The Private Equity Illusion

Posted on Tuesday, December 7th, 2010

Imagine this.  A private equity firm puts together 73 funds over a number of years with each one lasting 10 years. Funding occurs over the first 5 years of the life of each fund with distributions occurring the last 5.  All but 2 make money, the average total return being over 150%.  Better yet, over the last decade, not one fund loses money, having an average total return of just over 140%.  Sound too good to be true?  It’s not.  But most investors would salivate at this opportunity.  I can give it to you right now, and you don’t have to pay me exorbitant management fees plus a percentage of profits.  So how can I do this?  It’s called MATH.

Let me explain.

Dollar cost averaging is one of the most powerful investing tools.  Put money in over time, and it matters less what the markets do, because if they go down, you just buy in at lower prices.  For example, the S&P 500 10 year total return the last decade was -9%, but if you had put in equal amounts over 10 years, your total return would have been +5%, a 14% difference.

What do private equity funds do?  They ask for your money over time as they find opportunities to invest your money in.  And by doing that, they get the benefit of dollar cost averaging.  Since investors are probably not tracking what the money would have done elsewhere, they tend to evaluate the private equity fund in isolation.

So how have real private equity funds done?  It seems not any better than managers of public equity funds.  A recent WSJ article goes into some detail.  Still the cache of being in an exclusive “club” that supposedly can give market returns without market risk continues to draw investors.

So are you still wondering what my mythical fund was?  It’s not mythical.  It’s the DFA Targeted Value Index, a small/mid cap value index which DFA’s real namesake fund is patterned after.  The returns were based on 83 years of data with each “fund” based on a decade of returns starting in 1928.  And here’s some good news – if you work with us, you’re likely in the fund now.

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