The below article has been published in Investment Officer in June 2023
Private equity is gaining in popularity, which is not surprising given the strong returns the asset class has achieved in the past. However, as of 2023, the market for private investments looks much less promising. Is a repeat of the golden years still realistic?
“A rising tide lifts all boats.” This saying aptly illustrates the state of capital markets since the aftermath of the credit crisis, particularly for private equity. The market was characterized by low interest rates, abundant credit availability, and ever-increasing valuations. Under these favorable conditions, many private equity managers were able to consistently achieve better results than the public markets, often with the use of leverage. Since the early 21st century, the asset class has delivered 4-5% higher annual returns for investors compared to publicly traded stocks. In recent years, investors have therefore started investing in private equity with high expectations. However, smooth seas do not make skilled sailors. It remains to be seen whether these expectations can be fulfilled.
As a result of economic uncertainty, the waters in which private equity operates have become more turbulent. Nevertheless, the colorful pitch decks of new funds show that managers still expect high returns. The targets they set, such as a gross return of three times the investment and +25% IRR, still seem to be more of a norm than an exception. Is this misleading for new investors, or are we underestimating the ability of private equity to adapt to the changing tides?
The Four Horsemen of the Apocalypse
It is understandable that managers present expected returns to convince investors, especially if they have a limited history of successful investments. Given the cooling fundraising environment (with a roughly 20% decrease in committed capital in 2022 compared to 2021), it is likely that managers will continue to predict smooth sailing. However, four key developments raise questions about the feasibility of the high expected returns:
- Fear of an economic crisis
- Influx of dry powder
- Higher interest rates
- A slowdown in exits
In the New Testament, the Four Horsemen of the Apocalypse symbolize figures who predict the end of times. Are the four developments listed above these ‘horsemen’, or is it simply that a new era for private equity has begun? These ‘horsemen’ at least suggest that the waters in which private equity operates have become more turbulent. How should investors navigate this new tide?
A disciplined allocation policy and optimal exposure to private equity are essential within a broader investment portfolio. Investors quickly feel wealthy when one of their funds performs well. However, the previously mentioned premium of 4-5% per year can only be achieved if investors are consistently invested in the asset class. Consistency in allocation policy is therefore crucial, because these turbulent waters also offer opportunities for investors. In fact, the years immediately following the credit crisis were some of the best private equity has experienced. It is, of course, still important that investors diversify their investments across styles, types of managers, sectors and regions.
The power of selection
Another crucial point for navigating turbulent waters is manager selection. Unlike investing in publicly traded stocks, where it is relatively easy to replicate the returns of the broad market, this is not the case with private equity. As the graph below shows, the dispersion between managers is significant. The performance difference between the top and bottom 50% of managers is nearly 16% (!) annually. Even the difference between an average manager and a top-performing manager is substantial. A thorough due diligence process is therefore essential. Investors should carefully examine factors such as the composition and experience of the team, the replicability of the strategy, the fund terms and the track record.
Source: Preqin Market Benchmarks
Conclusion
Unfortunately, investors do not have a crystal ball and it remains uncertain whether the abovementioned challenges will indeed turn out to be the Four Horsemen of the Apocalypse. However, in the long term, private equity remains a valuable addition to investment portfolios. Its diversified nature, illiquidity premium, and managers’ ability to actively create more value than the public markets make it an attractive asset class. However, regardless of the waters in which private equity operates, the importance of the right seaworthy vessel with an experienced captain remains clear.