Real Returns: Are Private-Equity Gains Built to Last?

July 5, 2013, 6:05 p.m. ET

Real Returns: Are Private-Equity Gains Built to Last?

MARK HULBERT

A new study shows that one of the chief benefits of private-equity firms is largely an illusion. The study comes as Dell DELL -2.10% shareholders prepare for a July 18 vote on whether to accept a bid from founder Michael Dell and private-equity firm Silver Lake Partners to take the company private at $13.65 a share.

To be sure, many private-equity buyout funds have in the past produced superior returns. But their fees are steep—typically 2% of assets plus 20% of any profits. And many of their advantages are either ephemeral or can be replicated at a much lower cost.It is understandable why many people would believe a company should do better after going private. Freed of the short-term constraints of keeping Wall Street happy, such companies can instead invest in what will best promote their long-term advancement.

Researchers have had trouble testing that logic, since the performance of private companies is by definition private. A new study accepted for publication by the Journal of Financial Economics overcomes this obstacle by focusing on the corporate tax-return data of more than 300 firms taken private by private-equity firms between 1995 and 2007. Even private companies have to file tax returns, after all.

After going private, the researchers concluded, such companies didn’t perform any better on average than they did before. Jonathan Cohn, a finance professor at the University of Texas, Austin, and one of the authors of this new study, says the agreement under which he and his fellow researchers were given access to Internal Revenue Service data prevents them from sharing data about any individual company.

Still, their conclusions reflect an average of the several hundred companies they studied and take into account return on sales, return on assets, economic value added and other performance measures.

The authors didn’t just focus on companies after they went private. They also compared the performance of such companies to a sample of other companies that were broadly similar except that they remained public. They found no difference in the operating performance of both groups.

These findings don’t mean that the average buyout firm can’t produce impressive returns. It just means that improved operating performance isn’t the source of those outsize returns.

So where do the returns come from? One example is market timing, Mr. Cohn says. Buyout firms often pick opportune times to take companies private and then sell them. Increased debt, or “leverage,” can magnify returns. And firms can realize tax savings because of increased debt-service costs.

Why should investors care that a buyout firm’s profits are coming from these other sources rather than improved operational performance of the companies that buyout firms take private? One reason is that these other sources too often turn out to be fleeting. As a result, it is relatively rare for a successful buyout firm to repeat its success in a subsequent period.

Consider the market timing on which so much of buyout firms’ success is dependent. Consistently being able to time the market is notoriously difficult, says Lawrence G. Tint, chairman of Quantal International, a risk-management firm for institutional investors.

Another factor makes it even more difficult for buyout firms to repeat their success. “The most profitable firms often attract large amounts of capital at market tops, which puts considerable pressure on them to put that capital to work at inopportune times,” he says.

In any case, individuals—acting on their own and without having to pay high fees—can largely take advantage of the same factors that are a big source of the buyout firms’ profits.

For example, there is nothing stopping you from investing in companies when they are out of favor and therefore cheap, and then selling when valuations are high.

And you can easily achieve the functional equivalent of a buyout firm’s leverage without incurring any debt. By increasing the percentage allocated to stocks of your overall portfolio, you can match the additional equity exposure you would have seen by investing directly in that firm. One of the cheapest ways of doing that is the Vanguard Total Stock Market VTI +1.07% exchange-traded fund, with an expense ratio of just 0.05%, or $5 per $10,000 invested.

If you do want to invest directly in private equity, there are three funds that do so. Two of them are open-end mutual funds: the ALPS/Red Rocks Listed Private Equity Fund,with an expense ratio of 2.88%, and the Vista Listed Private Equity Plus Fund, with an expense ratio of 2.99%. An ETF, the PowerShares Global Listed Private Equity Portfolio, PSP +0.27% has a 2.32% expense ratio.

These funds have trailed the overall stock market’s 7.0% annualized gain over the past five years, as measured by the Standard & Poor’s 500-stock index with dividends reinvested. The best performer of the three funds, the ALPS/Red Rocks fund, had a 2.1% annualized loss, according to Lipper.

What about Dell? The company declined to comment, though it has said that it feels the buyout offer is the best course for shareholders. But Mr. Cohn says, “Our study suggests there is no reason to expect it to operate any more profitably as a private company than it would if it were to remain public.”