As private equity investments become more commonplace in pension fund portfolios, is the asset class really worth it?

According to a paper by Ludovic Phalippou, professor of financial economics at the University of Oxford’s Saïd Business School, private equity funds have failed to outperform equities over a 10-year period. But the real catch is the expense of these investments when considering the associated fees.

Between 2006 and 2015, private equity performance, net of fees, was essentially in line with public equity markets, noted the paper. Further, large U.S. pension funds have seen about US$1.50 in return from private equity funds for every US$1 they’ve invested since 2006, also largely in line with public equity performance.

“A more subtle, but crucial, related point is that the public equity portfolio of institutional investors is usually internationally diversified; thus, their public equity portfolio has a return close to that of MSCI world index,” it said. “The private equity portfolio, in contrast, is mostly invested in the U.S. As U.S. stocks have outperformed non-U.S. stocks, institutional investors that simply compare their public equity with their private equity returns, without separating the U.S. and non-U.S. components, see a higher past performance in private equity, leading to the often-heard statement that private equity has been the highest-performing asset class for institutional investors.”

With this “evident failure to outperform,” as Phalippou described it, institutional investors, especially pension plans, may genuinely remain faithful to the promise of excess returns from private equity out of embarrassment. “Think of a pension fund board admitting paying billions of carry in order to achieve the same returns as public equity markets. Board members and trustees typically have what economists would call poor incentives, in that they face only a potential downside (mostly reputational) with no upside. This encourages herding behaviour: it is easier to follow the crowd and hard to be a contrarian.”