Private Equity’s Hidden Edge: What the Fed’s Secret Data Reveals

If you've been frustrated with your private equity allocations or wondering whether the hefty fees are worth it, a new study from the Federal Reserve gives some answers… Researchers got their hands on the complete, confidential regulatory filings (SEC Form PF) that every major private equity fund must submit to the government. No cherry-picking, no marketing spin, no sample selection bias that has plagued previous PE studies.

Think about it this way – every prior study on private equity performance has been like trying to understand the restaurant industry by only looking at the establishments that volunteer to be in Zagat. This study is like having access to every restaurant's health department inspection records, tax filings, and actual customer receipts.

SEC Form PF is a confidential regulatory filing required of all SEC-registered investment advisers with at least $150 million in private fund assets under management.

The form asks for detailed information about each private fund including asset values, borrowings, investor classifications, performance, strategy, counterparties and trading style. It captures everything from internal rates of return and leverage ratios to industry concentrations and portfolio company details.

Unlike other regulatory filings, Form PF filings are confidential – meaning they are not available to the public. Under Dodd-Frank, the SEC is even authorized to withhold Form PF information from Congress. This study was the first to access this treasure trove of mandatory, comprehensive data – eliminating the sample selection bias that has plagued every previous private equity study.

The headline finding? Private equity genuinely outperforms public markets, and it's not even close. We're talking about superior returns and better risk-adjusted performance across virtually every major industry sector. 

This outperformance isn't just some statistical quirk or the result of a few superstar years. It's consistent across the entire 2004-2023 period studied, even accounting for the 2008 financial crisis and recent market volatility.

Reward-to-Risk Ratio Explained

The 1.55 vs 1.1 comparison is measuring average annual returns divided by the standard deviation (volatility) of those returns. Think of it this way:

This means private equity is delivering about 41% better risk-adjusted performance than the public markets. You're getting more bang for your risk buck.

Here's where the study gets actionable for your portfolio allocation: bigger is definitively better in private equity. The data shows a clear, monotonic relationship between fund size and returns. Limited partners in the largest funds earn roughly 4% more annually than those in the smallest funds, while also enjoying significantly lower volatility.

Larger funds can afford the best talent, conduct more thorough due diligence, provide operational support to portfolio companies, and access deals that smaller funds simply can't compete for.

It’s often argued that smaller funds can potentially arbitrage cheaper valuations at smaller companies due to lower competition and higher risk. Here's why the data suggest that size still wins:

The small fund arbitrage theory works in principle but breaks down in practice:

The study controlled for these factors and still found the size premium held. The reality is that while small funds can access cheaper initial valuations, large funds can better execute value creation and achieve superior exits.

Here's a counterintuitive finding that could reshape your thinking: while spreading investments across many industries reduces raw returns, the risk reduction is so dramatic that it actually improves your risk-adjusted returns. 

Funds investing in 10+ industries earn about 6% less in raw returns but have 13 percentage points lower volatility – a trade-off that significantly improves the reward-to-risk ratio.

This suggests that private equity's sweet spot might be moderate diversification (2-9 industries) rather than either hyper-focus or excessive diversification. It's portfolio theory in action: there's an optimal level of diversification where you maximize risk-adjusted returns rather than raw returns.

Perhaps the most surprising finding: leverage doesn't generate excess returns. This fundamentally challenges the conventional wisdom about leveraged buyouts (LBOs). The study found that funds investing in highly leveraged companies don't earn any premium for taking on that additional default risk and complexity.

This suggests that the private equity industry's heavy focus on LBO strategies – which have dominated headlines and fee structures – might be misguided. You're taking on additional risk without compensation.

For wealthy investors frustrated with public market concentration and seeking true diversification, this study provides compelling evidence that private equity deserves a serious allocation.

Focus on established players: The size premium is real and substantial. If you're allocating to private equity, prioritize access to large, established funds with proven track records over newer, smaller managers promising higher returns.

Question leverage-heavy strategies: The finding that leverage doesn't generate risk premiums should make you skeptical of LBO-focused funds that charge premium fees for taking on additional complexity and risk without compensation.

Embrace moderate diversification: Look for funds that invest across 2-9 industries rather than highly concentrated or overly diversified strategies. This sweet spot maximizes risk-adjusted returns.

Disclaimer

This newsletter is for informational and educational purposes only and should not be construed as personalized financial, tax, legal, or investment advice. The strategies and opinions discussed may not be suitable for your individual circumstances. Always consult a qualified financial advisor, tax professional, or attorney before making any decisions that could affect your finances. While we strive for accuracy, we make no representations or warranties about the completeness or reliability of the information provided. Past performance is not indicative of future results. All investments involve risk, including the possible loss of principal. The publisher, authors, and affiliated parties expressly disclaim any liability for actions taken or not taken based on the contents of this publication.