The challenges and attractions of Private Equity investing

With Private Equity investing becoming democratised via novel structures like Listed Investment Trusts. It is important that investors are able to educate themselves on the challenges and attractions of investing in this previously inaccessible asset class.

Whether classified as ‘venture capital’, ‘buyouts’, ‘secondaries’ or ‘co-investment’, private equity (or PE) investing is clearly different from share market investing. Compared to public equity – a largely passive form of company ownership – PE investing is characterised by the following challenges. 

1. Long-term illiquidity, whereby PE investments often require a substantial minimum commitment that may be ‘locked up’ for 10 years or more, 
2. Inflexible timing, as PE funds are often closed to investors and may remain uninvested for some time as they await underlying investment opportunities, 
3. Lack of transparency, with PE managers having limited information on target companies and end-investors receiving infrequent valuations, 
4. The absence of clear price discovery, meaning that transaction pricing in private markets depends substantially on negotiations, and 
5. Reduced separation between ownership and control which elevates the role of manager resources and expertise. 

Given these challenges, two further characteristics are observed. 

First is the outperformance of private equity compared to public equity. Conceptually, this follows from PE investors requiring compensation for accepting the complexities of PE. Second is the ability for skilled private equity managers to clearly and consistently distinguish themselves through superior performance. 

Private Equity’s superior performance 

Looking at returns, the outperformance of private equity versus global shares is widely acknowledged. In the literature, authors such as Harris et al(1) describe the robust nature of this result. 

Less well known is that the outperformance of PE has been achieved with lower risk or volatility than shares(2). This is an important result as higher investment returns are usually accompanied by higher risk. Where higher returns are accompanied by lower risk, as in the case of private equity, that asset class becomes compelling.

CHART 1: SUPERIOR RISK-ADJUSTED RETURNS

Chart 1 illustrates the higher returns and lower risk of private equity compared to global equities. Moreover, by displaying the ratio of return to risk, the chart shows the superiority of risk-adjusted PE returns relative to both shares and bonds. Interestingly, the chart also shows the superiority of bonds over equities – an observation we return to in Part 4 of our series.

A more consistent return comparison

Comparing the performance of PE to share market index returns could be misleading, however, due to the uncertain and variable timing of cashflows that is characteristic of private equity investments. To create a more valid comparison, one technique(3) is the calculation of a ‘Public Market Equivalent ‘(PME) equity return series that replicates private equity cashflows in a share market index.

Using this more rigorous PME approach, Chart 2 shows a performance comparison between US PE and US equities. Over time horizons from 3 years to 20 years, PE returns are again superior - with an average outperformance, or premium, of close to 3% per annum.

CHART 2: SUPERIOR LONG-TERM RETURNS

This magnitude of outperformance is consistent with that reported in the literature. Harris et al(4) refer to long term PE outperformance of “at least 3% per year” while JP Morgan identify a 15-year PE premium of 2.6% per annum(5).

Diversification and correlation

A final observation in relation to private equity relates to its diversification characteristics which we can measure by means of ‘correlation’.

From an investment perspective, correlation indicates how one security moves relative to another. Assets that are synchronised in their movements are described as perfectly correlated and have a correlation of +1. Conversely, when two securities move in opposite directions, they are perfectly negatively correlated, with a correlation of -1.

Combining negatively correlated assets can reduce portfolio risk considerably without impacting return. This is illustrated via the stylised example in the LH panel of Chart 3. In practice, such a degree of diversification is difficult to achieve. More common are the diversification benefits gained by combining assets with correlations of less than 1, as per the RH panel of Chart 3. Here, while the portfolio value still exhibits fluctuations, the volatility has been reduced. This is the case with private equity, where we observe a correlation with global shares of 0.8(6).

CHART 3: PORTFOLIO FIVERSIFICATION AND CORRELATION 

To conclude, we summarise the key conclusions in relation to private equity performance:

• private equity has consistently outperformed shares while exhibiting lower risk, thereby providing superior risk-adjusted returns, and
• private equity provides portfolio diversification benefits, being less than perfectly correlated to equities.

The above article is a whitepaper extract from a 4-part series Listed Private Equity: Private Equity Reimagined which explores the challenges and attractions of private equity investing. Traditionally, private equity investing involved accepting restricted access to the invested capital and a general lack of transparency. In return, the data clearly shows that private equity has consistently outperformed shares – before and after allowing for risk – whilst also providing diversification benefits.

Follow Livewire for Part 2 of the series Listed Private Equity - A Superior PE Investment which discusses the emergence of listed private equity as a means by which private equity assets can be accessed via publicly traded securities.

To download the entire whitepaper series, click here!

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(1) Harris, Jenkinson and Kaplan (2014) p.1880.

(2) Kinlaw, Kritzman and Mao (2015) p.30 table the standard deviation of US equities at 18% versus 12% for private equity, over the period 1996-2014.

(3) As per Bain & Company (2020), Cambridge Associates (2020) and Bergmann, Christophers, Huss and Zimmerman (2010).

(4) Harris, Jenkinson and Kaplan (2014) p.1880.

(5) J.P. Morgan Asset Management (2020) p.75.

(6) J.P. Morgan Asset Management (2020) p.105.

REFERENCES

• Bain & Company, “Global Private Equity Report”, 2020.
• BCA Research, “Private Equity: Have We Reached The Top?“, 2018.
• Bergmann, B., Christophers, H., Huss, M. and Zimmerman, H., “Listed Private Equity“ in Cumming, D.J. ed, Private Equity: Fund Types, Risk, Return and Regulation, 2010, Chapter 4, pp. 53-70.
• Cambridge Associates, “US Private Equity (Legacy Definition) - Index and Selected Benchmark Statistics”, March 2020, .
• Harris, R.S, Jenkinson, T. and Kaplan, S.N., “Private Equity Performance: What Do We Know?”, The Journal of Finance, 2014, pp.1851-1881.
• J.P. Morgan Asset Management, “Long-Term Capital Market Assumptions”, 2020.
• Kinlaw, W., Kritzman, M. and Mao, J., “The Components of Private Equity Performance: Implications for Portfolio Choice”, The Journal of Alternative Investments, 2015, pp. 25-38