Private Equity Adds Value in Tough Markets

Though the talking heads are divided on the ultimate direction of markets in 2016, no one seems to dispute that the reliable 8% IRR figure formerly known as “equity-like return” has vacated the premises, at least for the foreseeable future. The days of U.S. GDP growth at a ruddy 4% clip also seem to have gone the way of handwritten correspondence.1 Investors' needs for wealth accumulation and purchasing power preservation, on the other hand, have not adjusted downward with the markets and the U.S. economy. How — the investment question of the decade thus far has been— is an investor to bridge the gap?

Sometimes the market hands us a dislocation — it was all risk assets in 2009, especially mortgage-backed securities. Energy may be today's opportunity, though if successful, it will require patience. These are tactical plays, and investors may benefit in seeking them out. But they don't come around often. Meanwhile, there are also, longer-term, more persistent — or strategic — opportunities inherent in certain styles of investing.

Since the practice of investing in private equity involves buying and selling companies as public market investing does, private equity performance would seem to be just as chained to public markets and economic growth as that of any mutual fund. And indeed, private equity does have a “beta” component, a portion of its return that is related to how public markets fare. It also, however, has an “alpha” component — a “value-add”— that is quantifiable and that does not depend on strong markets and economies.

To quantify this value-add, we start with an equalizing factor — a conversion of public market returns to private equity terms by taking into account the timing of cash flows. (Private equity investments are not made in one lump sum like investments in mutual funds, ETFs or even hedge funds for that matter; rather, capital is “called” as needed to fund investments.) To arrive at a public market return under private equity conditions, research firm Cambridge Associates calculates a modified Public Market Equivalent (mPME) IRR for public market indices. The Cambridge mPME assumes that shares of an index are purchased and sold according to the same schedule and in the same proportion as in the private equity funds it is being compared against. Cambridge compares this number to its PE benchmark, and the difference between them is the amount by which private equity out- (or under-) performs a cash flow equivalent public market benchmark. Cambridge terms this number private equity's value-add, expressed in basis points.

This value-add number is not a constant— it fluctuates from vintage to vintage and can seem hard to pin down. It was mixed in the late '80s, substantial throughout the '90s and into the early aughts and tailed off heading into the 2008 crisis. The most recent vintages (2012 and onward) are either still in investment period or newly in harvest mode and have yet to demonstrate whether they can exit companies at value-additive multiples.

Despite the seeming randomness, exciting patterns emerge when we regress the value-add numbers over several vintage years against economic growth and market performance indicators. First, there is a negative correlation (-0.40) between private equity value-add and economic growth during the life of the matching vintage's funds.2 And second, there is a negative correlation between private equity value-add for a given vintage year and the annualized performance of the S&P 500 for the ten years that follow. Translation: private equity has historically added the most value relative to the S&P 500 in vintages where the fund's life is characterized by tepid U.S. economic growth and weak S&P 500 performance. This may come as a surprise initially, but it is actually intuitive: private equity funds start with an investment period, generally 3-5 years, during which capital is deployed. If the market is declining or volatile during that period, dealmakers at private equity funds may have the opportunity to invest at favorable prices — if, that is, they can muster the conviction to stay off the sidelines.

Private equity investing requires a lot of things that mutual fund and ETF investing does not, patience being key among them. Investors in private equity funds should expect to be unable to access their capital until the end of the fund's life, which is sometimes as long as 10-12 years away. Private equity funds also charge higher fees than public market options. But these are the price of added value. Private equity has offered outperformance over public markets generally and in particular when initiated in weak markets and weak U.S. economic growth regimes.3 This dynamic is the stuff that diversification is made of.

It should be noted that the Cambridge private equity index measures performance across the entire private equity fund universe that Cambridge studies and as such it represents average performance. While it goes without saying that investors should seek to invest in better-than-average funds, the pursuit of excellence is particularly important where private equity is concerned. Compare the IRR of the median 2012 vintage private equity fund in Preqin's database with the return required to make Preqin's top quartile, and the difference is nearly 1,000 basis points of net IRR.4

Uncorrelated value-add is there for the taking with private equity, but whereas you may be able to cover exposure to publicly-traded large-cap blend stocks via ETFs without sacrificing much in performance, private equity calls for rigorous manager selection and commitment minimums reduce your ability to diversify. It behooves the investor to choose carefully: there is a lot of alpha at stake.

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