Private Equity can be a winner but invest with your eyes open and your brain engaged
16 November 2021
Anyone engaged with their portfolio will have noticed two developments accelerating over recent years. Firstly, bond and equity performance has become increasingly closely correlated. Secondly, many large and attractive businesses are held privately. It’s getting harder to manage risk with a traditional portfolio and some opportunities are just off the menu.
Here we will examine whether the inclusion of Private Equity in your portfolio can help tackle these problems and what its impact on your overall return might be.
Private Equity (PE) is essentially an alternative form of funding. A PE fund will acquire private companies and look to implement change or drive growth. It has historically been seen as a complex asset class that your average punter would stay clear of. It’s difficult to access due to high minimum investments and the need for an extensive network, which means that most PE investors are institutional (endowment funds, pension funds etc.). Over recent years though, there have been more vehicles offering retail investors opportunities to invest in Private Equity. With the multitude of other more ‘vanilla’ asset classes available such as public equities, fixed income, real estate and commodities, this raises the question: what is the role of Private Equity in portfolios and does it actually add value? In short, it can help diversify, provide attractive risk adjusted returns and even protect on the downside. However, it’s not a straightforward world to navigate and achieving this outcome is certainly not easy for an everyday investor.
“We will argue that Private Equity does have a role, but there are some considerations you must evaluate carefully. As always be careful not to drink the Kool Aid…”
Firstly, let’s deal briefly with the plumbing so we can look at this issue effectively. In our opinion, Private Equity should be seen as a high risk asset. As such, it seems natural to consider the inclusion of Private Equity as a replacement for part of the equity allocation within a portfolio. However, comparing the performance of Private Equity against Public Equity is not a straightforward task. Private Equity funds hold cash back and time their investments carefully. They report their performance using internal rate of return (IRR), which excludes uninvested cash positions to take this into account. This is quite different from the typical total return measurement used to assess Public Equity. To overcome this, researchers have helpfully developed a measure known as ‘public market equivalent’ (PME) to calculate comparative performance. PME essentially adapts Public and Private Equity returns to account for these variances.
One recent study1, looked at over a thousand buyout funds with vintage years between 1997 and 2020. Using PME methodology, it found that including a 20% Private Equity allocation into a balanced 60/40 portfolio led to a 0.6% annualised outperformance. Although this might sound small, this becomes a meaningful additional contribution to returns when compounded over time. However, some institutions like Bain2 and JP Morgan3 have started to suggest that the outperformance of PE is narrowing. The FT’s US financials’ commentator wrote a piece in the Financial Times4 titled ‘Private Equity’s meh decade’ that reflected this thinking. He highlighted the diminishing outperformance of US Private Equity with total returns equalising the S&P 500 index over the last five years.
The answer is probably more nuanced than this though. Since 2016, returns of the S&P 500 have been driven by outperformance of the five largest technology companies (Apple, Microsoft, Amazon, Facebook and Alphabet), which together make up more than 20% of the index. These are quality companies and they have seen strong growth in earnings and margins over this period. However, much of this has been driven by sentiment from retail investors and increased flows into ETFs. This means that these companies are now valued at extremely high multiples of their earnings. If they are stripped out of the index, it tells a very different story. By contrast, Private Equity returns in Europe and Asia have significantly outperformed public markets over the same time horizon. In the UK, Public Equity returns have lagged global equity markets by over 150% over the last 10 years but UK PE has averaged 19.6% IRR 5, per annum, and outperformed global peers. The evidence for investing in Private Equity is nuanced, yes, but certainly compelling.
The theoretical rationale for PE is also persuasive. Holders of Private Equity believe that companies that are privately owned by a concentrated group of individuals are more conducive to effective decision making. This, in turn, drives growth. Deciding when to buy and sell companies or instigate change is generally much faster and easier with a smaller group of decision makers. Private Equity management teams, backed by an aggressive capital structure, are also highly incentivised to implement a much narrower and profit focussed agenda than typically found in publicly listed companies. Their desire and ability to harness leverage also plays a significant part.
Another advantage of investing in Private Equity is that information is confidential, unlike in public markets where any material information that may affect share prices must be disclosed. This opens up the possibility of large dislocations between prices and intrinsic value, offering opportunities for skilful active managers to generate significant returns. Historical data has shown that listed companies with a smaller market capitalisation tend to outperform larger companies over time, as there is generally more scope for these companies to grow and capture market share. Private Equity funds can benefit from this, with the ability to invest in private companies at early stages in their lifecycle.
Private Equity does offer some very interesting upside opportunity then, but interestingly it can also be great for managing drawdown risk. It helps to ensure that the mix of asset classes in a portfolio are uncorrelated in stress scenarios. During the peak of the Covid-19 crisis, the vast majority of assets class correlations increased – stocks, bonds and even ‘safe-haven assets’ like gold moved together. In contrast, historical data shows us that Private Equity investments typically behave defensively during Public Equity drawdown periods. Private Equity substantially outperformed public equities during the financial crisis for example. From March 2008 through to March 2011, public equities declined 3% while Private Equity gained 11%7. Private Equity investments are not revalued as frequently as public markets, which will create a smoothing effect on portfolio returns. Moreover, private markets are not subject to the same level of mass selling in stressed scenarios driven by deteriorating investor confidence. This is why they tend to hold up so well during tumultuous periods. We saw this during the Covid panic – which was characterised by an extremely swift drawdown and subsequent recovery in public markets, while many Private Equity funds experienced fairly minor devaluations even at the trough.
Let’s deal now with the barriers that have prevented even sophisticated retail investors from engaging with this asset class.
Regardless of the opportunity, many retail investors have been hesitant to hold Private Equity due to liquidity concerns. Traditional Private Equity funds are long lock-up vehicles, where capital can be inaccessible for many years. It’s certainly something to consider and if access to capital is your main driver, it may not be the best home for all of your money. However, if investors allocate only a portion of their capital to Private Equity and retain liquidity elsewhere, it can be a useful component for your portfolio. Most retail investors already contribute to a pension where they are not able to access the funds until retirement age but choose to benefit from tax relief in exchange for limited accessibility. The illiquidity associated with private markets creates opportunities that can be exploited through inefficiencies and illiquidity premiums – in many ways, it’s a similar trade off to a pension.
Though Private Equity funds are generally difficult for retail investors to access due to high minimum investment amounts, there have recently been more funds launched in semi-liquid structures with much lower thresholds. Of course, if your money is looked after by a wealth manager, their pooled funds can provide PE access to an everyday investor that may have proven entirely inaccessible on an individual basis.
Another concern is that the charges are high and performance fees are commonly levied. Conversely, public equities can be accessed at very low cost levels. This is true, so we have to dispassionately look at the maths. The figures previously referenced to compare public and Private Equity are net of all fees. In the right circumstances, it can be an extremely high returning asset class and it is necessary to pay the fees to access these returns. In the long run, regardless of cost, Private Equity will likely still outperform.
So what are the other considerations that might drive the decision to include Private Equity in your portfolio?
We need to look to the future. Whilst there is a case for PE from past data, it’s important to determine if the factors driving outperformance are still in place. The number of publicly listed companies is decreasing and more companies are looking for private funding to fuel growth. The number of US-listed public companies has fallen from over 8,000 in 1996 to just over 4,000 today8. Data from the UK show an even more drastic trend. The increasing investment universe in Private Equity has created opportunities for managers to generate strong returns.
In summary then, PE has offered some excellent historical outperformance in the right geographies and sectors, and the current environment seems to provide a platform for this to continue. Not only does it offer some potential outperformance but it can also provide downside protection in falling markets – the investing nirvana perhaps! If you have the capability and experience to access alternatives like Private Equity it can be key to effective diversification and achieving higher risk-adjusted returns. However, be cautious. Work with a team that has substantial experience in alternatives and for whom it’s an important area of focus for client portfolios. Those that fail to embrace them may be left behind, but consider this asset class with your eyes open and your brain engaged…
- Pitchbook study. Retrieved from https://www.institutionalinvestor.com/article/b1slspnq5t0f49/Is-This-the-End-of-the-Fiery-Public-Versus-Private-Equity-Debate
- Retrieved from https://www.bain.com/insights/public-vs-private-markets-global-private-equity-report-2020/
- JP Morgan. Retrieved from https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/private-equity-food-fight.pdf
- Retrieved from https://www.ft.com/content/c7c17c36-6046-415e-adad-68da72a96e1c
- BCVA Performance Measurement Survey. Retrieved from https://www.bvca.co.uk/Portals/0/Documents/Research/Industry%20Performance/BVCA-Performance-Measurement-Survey-2020.pdf
- Retrieved from https://fidelityinternational.com/editorial/blog/chart-room-why-stockbond-correlations-are-turning-positive-03685b-en5/
- Cambridge Associates. Retrieved from https://www.cambridgeassociates.com/insight/diversification-challenges/
- The World Bank. Retrieved from https://data.worldbank.org/indicator/CM.MKT.LDOM.NO?locations=US
Saltus Asset Management is a trading name of Saltus Partners LLP which is authorised and regulated by the financial conduct authority. Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.
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