Private Equity’s Paper Tigers

These elite funds style themselves as the alpha predators of the investing jungle. But their investors may be the only ones to get bitten.

With 2015 shaping up as the worst year for investing since the Great Recession, investors are wondering where to turn. Stocks? They had a tumultuous and disappointing year. Bonds? Credit concerns multiplied, and spreads widened. Oil or other commodities? Fuggedaboutit. For many investors, institutions in particular, private equity beckons as a singularly soothing and lucrative safe haven.

PE managers, the promise goes, protect your assets from the volatility wrought by a teetering China or a skittish Federal Reserve. And thanks to the managers’ adroit dealmaking and operational wizardry, returns magically outpace those in the stock market. No wonder private equity is increasingly the “alternative” of choice. Public pensions now have a tenth of their assets in these private and opaque vehicles; some endowments have much more.

Buoyed by uncommonly low interest rates, the industry has boasted of double-digit returns; the past few years, at least anecdotally, have been especially rich. “We’ve been waiting for big news from the PE industry for almost five years, and 2014 delivered,” exults a 2015 report from Bain & Co., an industry consultant, which goes on to tout the $456 billion in “exits”—cash redeemed from the sale of companies formerly held by private equity funds. It was “a year for the record books.”

I’ve always been uncomfortable with the Panglossian cheerleading that has surrounded private equity. Although the name has changed, it’s still the same industry once denoted as “leveraged buyouts”—that is, the business of buying companies with a thin slice of nonpublic equity and mountains of debt, in which fund managers grab richly generous (to themselves) fees. In theory the funds provide managerial expertise, improve the underlying businesses, and cash out—usually within three to six years. Until they do, investors rely on managers’ estimates to gauge their results. (That’s because PE is, indeed, “private”—there is no centralized reporting or standard index of returns.) Then there is all that debt, raising the nagging suspicion that the secret sauce, if one exists, of successful PE firms isn’t managerial competence but leverage.

I have wondered, too, whether the designation “alternative” is really appropriate. Are companies truly different by virtue of having private rather than public stock ownership?

At the very least, more reliable data has started to close the information gap. Public pension funds are required by the states in which they are domiciled to report on their PE holdings. Firms such as Cambridge Associates and Preqin have compiled returns from individual investors (generally known as limited partners, or LPs). The data is increasingly inclusive; moreover, since it derives from investors rather than fund promoters, it is less likely to be tainted.

And the data is pretty unambiguous. Over its now three-decade-plus history, PE outclasses the stock market (or at least the Standard & Poor’s 500) by about three percentage points a year. The edge is clear.

Or is it? What has really happened in private equity over those decades is that investors, net of fees, did about 25% better than the S&P up through the 2005 “vintage” year (denoting funds that first drew capital in 2005). But PE performance in the 2006 through 2010 vintages, tracked through mid-2014, has been running on par with the S&P.

That’s a stunning finding. It means that since 2006, this touted “alternative asset class nonpareil” has actually been mediocre. The conclusion comes from a soon-to-be-published paper, “How Do Private Equity Investments Perform Compared to Public Equity?” by Robert S. Harris, Tim Jenkinson, and Steven N. Kaplan. Kaplan, who is at the University of Chicago’s Booth School of Business, is probably the foremost private equity scholar in the galaxy. (Harris is with the Darden School of Business at the University of Virginia, and Jenkinson is at Saïd Business School at Oxford.)

Kaplan, in the past, has been positive on the industry, but he bristled when I called him a PE supporter. “I report what I find,” he told me. And what he and his colleagues find is that “post-2005 vintages have been roughly equal to public markets.” The trio relied for their data on Burgiss, a Hoboken, N.J., firm that provides support services to institutional investors and has turned its database into an ersatz index of limited partnership performance. The Burgiss data includes nearly 300 investors and some 1,800 funds (roughly split among private equity and venture capital) in North America alone.

While no one else has compiled such a comprehensive and critical study, supporting evidence has crept into the literature. In its 2015 PE report, published early in the year, Bain commented, “A disquieting concern lurks just beneath [PE’s] shining surface.” Relying on Cambridge data, Bain found that U.S. buyout funds underperformed a public market equivalent over one and three years, and merely matched it over five. Bain concluded, “PE’s continued ability to outpace public market gains over the long term can no longer be taken for granted.”

Given that the Harris-Jenkinson-Kaplan study, which will be published in the Journal of Investment Management, has been available online, it seems strange that hardly anyone has noticed. But money continues to pour into PE funds. As of 2014, they manage $2.6 trillion in assets and are sitting on another $1.2 trillion of “dry powder,” that is, capital committed but not yet invested. (The figures include those for venture capital funds. While VC is best thought of as a distinct business, figures for it and PE are often lumped together.)

According to Kaplan, historically PE has been least successful when investment capital is in ample supply. And at present, PE funds are choking on cash, driving up prices of potential targets. LPs as well as fund managers describe an auction environment in which targets are going for near-record multiples of cash flow. “There are certain sectors we used to invest in where we no longer do,” notes Ben Cukier, a founding partner at Centana Growth Partners, which specializes in PE investments in financial services and enterprise technology. “There are no cash flow multiples because [some] companies are losing money.” Adds a dealmaker in New England: “Right now we are back to where we were in 2006. It feels pretty frothy.” Consistent with such comments, capital committed to PE funds has lately been at its highest level ever relative to stock market capitalization, save for the pre-crash year 2007. It amounts to “wind in your face,” Kaplan says, “which is what we have now.”

Industry advocates, while not denying that relative results have tapered off, stress that private equity is not monolithic. Some fund managers are more talented than others; some are more nimble or invested in more fertile terrain. (Indeed, before fees, PE funds overall have beaten the S&P by a healthy margin, which suggests either some prowess on the part of their managers or, perhaps, the effect of leverage.) Boosters suggest that this is something that investors can know a priori. For example, PE data provider Preqin counsels, “By choosing the best-performing fund managers, investors can generate premium, long-term returns.”

Ah, wouldn’t we all love, retrospectively, to pick the best of anything? If only it were so easy. Adding to the challenge is that so-called persistence—the tendency of a PE firm’s past results to be predictive going forward—has plummeted, according to academic research. Gary Pinkus, North America managing partner at McKinsey & Co., says investors should look for funds with specialized capabilities, but as a McKinsey report under his name admits, “Track record is no longer a reliable indicator.” Echoes Kaplan: “It’s hard to tell what the good funds are.”

What the anecdotal evidence and various research studies describe is a picture of a maturing (or mature) industry. As with hedge funds, early returns were achieved by a pioneer group with apparently exceptional talent. The high management and profit-sharing fees may even have been deserved. As more players entered the game, it was inevitable that average competency would veer toward the mean. And even if every PE firm were imbued with genius, the mere fact that the field is so crowded would drive up deal prices and depress returns. Today an estimated 2,250 private equity funds are hitting the hustings raising cash. In 2014, such funds hauled in $177 billion, according to Preqin.

While private equity has not suffered the embarrassment of the hedge fund industry, which has trailed the market since the start of 2009, the evidence suggests that PE now provides outsize rewards only to its managers. The returns for investors are ordinary. And that, importantly, would make it a worse investment on average than the stock market because PE is illiquid. If you can’t earn a premium, why tie up your money for five, six, or more years?

So why do institutional investors and some well-heeled optimists keep falling for the pitch?

One selling point is the widespread perception that private equity is less volatile than traditional market investments. PE firms revalue their assets only once a quarter, so on the surface it’s far tamer than the stock market, a fact that institutional investors appreciate. What’s more, PE firms tend to adjust their valuations cautiously. One insider told me, “In a down [stock] market, they are not marking to market”—perhaps an overstatement, but suggestive of the tendency to smooth results.

But it should be remembered that the underlying businesses owned by PE firms are not less volatile than other real-world companies. To distribute profits, PE firms eventually have to sell assets. At that point real prices—and volatility—cannot be avoided.

Each institution, of course, thinks its PE funds will outclass the field—but as noted, funds are operating in a turbocharged market. According to S&P Capital IQ, LBO prices in 2015 (through early October) were almost six times cash flow, close to the peak reached in 2007. Earnings coverage was better due to more stringent bank regulation and lower interest rates. But for the 10 largest deals, debt accounted for nearly two-thirds of the purchase price, far above the 50% level that prevailed in the cautious period after the mortgage debacle. Make no mistake, the buyout market is bubbly. Even Bain refers to the “mountain” of capital chasing deals, resulting in “chronically high” prices.

Perhaps as a result of high going-in costs, PE firms are having to hold on to assets longer to wring out improvements. And they have all but ceased making the public-to-private deals that the industry was famed for. With stock prices so high, public firms are almost off-limits. Moreover, activist investors are pushing public companies to improve operations, eviscerating the rationale for buyouts.

PE firms, to be sure, have found new hunting grounds. Many are buying companies from other PE firms. There are even tertiary deals, in which operating companies are traded to a third fund. (Kaplan estimates that 25% of PE deals are PE to PE.) But think about this: If firm A buys a company ostensibly to engineer improvements, how many improvements will be left for buyout firm B (or C, or D)?

One seasoned private equity lawyer savvily points out that PE is a people business and that fund performance depends less on the brand name of the fund family than on the specific people managing the fund. Many big institutions, though, are too overwhelmed by the need to invest buckets of cash to pay close attention—and so much of that cash, in turn, now goes to giants as well. “It’s salad days for KKR, Blackstone, Apollo,” says Jonathan Grabel, chief investment officer at Public Employees Retirement Association of New Mexico, referring to the trio of titans in the PE realm.

It’s a truism that as funds expand, it’s harder for them to beat the market. It’s more difficult, after all, to find smart, cheap investments for all that money. Less known, but equally true, is that managerial incentives shift as well. If you talk to people in the PE world, you quickly encounter the fear that the largest firms are driven less by performance than by the hunger to gather assets. Management fees are so significant, Grabel says, that general partners often feel “a temptation to put money to work.”

A PE manager in Boston told me something similar. “In the early days,” he says, “there was a very good alignment” of investor and managerial interest. Managers covered their expenses with the fee—typically 2% of assets—and created wealth on the “carry,” their 20% share of the profits. But as assets under management grew, the biggest firms could reap huge profits merely from the management fee.

This is true even as some funds have buckled under investor pressure and cut their rates. “There is a misalignment” of interests, Kaplan says. “With the very big players that’s a real concern.” One could say that private equity funds have, at least in their thirst for assets and their run-of-the-mill returns, begun to resemble grubby, conventional mutual funds. As an industry, mutual funds long ago dropped any pretense of beating the market. Can private equity be far behind?

Roger Lowenstein is the author of the recently published America’s Bank and a director of Sequoia Fund.

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A version of this article appears in the December 15, 2015 issue of Fortune.