Private Equity vs. S&P 500: The New Active-Passive Performance Debate

The long-standing debate concerning the efficacy of active investment management versus passive indexing continues to evolve, pushing the boundaries of financial analysis into new asset classes. Eighteen years ago, a landmark wager between investment manager Ted Seides and Berkshire Hathaway CEO Warren Buffett underscored the challenges faced by actively managed hedge funds in outperforming the S&P 500. As that historic ten-year contest concluded with a clear victory for passive indexing, the financial community is now contemplating an equally significant, and perhaps more contentious, comparison: private equity’s performance against broad market indices.

• The original 2008-2017 wager pitted Protégé Partners’ hedge funds against a low-cost S&P 500 index fund, which ultimately prevailed.
• Warren Buffett’s victory resulted in a charitable donation exceeding $2 million to Girls Inc. of Omaha, facilitating the purchase of Protégé House.
• A new “shadow wager” is proposed to rigorously compare the performance of North American private equity buyouts against the S&P 500.
• This initiative seeks to validate private equity’s value proposition, particularly its ability to consistently outperform despite substantial fees.
• Ted Seides estimates the probability of private equity outperforming the S&P 500, net of fees, at approximately 40 percent.

The Historic Buffett-Seides Wager

The original bet, which spanned from January 1, 2008, to December 31, 2017, established a direct competition between a basket of hedge funds managed by Protégé Partners and a low-cost S&P 500 index fund. Despite initial optimism from the active management sector, the S&P 500 ultimately emerged victorious. While Buffett had initially assigned himself a 60 percent chance of winning, Seides, then president of Protégé Partners, had estimated an 85 percent chance in favor of the hedge funds. In retrospect, Seides acknowledged an element of overconfidence, suggesting that an unprecedented intervention by the Federal Reserve during the global financial crisis played a significant role in averting what could have been a “lost decade” for the broader market. Beyond the financial outcome, the wager fostered notable relationships, including annual dinners attended by Buffett, Seides, Todd Combs, Ted Weschler, and Scott Bessent, who now serves as the Treasury secretary. Crucially, Buffett’s triumph culminated in a charitable donation of more than $2 million to Girls Inc. of Omaha, enabling the acquisition of Protégé House.

Introducing the Private Equity Challenge

Building on the profound insights derived from this seminal wager, a new proposition has emerged: a direct comparison between North American private equity buyouts and the S&P 500. This matchup carries significant implications, especially as private equity expands its footprint into wealth management and institutional pension plans, seeking to unequivocally validate its value proposition. The central premise, echoing Buffett’s initial argument, revolves around whether sophisticated financial professionals, despite strong incentives, can consistently overcome the substantial fees inherent in private equity structures. Both asset classes offer diversified exposure to the US economy, sharing macroeconomic sensitivities and common sector concentrations. Technology and software, for instance, are prominently featured in private buyouts, much like the “Magnificent Seven” in the S&P 500. Furthermore, their valuation metrics, such as price-to-earnings (P/E) for public stocks and enterprise value-to-EBITDA (EV/EBITDA) for private buyouts, are largely correlated, which can facilitate arbitrage opportunities.

Structural Advantages of Private Equity

While sharing broad market exposure, private equity holds several theoretical structural advantages that could contribute to superior returns relative to the S&P 500. These include:

• Leverage: Private equity portfolios typically carry significantly higher debt-to-equity ratios, approximately 1.5 times, compared to the S&P 500’s average of around 0.6 times. Assuming positive returns and a return on assets that exceeds the cost of capital, this leverage can substantially amplify equity returns.
• Size: Businesses acquired by private equity firms are generally smaller than those comprising the S&P 500. Historically, smaller-capitalization companies have demonstrated a tendency to outperform larger ones, though this premium has been less consistent in recent years.
• Dispersion: Private equity exhibits a wider dispersion of returns among managers than public equities. This creates greater opportunities for skilled allocators to generate alpha through superior manager selection.
• Illiquidity: The illiquid nature of private equity investments can, counter-intuitively, benefit investors by precluding impulsive trading decisions—a factor often cited as undermining public market investor returns due to behavioral biases.
• Control: Private equity firms typically assume control ownership, enabling direct strategic intervention and the implementation of management incentives closely aligned with performance. This often leads to more agile and focused operational improvements than observed in widely held public companies.

Quantifying these theoretical benefits reveals the scale of the challenge. If the S&P 500 delivers a 10 percent return over a decade, private equity would need to achieve approximately a 15 percent gross return to outperform the index after accounting for its typically higher fees. Current interest rates and spreads suggest that the leverage component could bridge 2 to 3 percentage points of this gap. However, the multi-decade tailwind of declining interest rates, which historically bolstered private market returns, is no longer a given. Furthermore, while smaller companies can exhibit faster growth, the historical small-cap outperformance of roughly 1.5 percent per year over large caps has been marginally negative since the Global Financial Crisis. Combined, these structural benefits might account for approximately 80 percent of the required performance differential. The remainder hinges on the abilities of allocators to select top-tier private equity managers, the firms themselves to execute superior investments, and the underlying management teams to deliver exceptional operating results.

Outlook and The Proposed “Shadow Wager”

Despite the inherent tools available to private equity managers for value creation, predicting future performance remains a formidable challenge. Ted Seides estimates the odds of private equity outperforming the S&P 500, net of fees, at around 40 percent. This assessment underscores the complexity of the comparison and the significant hurdles private equity must overcome. The proposal for a “shadow wager,” initiated on January 1, with annual reporting over the next decade, aims to rigorously test this hypothesis and potentially uncover further insights into the long-term dynamics of private versus public market performance.