Since the end of the financial crisis and the stock market's climb out of 2009's deep hole, the S&P 500 has been on a tear. The run-up in the bull market has pushed that stock market index to new heights, and at Friday's close of 1,863 it continues to hover near its peak. As an asset class, private equity has been unable to get ahead of the market during the past five years. Sure, the private equity (or PE) funds have done well -- but so has my IRA. But that's not good enough. Pension funds and other PE fund investors pay high management fees to private equity firms in exchange for the promise of hefty returns far in excess of what they could get on their own through less risky investment in a stock market index fund. Private equity has not been able to deliver.
PE's response? If you can't beat the market, you might as well join it. The PE industry's bread and butter -- using lots of debt to buyout companies (LBOs), take them over, and sell them a few years later at a huge profit -- is taking a back seat to PE's new strategy of betting on the stock market. So-called PIPEs, purchases of stock in publicly-traded companies by private equity firms, are on the rise, up 42 percent in the first quarter of 2014 compared with 2013. Private equity funds are loading up on small-cap companies -- publicly-traded companies too small to be included in the S&P500. These companies typically do beat the S&P500, allowing PE to beat its stock market benchmark. But pension funds and other investors don't need private equity, they can make these investments themselves.
Private equity has also stepped up its investments in companies that will soon go public in an IPO and be listed on a stock market. Even private equity giants such as The Carlyle Group and TPG are making these so-called growth investments. They are buying shares in young companies and betting they will make money when the companies go public. Carlyle has invested $500 million in Beats, and TPG has invested $475 million in Airbnb. Just last week TPG provided a loan of $750 million to Chobani, the popular Greek-style yogurt company, that will convert to shares of stock and presumably yield a high return when the company goes public.
But betting on the stock market is something pension funds can do on their own -- at little or no cost.
Private equity funds are sitting on piles of cash including accumulated unspent funds from prior years -- so-called dry powder -- that they are unable to put to work. Despite mediocre returns compared with the stock market and the massive build-up of un-invested dry powder, pension funds and other investors still pay millions of dollars in management fees to private equity each year.
Pension funds have increased their investments in private equity and are paying high management fees in the expectation that returns will beat the stock market and enable them to fund retirees' pensions. With LBOs taking a back seat to investments in the stock market, however, it's not clear how PE will make the high returns pension funds are betting on.