Industry Professional's Perspective: "Is private equity worth it?"

Gintare Hennick
8 March 2024
The recent article on Financial Times "Is private equity actually worth it?" analyses the history and performance of private equity industry in the large institutional investors context. This is in light of a pending decision, whether NBIM, the largest sovereign fund in the world, should start investing in private equity. The quote "That makes investing in private equity funds more of a crap shoot" well summarises the sentiment of the article. Whilst well researched, one cannot help but notice a strong bias against the private equity industry and fails to offer a balanced view on some points. We discuss some of these points below.

Is Private Equity "Finished"?
The article argues that "With interest rates now higher and unlikely to return to zero <...> the private equity golden era is almost certainly over." Well, if private equity is "finished" in the high interest rate environment, the outlook for public markets is even worse, according to AQR's "A Fresh Look at Multi-Strategy Alternatives".

Source: AQR "A Fresh Look at Multi-Strategy Alternatives"

Additionally, AQR "Key Design Choices When Building a Risk-Mitigating Portfolio" research shows that 60/40 portfolios were not able to sustain the inflation shock in 2022 and experienced substantial losses, which led to one of the worst real returns in history, even lower than the GFC figures. The traditional and known portfolio construction approaches proved to be unpredictable in the modern era of finance.

Source: AQR "Key Design Choices When Building a Risk-Mitigating Portfolio"

The high dry powder and struggle to deploy argument. Last month, we wrote that in 2023 the global M&A activity plunged to a decade low of $3tn, with private equity-led buyout volumes globally plummeting by 38% to $433.6bn. There was a slowdown in both public and private markets transaction volume, which kept dry powder high. Nonetheless, if one looks at the "freshness of dry powder", that is the dry powder by vintage year, majority of it has not been older than 3 years, where a typical investment period for a private equity fund is around 5 years. This would indicate a fairly consistent deployment face rather than a struggle, given recent market conditions.

Source: Pitchbook "What dry powder levels mean for investors in a changing market"

With purchase price multiples going down, especially on the larger deal side, and pent-up demand from business executives to grow and accelerate technology adoption via M&A, the transaction volumes will pick-up. Potentially as opportune time as ever for buy-and-build and accelerated growth strategies in private markets.
Source: Capstone Partners "Building the Foundation for a Resurgence"

Private Markets Metrics Explained
"There are lies, damned lies, and investment return statistics" - a rather dramatic start on a discussion about private markets performance measurement and use of benchmarks. Initial point focuses on the IRR and how it can be tampered with. Indeed, there are ways to boost IRR, at least in the beginning, and any experienced private markets investor will recognise that in their due diligence. However, IRR is only one of several performance measurement metrics used in private markets. Others include MOIC (multiple on invested capital), DPI (distribution to paid in capital) and PME (public market equivalent). In fact, Goldman Sachs "Staying the Course in Private Markets" survey shows that private market investors place the greatest emphasis on MOIC, and not the IRR.

Source: Goldman Sachs "Staying the Course in Private Markets"

Whilst gross and net MOIC, IRR and DPI are key to proper investment due diligence and benchmarking in the private markets context, it does little to compare it with public markets. To bridge the performance measurement gap between public and private markets, only IRR can be used. The industry-wide PME methodology allows for better apples-to-apples comparison between two markets by calculating the IRR on the specific public market benchmark and comparing it to the returns of a certain private equity portfolio. This approach comes with its own challenges but so does any other performance measurement exercise. Even in the more mature public markets there are still different performance measurements methods and known biases. The same in private markets, one has to understand the nuances and look at it in the context of other performance metrics.

When it comes to benchmarking, again there are two quite distinct goals and methodologies. The first one aims at ranking private market managers amongst their peers and uses private markets specific benchmarks. The ranking is done for MOIC, IRR and DPI metrics. The second approach compares public vs private markets performance. Arguably, the former is more important in the manager selection process and than the latter serves as indication between public and private markets allocation trade-offs.

The choice of public markets benchmark often causes debate due to geography tilt and company size. The most common ones are the S&P 500 and MSCI World. The choice of S&P 500 as a benchmark is often challenged due to large company size and high concentration as not the best comparison for smaller companies and a highly fragmented private equity market. But it has also been the best performing US public markets index for the past 5-15 years. One way to look at it is to say "Who is the best in public markets and see if I can beat it". And private markets do beat it. Hamilton Lane's "2024 Market Overview" research shows that private equity has outperformed S&P 500, MSCI World and MSCI US Cap.

Source: Hamilton Lane "2024 Market Overview"


Leverage & Value Creation
The article also references 80s and 90s private equity deal making environment several times, known for aggressive business tactics and high returns driven by substantial levels of leverage. Interestingly, it also recognises that the environment has changed since then, but only when it comes to disregarding high returns of that time. We believe the private markets context has changed significantly since "Barbarians at the Gate" days. The growth of private markets industry, increased competition, manager specialization and new strategies paint quite a different picture these days. Instead of ripping companies apart, the buy-and-build, succession planning and accelerated growth strategies are more prevalent these days. The leverage is one part of the equation but the role of it has significantly decreased over the years. Goldman Sachs "The New Math of Private Equity Value Creation" showed that  GP leverage has decreased significantly since GFC, it is not the main lever to drive value anymore. Instead the focus is on the EBITDA margin expansion and benefiting from market multiple expansion.

Source: Goldman Sachs "The New Math of Private Equity Value Creation"

The Conundrum of Fees
The challenges of high fees, access to co-investment flow and lack of transparency. Or as FT puts it "And given the amount of capital going into private equity, fee discounts aren’t going to be huge" and investors "have hard time figuring it out exactly what they're paying".

Hamilton Lane "The Truth Revealed: Private markets beats public markets - even after fees" report shows that private markets have outperformed public markets even after fees are considered. Whilst the fees might be higher than in public markets, it still managed to outperform on the net return basis.

Potential challenges with accessing the co-investment flow and hence gaining a fee discount. Most SWFs and large pension funds have "moved on" to the next phase of private markets investing, where they invest directly and do not solely rely on GPs co-investment flow. Hence, given the size and later start in private markets, we believe NBIM will have a good opportunity to access co-investment deal flow.

As for investors having "hard time figuring it out exactly what they're paying", the robust due diligence process that involves investment, operation and legal & tax due diligence process is of the essence to understand the terms and all relevant fees. After that, a thorough monitoring processes has to be set-up. The processing of large volume items such as cash flows, NAV statements, fee reporting and tax returns is now highly commoditized and can be processed by different players. Nonetheless, it is essential to have an in-house team set-up that has expertise and knowledge base to execute higher level monitoring processes.

Potentially this is one aspect that serves NBIM well in being late in the game as other institutional investors have similar needs and have already set reporting frameworks. In fact, Global Pension Transparency Benchmark 2023 shows that whilst NBIM has the highest ranking of transparency, other top 5 institutions are only a couple scores apart from NBIM, in overall score and in some cases in costs. All of these four institutions have significant private markets allocations in their portfolios. Hence, there is a way to gain transparency more than the headline articles would make you think.

Source: Global Pension Transparency Benchmark 2023


NBIM and Private Markets
Last month, we discussed that all of the largest SWFs have been investing in alternatives for a while now and have built 22% - 65% allocations to this asset class. NBIM stands at stark contrast with no allocation to private equity. We also argued that the decision will not be taken lightly and will require a lot of planning. We proposed the phases of this potential project in the "The Ways to Start" section. We emphasise the words "process" and "phases" as it will take several phases to deploy large amounts of capital and to move to a slightly different investing approach in each phase. The process of learning and education will take time, which also includes educating highly opinionated Norwegian publics. Though, this is not a new challenge but rather a recurring theme for the past 20 years as witnessed by the speech of Knut N. Kjær in 2006: "The paradox is that the fluctuations that are commented on are considerably smaller than those that do not receive the same degree of attention." We believe the best path is education and moving away from the outdated "Barbarians at the Gate" narrative.

We hope this gives a bit more balanced view on some data points and metrics in private markets. Whilst it comes with its own challenges, as does any asset class, the proven outperformance and ever evolving private markets landscape can hardly be ignored at this stage. After all, the hardest part in investing is to think long term but act now. As you might have guessed, we believe private equity is definitely not "finished". In fact, it might be as opportune time as ever to start investing as a new LP with more meaningful data points to evaluate GPs, more reasonably priced investment opportunities and no prior portfolio to deal with. 

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