long haul, there are going to be some periods where one asset class outperforms the other. And as long as they don't move exactly together, you should get, let's say they have the same return, not a better return, but they're moving differently. By investing in more than one asset class, you're getting the same return with less risk. And so that's where certainly if you put a lot of money into buyout funds 2000 to 2019, you way outperformed, even though over the entire period, even though you didn't outperform over every individual period, which goes to your next question going forward.

18:46What makes sense? That's where it's really, it's super hard because it's a lot easier to look backward than it is to predict the future. You have to come to some, I guess, expectation. what is this asset class going to do in terms of return relative to, say, the S &P 500? Is it uncorrelated or not perfectly correlated? And then the right answer is, if you think these asset classes have similar returns or private equity might be slightly higher, then you allocate to each of the asset classes, which is diversification. How much is S &P correlated with buyout? This is sort of the shocker or it's surprising is they're not perfectly correlated.

19:48So you definitely get diversification benefit from holding buyout and the S &P 500. You can see that from what I just showed you. Buyout outperformed those vintages through 2019, and buyout is underperformed probably 2020 to 2021, so they're not moving in lockstep. So and the returns have been higher on the buyout. So you get you get some higher returns and you get diversification benefit. The other question people ask, which is, I think, you know, is is buyout just a leveraged investment in the S &P 500? And if it were a leveraged investment in the S &P 500, you would you would see two things.

20:41number one you would see them move in lockstep which you haven't seen them do I just told you they didn't move in lockstep you would also see a beta well above one and what a beta is is how the returns on a private equity fund move with the returns on the S &P 500 so if they were you were just, the buyout fund was just like the S &P 500, the beta would be one. If it were a leveraged investment in the S &P 500, and we think buyout firms probably have 50, 60 % leverage, public companies, 10, 20%. So that'd be like a 40 % difference. You'd see a beta of 1.4 or 1.5. And you actually see betas of one when you estimate based on, and this is based on cash flows, not marks.

21:45So they have kind of the same risk as the S &P 500. They don't move like the S &P 500. And that gives you diversification benefit. Double click for the audience. One of the most important things about Burgess and LP driven data. One is it's driven by LP. So there's no survivorship bias and there's no GPs only sending data in when it's positive. The second one is this aspect of DPI. DPI is ground truth. You could hem and haw for 20 years, say, I'm good, I'm bad. You could understate, overstate. The proof is in the pudding. What dollars do you return back? That is an objective measure. Growing up, I thought managing money meant paying bills and balancing a checkbook.

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23:39On the overmarking, they're going into fundraising cycle. They want to raise capital. On the undermarking, it's just the rule of conservatism. You don't want a Yale endowment that gets a 1.75x mark and the next quarter is 1.7x. It just doesn't make you look good. So a lot of established managers don't like that. But I want to go into the data, not in terms of narratives or your personal views. What does the data say when it comes to whether private equity buyout and or venture managers under mark or over mark as a general rule? And also, in which cases does the data show that one or the other happens?

24:16I've written two papers on this, at least. So number one, historically, and this is before the 2021 period where they went into deals at high valuations. Historically, on average, they undermarked a little bit. So this is your point that they want to be a little conservative. Right. And then the times when you do see them being a little more aggressive is when, as you said, when people are fundraising. and there are two things that go on when people fundraise. People tend to fundraise when they're top quartile. So when do you fundraise? You have a great realization, something good happens, that's when you go.

25:13And if your fund is not doing well, you don't fundraise. You wait until it is doing well. So it's pretty amazing when you look at who raises funds. There are like very few bottom quartile or even third quartile funds. It's mainly top quartile and second quartile. And what that means is, you know, when you fundraise and you compare yourself to other funds that were raised at the same time as your previous fund, you know, you're ranked in quartiles by the Burgesses, the Pitch Books, the Cambridges. and people go when they look good relative to their comparison set. So people tend to go when they've had good performance, and then the poor performers tend to write their assets up a little bit around fundraising.

26:11And people are aware of this. I mean, if you're an LP, you understand And you should be looking at the unrealized investments in the previous fund to see the extent to which they're doing that. And I think LPs understand that. So the first two questions you said, what is the, you know, what do people do? They basically, as you said, the marks historically are a little conservative. They get less conservative when people are fundraising. And that's what you see at the fund level. The people now saying that the marks, everything is overmarked, probably comes from that 2021 period where they made a lot of investments at high valuations and they haven't fully written them down.

27:09So we'll see what happens going forward, how much of that turns out to be overmarked. And I think it's too early to tell, obviously, on the research because you've got to wait and see what valuations those investments get sold at. a very famous manager, I no longer repeat his name because it's not the best quote attributed to him, but says that asset management is about having average return and great customer service. Now, clearly it seems like it's people don't fundraise when they're in third and fourth portal, but to what extent is that true? That if you have median returns and just great customer service and great LP management, and maybe great transparency, whatever else you would group in that bucket.

27:56To what extent do you see funds that are able to do that continue to survive and thrive? I won't name names because I, well, I could, but I won't at least initially, is if you look at the performance of the mega funds that were raised post great financial crisis, vintages 2009 to 2019 and look at mega funds, which were more than$10 billion, those funds, actually, their PMEs are lower than the average buyout PME. And I think some of them have performed S &P-like. And as a result, they're a little overall, they're a little bit over the S &P. Some of them are S &P-like, and they still raise a lot of money.

28:55So the mega funds, I think, are as a class in that bucket where their performance post-GFC has not been as good as the middle market folks, but they've continued to raise a lot of money and they've delivered you know, okay, overall, somewhat better performance than the S &P 500, but not as good as some of the others, but they give, probably give good customer service. They also allow you to write big checks. So there's, there's an economy of scale. And again, we'll see whether, whether that continues over time as people say, gee, the returns here are less than the returns at some of my alternatives.

29:45You're a great researcher and you don't like to speak off the cuff, but if I forced you to guess why LPs continue to invest into these funds, what would be the one or two factors that you think is driving LPs to invest in these mega funds that are underperforming S &P 500? I'm going to give a positive caveat to that. Even though the fund, let's say the fund is S &P 500, They also get co-invest rights in a number of these funds, the larger investors. And on the co-invest, they're not paying fees. So the blended S &P 500 on the fund and better than S &P 500 on the co-invest, they're beating the S &P 500.

30:32So I think I'll pull that back a little bit, that the larger investors will beat the S &P 500 less than they would have on sort of the smaller mid-market buyout funds. And I think that's probably the explanation. If you're a large investor, you know, big pension fund, big sovereign wealth fund who do the co-invest, they're going into the mega funds because that's where they can put the money to work. That's not an irrational thing for the large investors. For somebody, I think for an endowment that's a$10 billion endowment, then maybe you want to go somewhere else. For your$100 billion, trillion investor, then it makes perfect sense.

31:24Is there a back of the napkin way to convert a two and 20 into a percentage, an annualized percentage? Yes, there is. You have to tell me what the gross return is to turn it into net, because that as the gross return gets bigger, the spread gets bigger. So take a 25 % gross, which would be a very nice fund, right? 25 % gross is more or less 3x gross. The 3x gross, 25 % gross turns into like 19 net. So that'd be a - About a 6 % annualized fee. Yep, 6 % fee, absolutely. Absolutely. Said another way, if the fund is doing a 19 % and you were accessing co-invest, let's say that you weren't adversely selected, you would be getting another 6%.

32:22Correct. So if you were going apples to apples to S &P 500 and you were even now with a co-invest, you're 6%. And maybe if that's half of it, you're 3 % if you have one. Correct. Correct. And I think people say it's like co-invest like a quarter to 30%. So you take 30 % of the 6 % be 1.8%. That would be sort of industry-wide. So one of these memes in the market is large buyout because the leverage is not as attractive. Maybe there's the same access to leverage, but the interest rates are higher, is almost inferior to S &P 500. Small buyout, there's still like this operational value. you add that you could do and you could have multiple expansion, all these things.

33:10I'm asking you to project into the future, which is not something you typically do, but to what extent do you believe in that meme? And what are your thoughts on this? You've got mega, you got middle market, you have lower middle market on the buyout side. All of them, I think, have invested heavily in trying to add value to their companies. And I think that's the big change over, you know, when I started. So I started teaching private equity in 1996. And I would regularly have people in class, or I'd have GPs in class. And I had a framework as to, you know, how I evaluate deals. And one of the pieces of the framework is, how do you improve the business?