Investing Billions - E267: Why 95% of LPs Misread Private Market Returns

Episode Date: December 22, 2025

Do private markets actually outperform public markets once you properly adjust for risk or is that belief built on flawed data? In this episode, I talk with Dr. Gregory W. Brown, one of the leading academic researchers in alternative investments, about what decades of data really say about private equity, venture capital, and risk-adjusted returns. We break down why private-market performance is so hard to measure, how tools like the Kaplan–Schoar PME changed institutional thinking, and what investors misunderstand about beta, volatility, and alpha. Greg also explains why buyouts and ventures behave very differently, how fund size and geography affect outcomes, and what this research implies for building diversified portfolios today.

Greg, so you spent your career researching the markets as a distinguished professor of finance at UNC to start from a research lens. Why do you believe that alternatives investing is such a fertile grounds for research? From a academic research perspective, it's just woefully under research compared to public markets. We've been doing a lot of work the last 10 or 15 years relative to prior to that, not just because alternatives have gotten to be more popular, but because we've finally gotten our hands on data that we think is research quality data. So we're able to answer a lot of what people would think are sort of low-hanging free. type questions. But it's still very much a green space for academic research. So the lack of research is why there's a lot of opportunities for research. Absolutely. Yeah. So clearly the

private's world is growing significantly both in terms of AUM as well as significance. Why has so little research gone in the space? There's always a lag for academic research. It takes a while for people to kind of catch on to realize that something's important. Yeah. So you didn't really see serious academic research and public market space until the 60s and 70s, even though obviously public markets had been around for a long time. What's really happened the last 15 years is in addition to getting access to more data, people have appreciated that these are real markets, more capital is getting allocated, and there's a real interest among our stakeholder base to learn more about them and do that through sort of an objective academic lens versus an industry,

more marketing-oriented lens. And you just released your annual paper on private markets, performance, Maybe you could explain why is it so difficult to answer a seemingly basic question, which is do private investments, outperform public investments on a risk-adjusted return? The real reason for this is because we don't observe returns for private assets. You observe things that sort of look a little bit like returns. You can use net asset values to sort of calculate things that look like returns, but those are not market prices. And we know that net asset values are smooth. So in addition to just basically having it be difficult to get the data in the first place, the data that you get doesn't lend itself to the type of analysis that's usually done to calculate risk-adjusted returns. I previously had Professor Steve Kaplan on the podcast, and he's created this Kaplan-Shore index. Tell me about that index, and why is it so widely used in academia today? The Kaplan-Shore PME, public market equivalent, that's essentially the most widely used measure for doing risk-adjusted returns.

The idea is pretty simple. It's trying to capture how would you have done in a particular investment versus if you had taken the same capital and committed it to a public benchmark. So for example, instead of investing in a buyout fund, you were to have the capital calls for that buyout fund instead invested in the S&P 500, let's say. So it gives you a pretty good apples to apples comparison in terms of what the performance in the private fund was versus whatever you think the appropriate public benchmark was. And how does that work? Maybe double click on that because one is liquid, one is a liquid, one has capital calls. How do you smooth out those? It's actually a pretty simple calculation. I'd teach

my students how to do it in a spreadsheet, you create a total return index with the public benchmark, and then you use that as the discounting factor in just a present value calculation. So instead of using like a fixed, you know, interest rate or cost of capital, you actually use what the market returns were for each of the cash flows that that fund is experienced. So you would discount, you know, for example, all of the distributions back to the present using the kind of market return and then divide that by discounted value of all of the capital calls. And that ratio is essentially a market adjusted multiple. So, for example, a number like 1.2 would be equivalent to earning 20% more in the private fund than if you had invested in

the public benchmark. So it's, it's very intuitive. I mean, you can just think of it as a market adjusted multiple. You think about this index comparing private to public investments. What have been some insights that have come from this index? What are some lessons that institutional investors can learn from this public market, private market comparison. And how should institutional investors change their behavior in terms of how they invest? So this big study that we just released, and it's freely available on our website for anybody that wants to look at it, we took what we think is the most comprehensive data set, the Burgess MSCI data set. We took it across all types of funds, so not just private equity funds. We also look at real estate and

infrastructure and private credit funds. And, you know, we have my more than 30 years worth of data for a lot of these fund types of equity funds in particular. And we calculated what the risk-adjusted return was using things like the Kaplan Shore PME. We used some more sophisticated models too. And I think sort of the headline for equity is that buyout funds have done quite well on a historical basis, even after you risk-adjust them, depending on what period you look at and what benchmark you use, you know, things in the sort of two to five percent range better than the public markets. And interestingly, buyout funds have a market beta that seems to be about the same as the market.

Like, you would sort of think buyouts would be riskier because, you know, you tend to be high leverage. But empirically, if you just let the data tell you what the beta is and you do that using, you know, a range of different models, you pretty much always get a beta of one. So that's saying that buyouts are about the same risk level. Is beta just shorthand for volatility? In other words, higher return, but same volatility around their return or is there more to it? No, so beta is essentially how much market risk you have. So, like, the total volatility of a fund is going to be higher because there's going to be some idiosyncratic risk as well. So beta is just, you know, that's essentially, what is the scaled correlation with the market index that you're using?

And so to say that the beta is one just means that the market itself has a beta of one. It just means it's exactly the same amount of market risk as the market itself. I've been kind of trained to think about volatility and high volatility is good because it's higher returns, but obviously it's bad because the volatility of health and you're trying to smooth that out. How do you use beta in order to build the right portfolio? So this kind of goes back to like old-fashioned marketwoods portfolio optimization. And optimal portfolio theory tells us is that it isn't the total risk that matters because you can diversify away the idiosyncratic risk. What matters is only the market risk or the beta.

And so, you know, importantly, beta is the thing that you should get compensated for. Like if you have something that's really, really risky, but it's a diversifiable risk, you shouldn't earn a premium for that diversifiable risk. It's just the risk you can't diversify away. And that's what beta measures. So when you're thinking about, you know, sort of doing a discounted cash flow type of calculation, what matters is the beta of the asset, not the total risk of the asset. So in another way, if you do find an asset that's highly volatile with a beta of one,

that's a superior asset within a total portfolio versus one that has lower returns with a beta of one. Absolutely. Yeah. And so I think what's interesting about the study, that alpha? Is that the definite? So I mean, alpha, so you can think of alpha as just being what's the total return that you earned minus what you would have earned in a similarly risky, you know, sort of market adjusted. If a beta is more than one, you've got to lever up the market benchmark in order to properly

compensate for the risk that you're in this case. It would be, so if it had the same buyout turning two to five hundred percentage points, that is the alpha. Yeah, that is the alpha. And it's, you know, and it's pretty easy to calculate for buyouts because you can just take the difference between the market benchmark and index of buyout funds that we're looking at in the case of our study. What's also interesting is if you look at Venture, it's very different stories. So Venture has a beta that's much. much higher than one, right? So there, the kind of return hurdle is quite a bit higher because you need to be compensated for more risk. So even though venture has had higher returns on

average than buyout funds, on a risk-adjusted basis, there's less alpha, essentially zero alpha in venture. What kind of data are we talking about? Well, it depends on the model. The lowest estimate that we've got is about 1.4 for U.S. venture. Higher estimates are in the range of like 2.3. So, you know, it's meaningfully higher regardless of what method you use. Do you still think that it's a good idea to invest into venture when you have access, when you have access to top portals, or is that also something that you're challenging? This doesn't say anything about what any individual investor's experience is going to be. So if you have access to the best funds or you are able to select better funds,

then, yeah, your returns are going to be better than that average. We just simply take the pool experience of all funds that we have data for to say, what is the asset class as a hold on. So, yeah, if you have access to the top venture funds, then you're going to earn positive alpha, you know, very high probability because there's a lot of return persistence among those top funds or you can figure out who the next great VC is, that's a good investment for you. But if you're just throwing darts to pick your VC funds, you're not getting paid anything on a risk-adjusted

basis. The risk of asking a dumb question, let's say that you have a beta of two, and let's say you have diamond hands. You are completely cold calculated. You don't run for the streets when 95% of people do over a long enough period. Should you care about beta? And if so, why? The way that finance thinks about things is in terms of probabilities. And so, you know, if you have a really, really long horizon and you can never get cashed out, then that kind of positive, you know, long run return experience will be good for you. But, you know, history is littered with, you know, long run bad performance. I mean, think about investing in, you know, Japanese stocks at 1990, right, during the dot-com bubble, you know, there was a 10-year period where stocks underperform

cash, you know, when the dot-com bubble burst. So you can have very, very, you know, long periods of time where even risky assets that, you know, I've traditionally done quite well will underperform. And again, I'm ignoring behavioral finance, which for those I listen to the podcast know that I believe it's much more powerful than regular finance because people are ultimately human beings. But let's just ignore behavioral finance for a second. Is the practical risk there that there's a risk of ruin? In other words, if you have a 2% data and it goes down 20% for multiple years, you could literally be wiped out? Or what is the practical risk of these long time periods in the market where high beta assets are performing poorly. If you were to be invested in a

high beta asset and you were not diversified, there is something that would be like a risk of ruin. Because, you know, you could have, you could be down 80, 90 percent potentially. And certainly people that actually lever portfolios blow themselves up. That happens, you know, in the hedge fund world pretty regular by Warren Buffett says, which is why Charlie Munger says leverage is one of the three things that could ruin your career. Said another way, if buyout is a one beta, you wanted to take a similar risk to, let's say, venture, let's just say it's 1.75x beta, one could actually lever up their buyout investment and they would have the equivalent amount of risk. That's one way to think about it. And at least historically, you would have

had a better risk return profile doing that, rather than investing in venture directly. Again, if you sort of had the combined experience of investing in all venture funds. So introducing Genius Bank, the award-winning bank that does things differently for our kind of genius, spelled with a J. Award winning can mean many things, like most locations, but who still goes to the bank? For us, award winning means best newcomer bank of 2025 by bank rate. Visit geniusbank.com, Genius with a J. Genius Bank registered trademark is a division of SMBC Manubank. Awards are independently granted by their respective publication and are not indicative of future success or results. Within your research, you found

200 to 500 basis points, 2 to 5% outperformance on buyouts. It's obviously a non-trivial dispersion. What accounts are some of that dispersion and what are some practical tips that investors can take away in order to build out maybe something that gets closer to that four or 500 basis point outperforming? So it depends on time period. So some of the time periods have been better than others. We kind of look at three 10-year subperiods.

It depends on what benchmark you use. And the benchmark can make a lot of difference, especially over a shorter window. It actually turns out that, you know, if you use a small cap versus a large cap benchmark, it doesn't matter a lot over the full 30-year period. But, you know, certainly, you know, more recently having a large-cap benchmark has been a tougher hurdle because, you know, large-caps have outperformed small caps the last 10, 15 years or so. And then also geography matters quite a bit. So one thing that we found is that despite underperforming on an unadjusted basis, non-U.S. private equity has actually done better on a risk-adjusted basis. And so what

what we mean by that is like compare U.S. funds to a U.S. benchmark and compare European funds to a European public benchmark. Because foreign stocks overall have underperformed U.S. stocks, you know, that's, you know, you get a little bit better relative return when you're looking internationally. So, so actually venture internationally has done okay because, you know, the foreign markets haven't done very well. So what looks sort of like underperformance and just unadjusted terms is actually better relative performance. And you care about these relative outperformance and markets because when you're building your portfolio, your diversified portfolio, you invariably want exposure to certain parts of the world or certain markets in the world. So that relative outperformance is relevant versus just

the absolute performance. There's different ways to think about it. One is if you have an asset allocation model and you know, part of that is saying you want to be in global stocks. I mean, I think of buyouts and venture is just, you know, another form of equity. And so you might think I'm going to have a split of my foreign equity that's more tilted towards private markets if I think they're going to perform better, whereas in the U.S., maybe I'm more tilted towards public markets. So you can think about it in that sense. But the other one is if you're just wanting to know, like, do foreign buyout funds or venture capital funds add value, the answer is yes if you use the proper benchmark.

Or as you might think, the answer is no, if you were to, say, use a U.S. benchmark to evaluate foreign managers. And practically, that assumes that you would have exposure to not just. U.S. So it's a context of a public portfolio that you could even make a relative statement on the private portfolio. So I think if you're going to be allocated to global stocks and private is an option for you, you want to think like where is it that I'm going to get the best relative performance in global, global equities? And I think at least historically, you've gotten kind of even better relative performance outside the U.S. than in the U.S. So let's talk about fund size.

what does your research say about large buyouts, small buyouts, and does that play a factor in returns? So we did a study that we released last year that, again, sort of used this really large, comprehensive data set over a very long period of time to look at this question around scale. And what we found was that the average return for smaller funds was higher than for big funds. But that was driven by dispersion. It was driven by the fact that there's just a much bigger right tail in smaller funds than you see in the large funds. So essentially you're averaging in some really stellar performers among small funds to get to that higher average. If you instead look at the median performance, there's basically no difference in the median fund across size

groups. So, you know, if you want to sort of go fishing in the most productive pond for buyout funds, or venture funds, is true for venture as well, the best place to go is the small end of the market, you need the skill to identify who those top performing are going to be. Just a random draw doesn't do it for you. And because these are, you know, private funds, you can't sort of buy an index. You can't buy everything. So you need to feel confident that you have the skill to wade through what's, you know, a pretty large set of managers on the, on the small end and find the ones that are going to be those top performers because that's what drives the higher average. So in smaller funds, you want to be supposed to select.

and larger funds, it's hard to do well. It's hard to do poorly. Yeah, I think the practical implication is it's probably not worth your time doing a lot of due diligence on the big funds because they are, you know, the return experience is pretty similar. There's just not that same level of dispersion. So, you know, maybe if you're going to have some, you know, mega funds, you know, throwing darts is fine. But you definitely don't want to do that at the lower end of the market. You want to use your due diligence budget to go try to find some smaller managers that are going to be real winners. One of the other areas of research that you focus on is persistence of returns, which is if one manager does

well, how likely is he or she going to do in their next vintage? In venture, persistence has remained to be present, meaning that if you pick a manager that does well, he's more likely than on average to do well again. In buyouts, that persistence has lowered significantly over the last 15 to 20 years. Why is that? It's an interesting question. There's some research that sort of documents it pretty reliably. I'd say that what was significant persistence up until about, you know, 2000 and, you know, 10 vintage or so has pretty much gone away at the GP level. But interestingly, what's happened is people have started to analyze the deal partner's performance and found that there is persistence if you actually look at the individuals

who are doing deals. And these, what explains that difference is that people are moving around firms. And you can imagine, you know, a story where what's happened was, you know, people cut their teeth and we're doing really well, you know, it's a, you know, a big buyout shop. But they weren't the founders and the partners. They weren't getting the economics. They thought they deserved. And so then they went off on their own or joined another firm or something. And so they kind of took that talent with them, whatever ability it was, they were they were using to create value. And so, you know, the persistence followed them versus staying with the original GP. What's kind of a mind twist here is that if you follow the incentives, the most rational thing is that for that manager that has unique

deal flow or unique ability to pick is for him or her to leave, but it's also for that GP within that firm to let that person leave because there doesn't seem to be a correlation between the performance as well as their ability to accumulate assets. So both actors could be acting in completely rational ways, and the rational thing is for the person to leave and start a firm. Especially when you think that some of these very large firms are essentially asset gatherers now and earning the bulk of their profits through fees versus carry. And just to add another layer of incentives there, the LPs incentives, which many times in public pensions, I think it's 5.3 years or something they're average in that position. Their

incentives is actually to chase these brands and to chase these asset gathers as stamps on their resume rather than actually bring long-term asset appreciation to their underlying asset manager. So it's these perverse incentives across the entire spectrum. If you're working at a public pension, you know, it's the, you know, IBM issue, right? Nobody gets fired for, you know, buying IBM is the old saw, and it's the same thing with like these major GPs. So, you know, it's very low risk for people who have little upside in their careers to, to sort of take the big established brands. And I think the other challenge is, if you look at public pensions in the U.S., I mean, so many of them are under-resourced and understaffed. They just don't have the bandwidth

or resources that it takes to go out and do diligence on, you know, a large number of relatively least small or new GPs, and they rely on consultants who are also going to bias towards the big name brand folks. So I think there are clearly inefficiencies in the system and, you know, how it gets sorted out. You know, I don't know. I mean, there's other more sophisticated folks that are, you know, sort of investing in the smaller funds, obviously. And so I think those are going to tend to be, you know, endowments and foundations and other sorts of commercial entities, sovereign wealth funds that do have the resources to do that research. When we last chatted, one of my takeaways from our conversation is that venture is about being picked.

In other words, the founder picks the VC and buyout is about picking. So there is actually the skill of picking where venture, I would argue, the skill is actually getting picked. To what extent do you agree to that? The evidence does suggest that VC is more of a relationship type of business and having that reputation, having the access and the network, that's where the value is going to be created. Not that they don't do anything on the kind of operational advising side. I mean, I think there are, you know, firms that add a lot of value through that. But it is more of this kind of relationship-oriented business. And that is, you know, why I think the performance persists and venture, because people, you know, the founders want to be with the top VC firms and

the top VC firms get to see, you know, the best deal flow. And so it sort of makes sense that that network is going to stay intact. Whereas I think buyout is very different. I mean, if you think about, you know, the larger end of buyout space, I mean, effectively most stuff is being sold through auctions now. And so, like, you need to really think, like, why am I going to be the best bidder, the highest bidder for this asset? You need to have some sort of skill that revolves around value creation in order for you to justify, you know, why you're going to be the highest bidder, you know, essentially what's your comparative advantage to add value? Otherwise, it's, there's going to be a kind of a winner's curse in the big buyout space. And I think when you

move down at lower middle market, then it is very much about, you know, building a process for identifying companies where, you know, first of all, you find the companies, because in some cases is just, you know, you need to go out and beat the bushes to find viable investments. But then, you know, what does your playbook look like for adding value? And is that compatible with, you know, the types of companies that you're able to identify? To double click, the term they use comparative skill in large buyout, which is all the large buyouts have similar playbooks. In order to outperform that large buyouts, you need to have something very different. And the research seems to suggest that something doesn't really exist on average. The returns are definitely more compressed on

on the high end. So, you know, if we were talking about alphas in the neighborhood of like two to five hundred basis points for the for the large funds, it's going to be more like 200 basis points, right? It's going to be on the lower. It has alpha in all in large buyouts versus the public markets, but not necessarily between the different matters. The max seven last several years has just done incredible KKK outperform most venture funds. If you assume that this was a once in a generation thing where the large, large caps outperform, does that make an even stronger argument for private equity buyout? Or is that already? priced up. It's interesting to just think about what's happened, you know, the last few years with

the Mag 7. Basically, if you weren't in those, you know, seven stocks, your return experience was very different, even in public markets, right? And so we've done our benchmarking against sort of a value-weighted, you know, total market portfolio. That's kind of our preference. If you were to do this benchmarking on sort of a size match, so you say use small-cap stocks or a small-cap value for buyouts, which sometimes people do, then, you know, the numbers actually look a lot better historically. But recently, I mean, everything has lost in Mag 7, right? Just about, I mean, except maybe gold or Bitcoin or something. But, I mean, if you think about equity investments, private or public, been extremely difficult. What does this mean for investors in private equity? And I think there's,

you know, kind of two kind of bookend answers to that. And the truth is probably somewhere in between. One is that, you know, private markets had it today, you know, we're not going to see the same kind of returns going forward that we've seen in the past, you know, the opportunities in large cap growth. And so why even bother, you know, with private equity? Because it's, you know, its performance the last three to five years has been subpar compared to public markets. The other, and maybe you'll like this being the behavioral person, the other explanation is that we're in the midst of a bubble, right, in public markets. And the MAG 7 are going to come back down to earth. And so staying invested in private markets is the right thing to do. In fact,

it's probably a preferable thing to do if there's a bubble that's going to deflate because they haven't experienced that kind of bubble run up the same way that the Mag 7 has. And I think there is a historical precedent for this. If you look at the relative performance of private markets in the early aughts when the dot com bubble was bursting, that was the best relative returns ever for private markets. The alphas that we calculate these kind of PME type of market adjusted returns were, you know, double digit percentage for the vintages from like 2000 through 2005. It was the Pets.com, the web vans were public companies, so they just got clobbered and the private versions of them performed much better on a relative basis.

Yeah, it's not true of venture, but for buyouts, you know, the performance was okay for those vintages, but the public markets were so bad that the relative performance was fantastic. The prevailing wisdom is to look at asset class as if the valuations are constant. So early stage, it's as if you're always investing $20 million dollar valuation or, say, series A, it's $75 million. But of course, that's absurd because if you take into extreme, if everybody leaves Series A, the valuations go down. And if everybody goes in, the valuations go up.

And we've seen both sides of the story. So there is a game theory aspect to it, which is oftentimes the best time to be in asset classes is when everybody's away from them. Now, that's not always the case because sometimes you have, for example, private equity buyout. They have a lot of dry powder. So even though a lot of people aren't necessarily net new investors there, they still have a lot of money from the previous cycle. So it doesn't always work as a heuristic, but I do think there's this bias to look at asset classes as if the valuation is fixed, which doesn't make sense. I think that's right. And I think we have seen what looks to be a pretty big divergence between public and private market valuations right now. And I mean, private market valuations are depressed. That's why exit activity has been so low. People just don't like what they can sell stuff for right now at the same time that in the MAG7 valuations are just off the charts.

This isn't like advocating for private equity. But, you know, if I was forced, to, you know, put all of my money in either the Mag 7 or a diversified private equity portfolio, I would definitely pick the diversified private equity portfolio because it is more diversified, right? If you could put me in, you know, 20 different buyout funds right now, go to the secondary market and buy some of the different vintages and different strategies, that just feels like a much more prudent investment than even the S&P 500 that's, you know, now a third mag 7 value. Yeah, the SMP 493, as some people call it. Right.

Well, Greg, this has been an absolute masterclass. Thanks so much for jumping on. Look forward to continuous conversation live. It's my pleasure. Thanks for having me. Thank you. That's it for today's episode of How I Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person your network who'd find a valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.