Clockwork Perspectives

Do Private Markets Earn Their Keep? Part I: Buyout Funds


Kyle Rose

Time to answer the debate once and for all: are private equity markets worth it? Also, which private markets should I invest in? Also, is paying a premium for top-tier managers worth it? Also, what are the primary drivers of return? Also, what about buyout vs. growth equity vs. VC? Wait, what is the debate again?

The “debate” goes on and on because the answers to these questions are of course dependent upon how the questions are framed, which data sets are used, what time periods are analyzed, and a multitude of other factors. However, a new report by Michael Cembalest of JP Morgan Asset and Wealth Management provides some reasonable insight to those interested in digging a little deeper on some of these ideas.

In this two-part series, we take a look at Cembalest’s findings for the two primary categories for private equity funds, Buyout (roughly defined as funds that take controlling interests in undermanaged or underperforming businesses with the intention of making them more profitable) and Venture Capital (roughly defined as funds that make minority investments into start-ups looking to grow, including growth equity funds), and what they mean for investment managers in the alternative asset space. The data looks at a broad basket of fund results without particular bias towards geography or industry focus. First up, Buyout funds.

Are Buyout Funds Worth It?

When answering this question, the report looks at quartiles of two broad return-based measures of performance relative to the S&P 500: Public Market Equivalent (PME) and direct alpha on an Internal Rate of Return (Net IRR basis). These two metrics provide relatively redundant information so here we simply look at IRRs for simplicity.

US buyout IRRs by vintage year
US buyout direct alpha by vintage year

Absolute IRR on both a median and average fund basis by vintage year has been above 10% since 2006 and more recently peaked above 20%, a strong track record. However, on a relative basis the outperformance over the S&P 500 has gone from a high of 14% for 2001 vintage funds to averaging anywhere from 1-5% in the past decade. This appears to be a relatively small premium to compensate for things like illiquidity and expected equity risk premiums from a more volatile and less transparent asset class.

It should be noted that the report looks only at historical returns and does not evaluate risk adjusted returns or correlations to other asset classes, both of which should be important decisions for money managers when considering asset allocation.

Are Top-Tier Buyout Managers Worth It?

If you are asking yourself this question, you are likely already a fairly sophisticated investor working for an established institution. Why? Because most LPs do not actually have access to the list of top-tier managers who are regularly inundated with subscription interest in excess of what they actually have available. And if they are good enough to be considered a “top-tier” manager, it is likely because they have a strong performance track record and tend to give deference to existing LPs from prior funds when raising new money.

All those caveats aside, it is still a worthwhile exercise for anyone to consider whether or not paying that extra 10-15% of carry is worth the incremental expected return. The answer to this question lies in two charts that explore direct alphas and relative PMEs over time by manager quartiles.

US buyout IRRs by vintage year
US buyout direct alpha by vintage year

The first shows an absolute spike in alpha (relative to the S&P 500) in buyout funds that were formed between 1998 and 2003, with median IRR outperformance going from a high of ~14% for 2001 vintage funds to less than 5% in the previous 5 years. While in part due to the reduction in absolute outperformance since this high, the relative outperformance between top quartile and bottom quartile managers has also shrunk from ~24% to a still sizeable ~15%, and the 10% gap between top quartile and median performers has shrunk closer to 8%.

Perhaps more interestingly (especially compared to the venture capital results we will explore in Part II), the median and average returns for buyout funds tend to move in tandem, indicating that there is a somewhat normal distribution of returns by managers rather than serious out/underperformers. In the end, there is a sizeable premium to be gained from investing in top-quartile managers, though it comes down to the ability to properly identify and obtain capacity in those funds. If you work as an individual investor or a nascent family office, you will probably find yourself more often than not looking at investable options on the blue and red lines as opposed to the gold.

What are the Primary Drivers of Return?

Lastly, the report looks at three representative buyout funds from a larger buyout manager. One was founded before the Great Recession and the other two launched sequentially after. Common return components for buyout funds comprise three main sources: operational improvements (commonly measured by EBITDA growth), multiple expansion (being able to sell the company at a higher relative price than you bought it for), and leverage (buyout funds love to pile on cheap debt to enhance returns).

The findings were that operational improvements made up the plurality of returns for all three funds, but decreasingly so over time. While we should be careful to overinterpret results from a subset of fund breakdowns, these results would indicate that returns in the past decade are being driven more and more by debt and pricier market valuations than underlying strategic improvements from operational involvement from the buyout funds.


  • While buyout funds have continued to outperform the S&P 500 nearly every year for the past 25 years, the return premium is narrowing and now regularly averages under 5%.
  • The dispersion between returns from top tier and bottom tier managers has shrunk over time but remains robust, meaning there is still real value in being able to differentiate and invest between the two.
  • Sources of return for buyout funds have been more heavily weighted towards leverage and multiple expansion in recent years at the expense of actual underlying fundamental operational improvements made by fund managers.

While an uninterrupted growth in private markets and the search for alpha will undoubtedly continue to drive investment, investors would be wise to be wary of a sector with diminishing risk premiums and returns driven primarily by debt and frothy market valuations.

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