The main reason to invest in private equity is performance.
Additionally, PE adds diversification and stability to a portfolio. And, aside from this, illiquidity can actually be an advantage!
Private equity outperforms significantly over the long-term
No investor should be happy with average returns for PE. And yet, even when using just the average, PE significantly outperforms the public market indices.
As can be seen in Figure 1, PE has since 2001 returned 355% compared to 200% for the S&P 500 and 163% for the MSCI World. The outperformance is even more evident when looking at individual stages: buyout, 542%, and secondaries, 460%. Even Fund of Funds, normally viewed as fee-intense performance drag, outperforms with 208%.
Venture capital underperforms – but for good reason
VC returns only 27%. But, as this is net average returns, this is not surprising. VC has a much wider return dispersion and greater risk of losses than other PE stages and public markets. Consequently, the average return is expectedly lower. More on risk and quartile returns in future posts.
Figure 1: If you are not in PE, you are missing out!
Source: PE Compass, August 2019, data from Preqin 2019
Note: Net average returns from Q12001 – Q2 2018. To allow for comparison the two public market indices have been restated as public market equivalent. Past performance is not indicative of future results.
Private equity outperforms in adverse environments
This is evident in the periods around the GFC and the Euro Crisis, where both PE and the sub-stages clearly outperform the two public market indices - see Figure 1.
Private equity can act as portfolio stabilizer
For various reasons, mainly due to, quarterly reporting, conservative / sticky valuations, and time lags, private equity valuations don't to move dramatically from quarter to quarter. Consequently, PE does not experience the same deep / abrupt drawdowns as can be the case in public markets.
In more adverse economic environments this has two advantages
Portfolio stability: the overall portfolio is more stable, i.e. the total valuation does not move as dramatically
Quicker catch-up: because PE experiences less of a drawdown in a subsequent upswing a catch-up comes much faster
Examples of both these points can be seen in Table 1.
Table 1: In adverse markets PE has lower drawdown and a quicker catch-up
Source: PE Compass, August 2019, data from Preqin 2019. Past performance is not indicative of future results.
Investors should of course note and plan for, that the reverse is also to some extent true. In benign economic environments PE valuations are slower to catch up and may consequently not reflect the actual value and thus understates PE exposure in a portfolio.
Private equity illiquidity is an underappreciated advantage
Usually regarded as a disadvantage, illiquidity can in adverse markets be a significant advantage.
As investors cannot quickly exit their PE investments and often only at a substantial loss most have no choice but to stay invested. While unable to exit before the bottom this also means they get the full effect of a subsequent catch-up.
This stands in stark contrast to public markets. Here investor psychology and market timing can play in and may cause investors to exit too late (still hitting the bottom) and / or not get back in early enough (missing the upswing).
Having seen what happened around the GFC. It is only too easy to imagine the further value destruction that would have taken place had investors been able to freely, easily and cheaply buy and sell their PE positions.
Private equity can help lower overall portfolio risk
It should not over-emphasized and is certainly not a reason in itself to invest. But, private equity, as can be seen in Figure 2, has lover correlation with many other asset classes. For investors this can help diversify a portfolio and through that lower the overall risk.
Figure 2: Asset class correlations
Source: PE Compass, August 2019, JP Morgan Q3 2018. Past performance is not indicative of future results.
Note: You can see the full correlation matrix from JP Morgan here.
Other reasons to invest in private equity
Investors are faced with low / negative yield on fixed income, record high equity markets, fewer and fewer listed companies. This makes private equity a necessity. I will get to this in future posts.