However, the headline numbers come with caveats. First, they do not include the typically huge fees paid to the general partners who manage the funds. Mr Kaplan and Ms Schoar found that, on average, the returns to investors after subtracting these fees were slightly lower than they would have received by investing in the S&P 500 in 1980-2001.
Secondly, they found huge differences in performance between funds. In 1980-2001, the top quartile of private-equity funds produced an annual rate of return of 23%, well ahead of the S&P; the bottom quartile earned investors only 4%. Not only was there a large gap between the best and the rest, but their respective performances were also remarkably consistent. The study showed that the winners in private equity tend to keep on winning and the bad firms stay bad — if they remain in business. Anecdotal evidence suggests that this pattern has endured, with the notable change that big firms are now outperforming the rest and in turn attracting a disproportionate slice of new money.
What makes a top performer? Mr Kaplan lists some characteristics: the expertise to analyse deals and add value; the ability to attract the best executives and other talent to companies; and a strong network to search for deals, sometimes avoiding auctions.
Some suspect that success is all about higher levels of debt. Private-equity firms borrow heavily to buy companies — the equivalent of a gambler borrowing money to double his bet. Given that higher leverage equals higher risk, where is the benefit? As Fidelity’s Mr Gordon puts it, ultimately investors in private equity are backing the same companies that they held as listed groups. “Performance over time will be driven by the same factors: earnings growth, cost management and so on,” he adds. “The difference is leverage. Strip out the leverage and the correlation with quoted equities is tight.”
There is a lot to this. In the early days leverage was responsible for most of the superior returns. Moreover, the easy credit of the past three years has helped. (An arguably worrying development has been the rise in “leveraged recaps with equity dividends”, whereby a recently acquired company borrows heavily in order to pay a large dividend to its new owner.)
On the other hand, since the mid-1990s private-equity firms have taken every opportunity to stress that they do not depend on financial engineering — a technique that they say is now widely imitated by public companies and thus no longer a source of advantage. Instead, they prefer to draw attention to other ways in which they improve the firms they own.
One is corporate governance. Unlike the owners of public companies, who tend to be too remote and thinly spread to spend time and money closely monitoring a business, private-equity firms have big stakes. Because their people’s careers are on the line, they have a powerful incentive to keep a close eye on things. There is also a strong incentive to maximise long-term value — which is what stockmarket investors are valuing in an initial public offering (IPO). Asset stripping is rarely the best long-term strategy. Even when they sell — at least in an IPO — private-equity firms often retain a significant shareholding for years after.