Holding a magnifying glass to private equity
February 7, 2019
Just over half (51 per cent) of foundations and endowments said they believe private equity returns will outperform those of other asset classes over the next 12 to 24 months, according to a survey by NEPC Investment Consulting in late 2018. Conversely, only four per cent said they believe private equity returns will lag.
Institutions have been increasing allocations to private equity and continue to do so, leading to record amounts of funding in the space. Surplus capital begets higher valuations; buyout deal multiples are as high as they’ve been in decades and are rapidly converging toward public market levels. As dry powder accumulates, the industry has shifted, resulting in lengthening portfolio company holding periods, an increase in fund-to-fund transactions — often within the same sponsor — and a focus on deals with higher return potential, such as turnarounds. Given industry headwinds, the inherent complexity of the asset class and its typically higher costs, investors must determine the extent to which private equity has a place in their portfolios.
Private equity investments are typically valued using a quarterly net asset value methodology. It’s well-understood within the industry that both the infrequency of valuation and the inherent subjectivity of the process lead to artificially low reported volatility and cause return streams to appear less correlated to those of public markets. These issues can lead to suboptimal results from a portfolio construction standpoint — artificially depressed volatility and correlation will cause an asset class to be much more likely to be part of an efficient frontier portfolio.
Considering this alongside U.S. pensions’ dismal funded statuses, low global fixed income returns and the increasing application of the endowment model among not-for-profits, it’s easy to understand why institutional capital is flooding the space. Of course, it would be disingenuous not to acknowledge that private equity has generated returns in excess of the public markets over most time horizons, though this shouldn’t necessarily come as a surprise given that the asset class is generally characterized by high leverage and illiquidity.
The private equity secondary market features transactions in pre-existing investor commitments, generally years after their inception. Researchers at Ohio State University and Brigham Young University released a working paper proposing a new approach to evaluating performance, which used the actual prices paid for limited partner shares of funds in secondary markets. The approach consisted of constructing an index of buyout funds and inferring a time series of prices for each fund within the index based on transactions that occurred during the relevant periods.
The researchers found the buyout funds’ returns exhibited a beta greater than two, likely due in large part to the significantly increased leverage introduced by the general partners (fund managers). This elevated beta indicates significantly higher exposure to market risk and much less in the way of true alpha relative to what an allocator might expect when undertaking a private equity investment. Over the 2006 to 2017 analysis period, the buyout index averaged a 20 per cent return, yet after adjusting for the elevated beta, the assessed alpha using the capital asset pricing model methodology wasn’t significantly different from zero. In sum, the researchers concluded that buyout funds provided no outperformance of public markets on a risk-adjusted basis.
So investors must ask themselves: What level of alpha can one reasonably expect to achieve with private equity investing and does its benefit outweigh higher management fees and due diligence costs?
It’s worthwhile to note that issues around cost can be partially mitigated if an institution’s platform has sufficient scale and resources, since it may have the ability to use either direct investment or co-investment approaches as opposed to a typical fund structure. These approaches offer significant reductions in fees, though diversification is more difficult to achieve because capital per deal is generally significantly higher. Due diligence costs are generally greater when straying from the general partner—limited partner structure as well.
It’s critical for investors to assess their own governance structures and investment platforms to determine whether it’s appropriate to include private equity in their portfolios. This assessment is likely to uncover that, in many cases, investors would be better suited to focusing on more liquid, transparent asset classes in executing their mandates.
Emerson Savage is an associate institutional portfolio manager at Louisbourg Investments.