Key Takeaways
- • Almost 40% of private equity deals in 2018 were leveraged seven times or greater, according to LPC data, indicating aggressive debt loading practices across the sector.
- • Ninety-two percent of businesses owned by the top 16 private equity firms are rated several notches below investment grade by Moody's, with nearly one-fifth on distressed debt watchlists.
- • Academic research found 10-year bankruptcy rates for large US leveraged buyouts reached approximately 20%, compared to just 2% for equivalent public market companies—a tenfold disparity.
- • Cambridge Associates' private equity benchmark index recorded only 18 down quarters out of more than 100 from 1994 through mid-2019, with volatility at three to four-fifths public equity levels, suggesting returns may be artificially smoothed through mark-to-model accounting.
- • Replication benchmarks constructed from liquid public-market stocks are emerging as tools to validate private equity returns independently and address concerns about non-transparent valuation methodologies.
Summary
The private equity industry faces a fundamental credibility problem: mounting evidence of elevated portfolio risk stands in stark contrast to the sector's reported outperformance. According to LPC data, nearly 40% of private equity deals executed in 2018 carried leverage ratios of 7x or greater, reflecting an increasingly aggressive approach to capital structure. This debt loading occurs even as Moody's reports that 92% of portfolio companies owned by the top 16 private equity firms carry ratings several notches below investment grade. More concerning, approximately one-fifth of these companies are flagged on Moody's distressed debt list.
The disparity between risk metrics and reported returns has become the central debate dividing institutional investors and buy-side observers. One investment manager quoted in the analysis characterized the strategy bluntly: "I think it's the stupidest, riskiest possible thing you could be doing. People are going to get whacked by this stuff. It's going to be a disaster." Academic research released in 2019 provides quantitative support for such concerns, finding that large US leveraged buyouts experience 10-year bankruptcy rates around 20%, compared to just 2% for equivalent public market companies.
Yet the industry's actual reported returns paint an entirely different picture. Cambridge Associates' benchmark index of US private equity has experienced only 18 down quarters across more than 100 quarters from 1994 through mid-2019. Buyout funds have consistently beaten public equity returns across all regions and timeframes measured—one, five, 10, and 20-year horizons. Reported volatility has remained at approximately three to four-fifths the levels seen in public stocks, suggesting substantially smoother performance.
Skeptics attribute this performance paradox to accounting opacity. Private equity funds mark assets to model rather than to market, a practice that effectively reduces reported volatility and obscures true performance volatility. To address this credibility gap, institutional investors now have access to a growing array of replication benchmarks—indexes constructed to replicate private equity-type exposures using liquid public-market stocks. These benchmarks serve as independent cross-checks against reported returns, enabling more transparent validation of whether private equity's historical outperformance is genuine or an artifact of valuation methodology and infrequent mark-to-market pricing.
The disparity between risk metrics and reported returns has become the central debate dividing institutional investors and buy-side observers. One investment manager quoted in the analysis characterized the strategy bluntly: "I think it's the stupidest, riskiest possible thing you could be doing. People are going to get whacked by this stuff. It's going to be a disaster." Academic research released in 2019 provides quantitative support for such concerns, finding that large US leveraged buyouts experience 10-year bankruptcy rates around 20%, compared to just 2% for equivalent public market companies.
Yet the industry's actual reported returns paint an entirely different picture. Cambridge Associates' benchmark index of US private equity has experienced only 18 down quarters across more than 100 quarters from 1994 through mid-2019. Buyout funds have consistently beaten public equity returns across all regions and timeframes measured—one, five, 10, and 20-year horizons. Reported volatility has remained at approximately three to four-fifths the levels seen in public stocks, suggesting substantially smoother performance.
Skeptics attribute this performance paradox to accounting opacity. Private equity funds mark assets to model rather than to market, a practice that effectively reduces reported volatility and obscures true performance volatility. To address this credibility gap, institutional investors now have access to a growing array of replication benchmarks—indexes constructed to replicate private equity-type exposures using liquid public-market stocks. These benchmarks serve as independent cross-checks against reported returns, enabling more transparent validation of whether private equity's historical outperformance is genuine or an artifact of valuation methodology and infrequent mark-to-market pricing.
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