For decades, the characteristics of private equity have made the asset class an attractive proposition for those who could participate. Now that access to private equity is opening up to more individual investors, the untapped potential is becoming a reality. So the question to consider is: why should you invest?
We’ll begin with the main arguments for investing in private equity:
- How and why private equity returns have historically been higher than other assets on a number of levels
- How including private equity in a portfolio affects the risk-return profile, by helping to diversify against market and cyclical risk
Then, we will outline some key considerations and risks for private equity investors.
If you are unfamiliar with the basic characteristics of private equity, we’d recommend you take a look at the previous section: What is private equity?.
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1. Higher returns
One of the main reasons for introducing private equity into a portfolio is the potential to raise the overall portfolio return. With that in mind, research shows that private equity returns compare well on a number of levels, which we will cover here: compared with the public equity market, compared with other private market asset classes, between quartiles, and when added to a portfolio.
Private equity vs public equity
You may be aware of the longstanding question about whether private equity returns have historically outperformed public equity. The simple answer is: yes, by a significant margin.
Additional comparisons are made below.
Private equity vs other asset classes
When it comes to introducing a new asset into a portfolio, the most basic consideration is the risk-return profile of that asset.
Historically, private equity has exhibited returns similar to that of Emerging Market Equities and higher than all other traditional asset classes. Its relatively low volatility² coupled with its high returns makes for a compelling risk-return profile.³
Performance between quartiles
Every private equity fund has a particular return target and specific strategy to reach that goal, so it’s unsurprising that fund returns vary a lot. In fact, private equity fund quartiles have the widest range of returns across all alternative asset classes - as you can see below.
That said, the top quartile return for private equity vintages between 2007-2017 was higher than any other by more than 7%, while the median quartile was higher than all other asset classes by at least 4%.⁴
The takeaway is that fund selection is crucial. At Moonfare, we carry out a stringent selection and due diligence process for all funds listed on the platform.
How private equity affects portfolio returns
The effect of adding private equity into a portfolio is - as always - dependent on the portfolio itself. However, a Pantheon study from 2015⁵ suggested that including private equity in a portfolio of pure public equity can unlock 3.16% of annualised excess returns (“alpha”).
We will look into constructing a private equity portfolio How to build a diversified portfolio?. But - to get a simplified idea of how including private equity might affect overall returns - we can take a look at models of various sample portfolios. The chart below illustrates how introducing private equity to a portfolio of publicly traded stocks and bonds affects the risk-return profiles.
Why are historic private equity returns higher?
We introduced the unique characteristics of private equity in detail in section What is private equity?. These characteristics make the asset class fundamentally different from public equity in ways that can drive returns up at the fund or portfolio level:
- Opportunity access: The pool of companies available for investment across public markets is limited and every traded company faces enormous scrutiny. Whether you agree that public markets can ever be truly ‘efficient’ or not, by the time a company has gone public its value is likely to be already recognised, driving up the price.
On the other hand, the best private equity firms have access to an even bigger pool of unknown opportunities that do not face the same scrutiny, as well as the resources to perform due diligence on them and identify which are worth investing in. Investing at the ground floor means higher risk, but for the companies that do succeed, the fund benefits from higher returns.
- Active, value-adding ownership: When an investor buys shares in a public company, the level of control they acquire is marginal. If they choose not to exercise voting rights, it drops to zero. When a private equity firm invests, they almost always take on a level of active ownership. This ranges from advisory and assistance to fully restructuring and running the company. The larger private equity firms have specialised value creation teams that are dedicated to a singular aim: actively adding value to increase the return as much as possible in the long run.
- Alignment of interests: When it comes to active management, the closest cousin of a private equity fund is a public equity fund. Both public and private equity fund managers commit to investing a percentage of the fund but there remains a well-trodden issue with aligning interests for public equity fund management: the ‘principal-agent problem’.
When an investor (the ‘principal’) hires a public fund manager to take control of their capital (as an ‘agent’) they delegate control to the manager while retaining ownership of the assets. In many public funds the manager earns a fee no matter how the fund performs, while the investor retains liability for any losses. In the case of private equity, the General Partner doesn’t just earn a management fee. They also earn a percentage of the fund’s profits in the form of “carry” (usually 20%). This ensures that the interests of the manager are aligned with those of the investors.
Private equity funds also mitigate another form of principal-agent problem. We can also consider the company management as an ‘agent’, tasked with running the company for investors. A public equity investor ultimately wants one thing - for the management to increase the stock price and/or pay out dividends. The investor has little to no control over the decision. We showed above how many private equity strategies - especially majority buyouts - take control of the running of the company, ensuring that the long-term value of the company comes first, pushing up the return on investment over the life of the fund.
2. Diversification and risk mitigation
Modern portfolio theory tells us that we should reduce business and financial risk as much as possible through diversification, which is best achieved by selecting assets that have attractive long-term returns but exhibit a somewhat low correlation with each other. Private equity can therefore help to diversify a portfolio by mitigating both public market risk and cyclical risk.
Public market risk
Diversifying within the public equity universe by using factors such as capitalization can reduce idiosyncratic risk, but still leaves a portfolio made up of highly correlated assets. To achieve a greater reduction in portfolio risk, we should seek out assets with a lower correlation to the public market.
Private equity funds represent an asset class that offers a lower correlation with public market movements. While economic conditions may affect the performance of portfolio companies at a fundamental level, private equity managers seek to create value over the long term by investing capital directly into private companies and then working with those companies to ensure that its capital is effectively utilised to increase value. This contrasts with public equity investments that represent secondary transactions which will benefit more from ongoing economic growth.
Because private equity investments take a long-term approach to capitalising new businesses, developing innovative business models and restructuring distressed businesses, they tend not to have high correlations with public equity funds, making them a desirable diversifier in investment portfolios.
In particular, the graph below shows the average correlation between individual buyout funds and the relevant geographic public market since 2001.
Consider the US. Even in such a market that is highly integrated and interconnected, with companies affected by the same economic, fiscal and monetary conditions, the correlation between private equity buyout funds and public equity has not hit 50% since 2001. In Europe - a far more fragmented market - the correlation between buyout funds and public equity is far lower in the same time period, sometimes negative.⁷
Cyclical risk
Since private equity funds have far more control in the companies that they invest in, they can make more active decisions to react to market cycles, whether approaching a boom period or a recession. The result is that private equity funds are more likely to weather downturns.
Take the chart above. Besides the consistently higher private equity return for these pension funds, the market drop as a result of the 2007-2009 recession is felt later, with a faster rebound. Also, while public markets stagnated during 2011 and 2014, private equity returns continued to see positive performance.
Private equity firms that focus on value creation are well-placed to outperform public equity managers in market downturns. McKinsey research found that firms with value-creation teams meaningfully outperformed others during and after the 2008 global financial crisis, achieving returns around five percent higher (23%) than firms without portfolio-operating groups (18%).⁸
The effect of private equity on portfolio risk
It is worth pointing out that including private equity is unlikely to reduce the overall portfolio risk. In the sub-section ‘How private equity affects portfolio returns’ above, we saw how including private equity in a sample portfolio increased the overall return while also increasing the overall risk.
That said, if we look at the same type of example put differently, we can see that including private equity increases the return disproportionately to increasing the risk. Take the illustration below: a series of sample portfolios constructed with public equity, fixed income and private equity benchmarks between 1994-2019.
The traditional 60/40 portfolio of equity and fixed income assets had a risk level of 9.4%, over a return of 8.5%. By including an allocation to private equity, the sample portfolio risk increased to 11.1% - but the return also increased to the same figure.⁹
This is just an example based on a theoretical portfolio, but it shows how it is possible to use private equity allocation to diversify a portfolio and allow for greater modulation of risk and return.
Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.
