Private Markets: Debunking the Myth of Superior Returns
Asset owners have significantly increased their investments in private markets over the past 20 years, driven by a misconception that private debt and equity offer significantly higher returns than public markets. What fuels this belief in the outperformance of private capital funds? The use of since-inception internal rate of return (IRR) and the media’s coverage of the sector’s performance hold the key.
The Yale model, which suggests superior returns from a heavy allocation to private equity funds, hinges on the since-inception IRR. While this metric is widely used, particularly in the retail sector, it’s essential for investors to distinguish IRR from the rate of return on investment (ROI).
This article marks the beginning of a three-part series aimed at addressing this issue, offering strategies for evaluating fund performance critically, and suggesting alternative metrics and benchmarks. The ultimate goal is to urge regulators or the industry to discontinue the use of since-inception IRR in favor of horizon IRRs to provide investors with more accurate and transparent data.
Migration to Private Markets
The trend of institutions flocking to private capital funds has seen exponential growth over the last two decades, with high-net-worth individuals and retail investors following suit. The total assets under management (AUM) for private capital funds witnessed a fifteen-fold increase, growing at 14% annually in the last 25 years.
Evaluating Performance Metrics
While the belief in superior returns fueled the shift from traditional asset classes to private markets, the data reveals a different reality. A closer look at the performance metrics from a vast database, including over 12,000 private capital funds with $10.5 trillion AUM across its history, paints a less glamorous picture:
- Median IRR: 9.1%
- Pooled IRR: 12.4%
- TVPI: 1.52
- KS-PME: 1.05
These figures, although strong, pale in comparison to the historical returns from the US stock market, averaging 12% annually over almost 100 years.
Myth Propagation and Media Influence
The underlying cause for the unwavering faith in the superiority of private capital funds is explored through news coverage and industry publications. Exhibits showcase articles across different years, highlighting eye-catching performance metrics from various private equity funds. However, these figures, often mistaken for rates of return, are actually IRRs, subject to interpretation and assumptions.
Conclusion
The surge in private markets’ popularity, driven by misconceptions about superior returns, questions the reliability of common performance metrics. Investors are encouraged to discern between IRR and ROI to make informed decisions. In the next part of this series, we will delve deeper into the intricacies of IRR and its nuances, offering clarity on the real picture behind private market investments.
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