CA Answers: Are Private Equity Returns Doomed?

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

Andrea Auerbach

No. You just need to know where to look. Given the low return environment, many investors are exploring private equity investing for the first time, attracted by data points such as the 10.7% ten-year return for the Cambridge Associates LLC US Private Equity Index®. The increased demand and, therefore, expected increased supply of capital for private equity funds comes as the capital overhang is already at an all-time high, as is the average annual purchase price multiple. This combination of factors may well contribute to lower average returns over time, but private equity investing is not about averages.

Longtime observers of private equity know the return dispersion of private equity funds is immense and second only to the return dispersion of venture capital funds. There is no “index hugging” in private equity. Even in a market where the vast majority of investments are “won” in an auction process and sponsor-to-sponsor investing is on the rise, any given vintage year will show an average dispersion of 1,400 basis points* (bps) between the top quartile fund and the bottom quartile fund. Larger US private equity funds have a 780 bp dispersion between the top quartile and bottom quartile funds, and smaller funds experience more than twice that. To assume the average return in private equity is to overlook the diversity offered by the thousands of funds available in the United States, not to mention globally. “Outsized” returns are alive and well in private equity; you just need to know where to look.

Key elements to remember when investing in private equity: funds are building portfolios of unique investments (one fund is typically the sole institutional investor in a specific company) during their multi-year investment periods, and each fund is pursuing investments according to its own stated strategy. Details including sourcing, structuring, and post-investment value add, among others, will vary greatly depending on the approach developed and pursued by that fund. When funds buy, what they pay, when they monetize their investment, how they navigate the various inflection points with a particular investment, plus who at their firm is pursuing all of the above and how they are compensated will influence outcomes for investors.

To do better than the median net internal rate of return (IRR) to limited partners (LPs) of 11.4%8—which even so is quite compelling relative to public equity market options—the informed alternative investor is focused on identifying managers with the potential to outperform. Where to find these managers? The lower end of the private equity arena.

Here, as noted, dispersion is twice that of the larger funds, and the industry’s evolution can be clearly spotted. Strategies are constantly expanding in multiple directions as funds specialize in various ways, seeking sustainable competitive advantages. Sector-focused funds, strategy-focused funds, funds with a key competency in sourcing or operational value add or structuring, any of these alone or in combination with other elements, including innovative fee structures, can offer LPs an edge within their programs. Much of the specialization and innovation is happening in the lower registers of the market, often in funds with less than $1 billion in commitments. Take, for example, sector-focused investing—in our analysis the average outperformance of sector-focused fund investments over generalist fund investments (funds that invest across a broad range of sectors) has been 570 bps. That average is certainly something investors can appreciate.

Make no mistake: private equity investing isn’t getting any easier, for general partners or LPs. LPs pursuing portfolio construction face a tradeoff: concentrate capital with fewer (probably larger) managers or expand the selection with a wider range of (probably smaller) managers with some degree of specialization to incorporate higher return potential? Most investors will find the answer is some combination of both as they calibrate exposure appropriately for their own risk tolerance, illiquidity capacity, and fund oversight capability.

Andrea Auerbach, head of global private investment research, Cambridge Associates

Originally published on November 29, 2016

*Based on data compiled in the Cambridge Associates Private Investment Database from US private equity funds, including fully liquidated partnerships, formed between 1986 and 2012.