The Pluses and Perils of Private Equity

May 9, 2019

As investors, there are a plethora of investment options out there and it’s important to keep track of them.  Not to chase investments or a story, but to watch how things change, what data becomes available, and when something that might not have been an investment for you looking backward should become an investment looking forward. One asset class that continues to grab attention is Private Equity.

What is Private Equity?

Private Equity is an investment in companies that are private (not listed on a stock exchange).  Private Equity funds are typically a partnership between a manager and investors who lock up their money for use to purchase private companies until their eventual sale.

Perceived Benefits of Private Equity

Private Equity is known for higher returns and diversification in the form of risk reduction.  Sounds great!  But let’s dive into this a little further.  On the risk side, Private Equity shows less dramatic moves in value. Much of this pertains to the difference in valuation standards between private and public markets. With a publicly traded stock, values move around every minute making you feel the risk that comes with the investment. However, Private Equity doesn’t work this way.  Much of these valuations do not change for months at a time. By having less frequent valuations, this can smooth out the roller coaster ride, making overall risk and correlations to the public markets seem lower. This is like a public investor who checked their portfolio before the 4th Quarter of 2018 and looked again after the 1st Quarter of 2019. The ending value looks about the same, but if you checked more often you absolutely felt more risk.

Another draw of Private Equity is diversification and return.  After all, it’s factual that the number of public companies has dropped over time (see below).  So, to maintain diversification, access to the private markets may not just be desired, but necessary. However, during the last 25 years (see below), Cambridge Associates found that Private Equity has not outperformed the S&P 500.

Sources: Cambridge Associates, World Federation of Exchanges, Standard & Poor’s, J.P. Morgan Asset Management. *Number of listed U.S. companies by the sum of the number of companies listed on the NYSE and the NASDAQ. The Cambridge Associates Modified Public Market Equivalent (mPME) methodology determines how much the private equity funds’ cash flows would have earned had they been invested in the S&P 500 instead.

Increased Competition

Through much of the recovery since the Financial Crisis of 2008, we have been in a period with low-interest rates. This environment can be ideal for Private Equity funds, which tend to borrow money to buy out companies. With great rates along with a flood of cash inflows, competition within this space increased. More capital coming into Private Equity caused valuations to also increase. All else equal, you’d rather pay less than more for a company to position yourself for better returns. Some of the most recent data suggest the longer-term outperformance of Private Equity comes from a couple of factors, one being the valuation discounts that existed in the earlier part of this chart. Those have since eroded.

Sources: Preqin, Ptichbook, S&P LCO, J.P. Morgan Asset Management. Data as of 12/31/2018

Performance Dispersion

Even so, there are pockets of Private Equity that continue to soar, bringing up one last point, performance dispersion. That’s how much of a difference there was between the best and worst managers in the asset class. This is particularly pronounced within Private Equity where the range of returns can be highly dependent on selecting the best manager. To make this matter more difficult, the top managers within this space can have large barriers to entry, oftentimes requiring massive amounts of investment which are only feasible to large endowments, pension funds, and ultra-high net worth individuals.

Sources: Lipper, NCREIF, Cambridge Associates, HFRI, J.P. Morgan Asset Management.

Global Equities (large cap) and global bonds dispersion are based on the world large stock and world bond categories, respectively, manager dispersion based on 2013-2018 annual returns for global equities, global bonds. U.S. core real estate and hedge funds, U.S. non-core real estate, U.S. private equity, and U.S. venture capital are represented by the 5-year horizon international rate of return. Data are as of 12/31/2018.

Conclusion

Although Private Equity certainly has an allure, an allocation to these types of funds may not add as much as might be desired to a typical portfolio. Controlling the basics, while somewhat boring compared to Private Equity, tend to deliver the results that are needed in order to enjoy a full life.

Matt Logue is an Advisor at BDF.  He sits on the firm’s Investment Committee and contributes to developing BDF’s overall investment strategy. Matt graduated Magna Cum Laude from Carthage College earning a Bachelor of Arts degree in Finance and Economics.  He has his Series 65 license and is a CERTIFIED FINANCIAL PLANNER™ professional.