The Truth Revealed: Private markets beats public markets - even after fees
Once considered speculative, private markets occupy a rising share of investor portfolios, especially as the structural hurdles for high-net-worth (HNW) investors have lessened. Investors and advisors who understand private markets are well positioned to make recommendations about how to best incorporate private markets into the portfolios they manage.
This Truth Revealed series explores private market investing with three objectives in mind:
- To dispel some of the incorrect notions about private markets;
- To help investors and advisors better understand private markets’ potential to outperform public markets;
- To assist investors and advisors as they consider how private markets investing may align with their investment objectives
What you should know
- It is true that headline fees are generally higher in private markets than in other asset classes, though this is only part of the story
- Management fees for private equity funds average 1.5% - 2% of the committed capital per annum. Managers also earn a performance fee, typically 20% of the realized profits, provided their returns exceed a minimum threshold.
- On a net basis (after all management fees, expenses and performance fees are accounted for) private equity funds have beat public equities over most of the past 20 years — even during the recent bull market for public stocks.
Private Markets Beats Public Markets - Even After Fees
Within investor circles, there’s a perception that private markets are an expensive asset class. There is no denying it: headline fees are generally higher in private markets than in other asset classes. All else equal, higher fees create a drag on the net performance. Those fees must make it hard for private markets to outperform other asset classes, right? Or do they?
Let’s start by addressing private markets fund fees. Private market managers charge a management fee, which varies over the course of the fund's life. The management fee for closed-end private equity funds is typically 1.5% - 2% of the committed capital during the investment period (usually the first 3 to 5 years) of the fund.
By way of background, a closed-end private equity fund is a type of investment fund that pools investor capital and uses it to invest in private companies or assets. The fund issues a fixed number of shares that typically have a finite lifespan.
As the fund completes its investment period, the management fee generally decreases. Following the investment period, management fees are customarily charged on net invested capital (often a smaller amount than committed capital). The fee may include a step down. A common stepdown is a 10% fee reduction. Rather than being based on the committed capital, the fee is calculated on a smaller amount – namely, the net invested capital. This is a different construct than mutual fund fees, which are usually assessed on net asset value (NAV).
An additional component of a private markets fee structure is carried interest, sometimes referred to as a performance fee or ‘carry’. Carried interest is the percentage of investment profits – typically 20% for private equity funds – that the fund manager keeps for themselves. The manager must exceed a minimum return threshold – usually 8% – to earn their carried interest. While performance fees can be substantial, they are not new to the asset class and they have largely stayed consistent for the past several decades.
So are the high fees justified by high performance? Let’s explore private markets performance data in more detail to find out. Hamilton Lane has developed a comprehensive database of private markets fund performance, encompassing over 50,000 funds and more than $16.9 trillion of private capital, as of December 31, 2022. Most importantly, Hamilton Lane tracks the net returns of private markets funds after management fees and carried interest are accounted for.
This data suggests the majority of private equity funds have outperformed stocks, especially over the past 20 years. In fact, only in vintage year 2000 was this not the case.1
All Private Equity 10-Year Rolling TWRs
What we’ve found compelling is private equity’s consistent outperformance relative to public markets. Over nearly all 10-year time periods since the turn of the century, private equity has bested traded equities.
We also see that buyout transactions – i.e., when private equity funds completely acquire a company – have outperformed global public equities in every vintage year by an average of 1,079 bps. Private credit has outperformed public leveraged loans in every vintage year by an average of 625 bps. And remember, this is all net of fees and carry charged by fund managers.
Buyout IRR VS. PME
By Vintage Year
Private Credit IRR vs. PME
By Vintage Year
The net result – both figuratively and literally – is that private markets are growing, and with good reason: even on a net performance basis, private equity has an exceptional risk/return profile.
Continue reading our Truths Revealed series for more insight into the private markets for HNW and UHNW investors.
1Source: Hamilton Lane Data via Cobalt, Bloomberg (January 2023)
Strategy Definitions
All Private Markets – Hamilton Lane’s definition of “All Private Markets” includes all private commingled funds excluding fund-of-funds, and secondary fund-of-funds.
Co/Direct Investment Funds – Any PM fund that primarily invests in deals alongside another financial sponsor that is leading the deal.
Corporate Finance/Buyout – Any PM fund that generally takes control position by buying a company.
Credit – This strategy focuses on providing debt capital.
Mega/Large Buyout – Any buyout fund larger than a certain fund size that depends on the vintage year.
Private Equity – A broad term used to describe any fund that offers equity capital to private companies.
ROW – Any fund with a geographic focus outside of North America and Western Europe.
ROW Equity – Includes all buyout, growth, and venture capital-focused funds, with a geographic focus outside of North America and Western Europe.
SMID Buyout – Any buyout fund smaller than a certain fund size, dependent on vintage year.
Index Definitions
Credit Suisse High Yield Index – The Credit Suisse High Yield index tracks the performance of U.S. sub-investment grade bonds.
Credit Suisse Leveraged Loan Index – The CS Leveraged Loan Index represents tradable, senior-secured, U.S. dollar-denominated non-investment grade loans.
MSCI USA Small Cap Value Index – The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the U.S. equity market.
MSCI World Energy Sector Index – The MSCI World Energy Sector Index measures the performance of securities classified in the GICS Energy sector.
MSCI World Index – The MSCI World Index tracks large and mid-cap equity performance in developed market countries.
S&P 500 Index – The S&P 500 Index tracks 500 largest companies based on market capitalization of companies listed on NYSE or NASDAQ.
Other Definitions
Desmoothing – A mathematical process to remove serial autocorrelation in the return stream of assets that experience infrequent appraisal pricing, such as private equity. Desmoothed returns may more accurately capture volatility than reported returns. The formula used here for desmoothing is:
Where rD(t) = the desmoothed return for period t, r(t) = the return for period t, ρ = the autocorrelation
rD(t) = (r(t) – r(t-1) * ρ) / (1 – ρ)
PME (Public Market Equivalent) – Calculated by taking the fund cash flows and investing them in a relevant index. The fund cash flows are pooled such that capital calls are simulated as index share purchases and distributions as index share sales. Contributions are scaled by a factor such that the ending portfolio balance is equal to the private equity net asset value (equal ending exposures for both portfolios). This seeks to prevent shorting of the public market equivalent portfolio. Distributions are not scaled by this factor. The IRR is calculated based off of these adjusted cash flows.
Sharpe Ratio – The Sharpe Ratio is the average return earned in excess of the risk-free rate per unity of volatility or total risk.
Time-weighted Return – Time-weighted return is a measure of compound rate of growth in a portfolio.
Volatility – Volatility is a statistical measure of dispersion of return, specifically standard deviation.
15-Year Asset Class Performance Chart: 15-Year Asset Class Performance: Indices used: Hamilton Lane All Private Markets with volatility desmoothed; Hamilton Lane All Private Equity ex. Credit and Real Assets with volatility desmoothed; S&P 500 Index; Russell 3000 Index; MSCI World Index; HFRI Composite Index; Hamilton Lane Private Credit with volatility desmoothed; Credit Suisse High Yield Index; Barclays Aggregate Bond Index; Hamilton Lane Private Real Estate with volatility desmoothed; Hamilton Lane Private Infrastructure with volatility desmoothed; Hamilton Lane Private Natural Resources with volatility desmoothed; FTSE/NAREIT Equity REIT Index; DJ Brookfield Global Infrastructure Index; MSCI World Energy Sector Index. Geometric mean returns in USD. Assumes risk free rate of 2.4%, representing the average yield of the ten-year treasury over the last fifteen years.
Spread of Returns by Down and Up Markets Chart: Spread of Returns by Down and Up Markets: Up markets are defined for equity strategies if the vintage year was above 11% IRR and down otherwise. Real Estate and credit strategies had a threshold of 9% for up markets.
Real and Nominal Return of Select Asset Classes Chart: Real and Nominal Return of Select Asset Classes: All inflationary periods since 1928 are defined as years where inflation was above the median level of 2.7% and increased over the respective year by more than 1%. Nominal returns taken as the median within the respective high and low inflationary periods. Real returns for both U.S. Bonds and Private Credit calculated as [(1+median nominal return)/ (1+Inflation in the median nominal return period)]-1.U.S. Bond returns calculated using a mix of 50% US T.Bond and 50% Baa Corp Bond annual returns.
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The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12-year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return.
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As of May 31, 2023