By Michael McKeown, CFA, CPA - Chief Investment Officer
Yale Endowment's Chief Investment Officer David Swenson belongs on the Mount Rushmore of institutional investors for changing the game of allocation and manager selection. At first he was radical for advocating that the majority of the Yale Endowment be allocated to private equity, real estate, and hedge funds.
Then he wrote Pioneering Portfolio Management in May 2000. With that publication, his strategy gained mainstream acceptance. Copy cats popped up, looking to emulate the success of his strategy. Yale continued to prosper, but it brought along thousands of new investors into these asset classes.
Assets poured in. The private equity industry raised capital from investors in staggering amounts. In 2003, the industry raised $105 billion. Over the last five years ending in 2018, the average raise was $787 billion. The bulk of growth the last ten years came from large buyout, venture capital, and direct lending.
Source: Bain & Company
By the mid-2000s, the allocations to private investments became conventional in portfolios. However, the private allocations came at a price. Since 2005, the private equity industry (traditional buyouts and growth funds) just barely beat public equity benchmarks. This was after crushing them 8%+ per year from 1993 to 2005!
After 2005, the lead for private equity shrank to 0.6% to 1.2%, depending on the benchmark.
"Price is what you pay, value is what you get." - Warren Buffett
All things being equal, if an investor purchases a company at a lower value than a higher value, the returns improve.
Private equity had a large value advantage for a long time. The chart below shows that multiples were much higher in public markets before 2005. The last decade shows the median market value of private equity and the public market benchmark, the S&P 500 index, trades nearly in lockstep. This is another reason the advantage for private equity over public equity has decreased over time.
Source: Verdad Capital, American Affairs Journal
The silver lining for private equity investors is that the spread from the top to the bottom remains similar. Before 2005, the spread from the upper quartile of funds to the median fund was 7.6%. After 2005, this spread was 6.2%. The spread from the median to the lower quartile was 7.1% before 2005 and 5.9% after 2005.
The data previously backed up that top quartile managers persistently stayed among the best. The rule of thumb among private equity investors was the same. However, a study from MIT shows data suggesting only a 33% chance that a previous top quartile fund will stay that way with the next.
Producing outsized gains in private equity is not impossible, but likely much more difficult than in the past. There will be outperforms in the future, but manager selection becomes even more important if the median manager return is flat to up only 1% versus the public markets. Deal flow will matter even more for these managers. The sad thing is that at least half (and likely more) will not provide any value to investors for returns.
The positive aspect will be the lack of liquidity. This may be backwards from how some think. However, when public markets will invariable enter a bear market, investors will not have the option to sell. The 'smoothing' of returns on a quarterly basis by private equity investors show less volatility over time, but this is an advantage of the system rather than the true underlying businesses likely be so much less volatile. After all, they are operating just a like a public company has to, but without disclosing sales and earnings results over 90 days or so.
In an interview with Chris Ailman, the Chief Investment Officer of CalSTRS (California State Teachers' Retirement System with $240 billion in total pension assets) discussed how they approach private equity. They believe the illiquidity premium return of the asset class of public equity fell from 5% in the 1990s to 3% in the 2000s, to an estimate of 1.5% today. It is certainly sobering to those looking at past track records and expecting a repeat of the big outperformance from 'the good old days.'
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