Granted, it's tosh that those who run private-equity funds possess arcane knowledge denied to the likes of you and me. Yet it is worth considering the idea that private investors' portfolios should have an exposure to private equity. After all, if a class of investment regularly outperforms the world's equity markets, then you are going to want to have some capital invested in it.
According to the 2017 Global Private Equity Report from management consultant Bain & Company, the historical outperformance of private equity is clear. True, there is a difficulty comparing private equity's returns with those of the world's stock markets because the former are lumpier; profits from disposals are variable and unpredictable and meanwhile there is little of the smoothing effect of regular dividends that you get with quoted companies. To compensate, Bain borrows a measure that modifies the timing and size of private-equity funds' cash flows as if the funds held shares in listed companies.
On that basis, US private-equity funds returned 6 per cent in the year to end June 2016 compared with 4 per cent for the S&P 500 index of major US companies. In Europe the contrast was more dramatic - the MSCI Europe index of big companies fell 11 per cent over the same period, yet European private equity funds returned 10 per cent.
The longer-term outperformance is even more marked. Over the past five years returns from the MSCI Europe index have averaged 7 per cent while European private-equity buy-out funds have averaged 13 per cent; over 20 years the figures are 5 per cent for the MSCI index and 15 per cent for private-equity funds.
That degree of outperformance looks impressive, but also prompts the thought: it's all very well to adjust private equity cash flows so they behave as if they were those of quoted companies; however, what happens to stock-market returns if you adjust quoted companies' balance sheets so they carry the same amount of leverage as private equity?
It's common knowledge that aggressive use of borrowing accounts for a large part of private equity's success. Where capital employed is mostly debt and the cost of debt is subsidised by the tax deductibility of interest costs, then residual profits yield fat returns for the slither of equity employed.
Meanwhile - rightly or wrongly - quoted companies tend to have more conservative balance sheets, where there is less debt and more cash. Logically, if quoted companies were put on the same financial footing as private-equity companies, then their returns - and, implicitly, the stock markets' returns - would be closer to those produced by private equity. Certainly, a similar exercise was done to compare returns on government bonds with those of quoted companies by adding in notional leverage. The result was that, hey presto, bond returns displayed the characteristics - the scale and the volatility - of company returns. The assumption is that something very similar would happen to the returns of geared-up companies and that would serve to undermine the whole point of private equity.
Of course, one day governments in the developed world may have the guts to tax the cost of debt in the way that equity dividends are taxed and, at that point, the limitations of private equity would be badly exposed. Meanwhile, private investors who still want an element of private equity can achieve that the low-cost way via exchange-traded funds (ETFs).
However, these ETF returns don't leave you breathless, appearing to owe as much to leverage as to the skills of fund managers. For example, there is iShares Listed Private Equity (IPRV), which holds stakes in listed US private-equity houses. This was launched in March 2007, a year or so before the great credit crunch. The pain it suffered then means its return since launch pales besides that of the S&P 500 - 6 per cent versus 71 per cent. Since the nadir of March 2009, the ETF has bounced higher than the S&P index - by 548 per cent against 229 per cent. But that may be no more than what would have been achieved by the effect of extra leverage in an era of near-zero interest rates.
In Europe, private equity's performance looks better. At least, the LPX MM Private Equity Fund (XLPE) from db x-trackers has far outpaced the MSCI Europe index. XLPE is up 73 per cent since its launch in January 2008 while the MSCI index has fallen 21 per cent. Since the bottom, XLPE has bounced 604 per cent against just 90 per cent for the Europe index.
But that may not tell us much about the future, especially as the Bain report says that today's private-equity industry is "more competitive, with many more participants and massive amounts of capital competing for a limited set of deals". That spells lower future returns and warns us more than ever that this insiders' form of capitalism owes as much to image and to leverage as it does to substance.
