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Why invest in private equity?

For decades, the characteristics of private equity have made the asset class an attractive proposition for those who could take advantage. Now that access to private equity is opening up, the untapped potential is becoming a reality for the portfolio of many individual investors. So the big question to consider: why should you invest?

In this second section, we’ll begin with the main arguments for investing in private equity:

  • How and why private equity returns are higher than other assets on a number of levels
  • How including private equity in a portfolio affects the risk return profile, by helping to diversify against market and cyclical risk

Then, we will outline some key considerations and risks for private equity investors.

If you are unfamiliar with the basic characteristics of private equity, we’d recommend you take a look at the previous section: What is private equity?.

Higher returns

Realistically, the main reason for introducing private equity into a portfolio is the potential to raise the overall portfolio return. With that in mind, research shows that private equity returns compare well on a number of levels, which we will cover here: compared with the public equity market, compared with other private market asset classes, between quartiles, and when added to a portfolio.

Private equity vs public equity

You may be aware of the longstanding question of whether private equity returns have historically outperformed public equity. The simple answer is: yes, by a significant margin.

Source: Cambridge Associates, 30 June 2018; MSCI Equity Index alongside the internal rate of return for the Global Private Equity Index (pooled return), annualized over 5-, 10-, 15- and 20-year periods.

For a more complex answer, let’s pick apart what is being debated here and why.

Private vs public - the Net question

Private equity firms actively manage their portfolio companies and charge higher fees. Since this is not the case for public markets, a common argument is that private equity underperforms public equity on a Net basis (after fees). This is the true return achieved by the investor, so it’s what really matters.

In a 2021 analysis, JP Morgan¹ found that the private equity industry is still outperforming public equity and broke down this argument, quoting Steve Kaplan from the University of Chicago Booth School of Business. Kaplan asserts that the arguments against public equity are intrinsically flawed: They compare public equity with all alternative asset classes: including real assets, real estate, infrastructure and energy.

If we narrow down the definition of private equity to three most common forms - buyout, growth equity and venture capital - there is outperformance. We’ll compare private equity returns with those of other alternative asset classes in the next section.

Private vs public - what are you actually investing in?

The simplified comparison between public markets and private equity is also flawed when it comes to what you are actually buying. It is possible to invest in an overall public equity market (like the MSCI World shown above) through an index tracker fund, but a private equity investor does not invest in the overall private equity market. They commit capital to an individual fund (or fund of funds) that is carefully selected to suit the investor’s portfolio. We’ll take a look at a more meaningful measurement below: the effect of private equity on a portfolio.

Private equity vs other asset classes

When it comes to introducing a new asset into a portfolio, the most basic consideration is the risk-return profile of that asset.

Historically, private equity has the highest annualised return compared with all other asset classes, public or private. Combined with a volatility that is far lower² than any asset class that gets even close to the same return, the result is a compelling risk-return profile.³

From 1Q86 to 4Q20 where data is available, deemphasizing 2008 and 2009 returns at one-third the weight due to the extreme volatility and wide range of performance, which skewed results. Using MSCI AC World Gross USD for Listed Equities; Barclays Global Agg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash. Source: Bloomberg, MSCI, Cambridge Associates, KKR Global Macro & Asset Allocation analysis.

Performance between quartiles

Every private equity fund has a particular return target and specific strategy to reach that goal, so it’s unsurprising that fund returns vary a lot. In fact, private equity fund quartiles have the widest range of returns across all alternative asset classes - as you can see below.

1Methodology: Internal rate of return (IRR) spreads calculated for funds within vintage years separately and then averaged out. Median IRR was calculated bytaking the average of the median IRR for funds within each vintage year.Source: Burgiss

That said, the top quartile return for private equity vintages between 2007-2017 was higher than any other by more than 7%, while the median quartile was higher than all other asset classes by at least 4%.

The takeaway is that fund selection is crucial. At Moonfare, we carry out a stringent selection and due diligence process to all funds listed on the platform. 

How private equity affects portfolio returns

The effect of adding private equity into a portfolio is - as always - dependent on the portfolio itself. However, a Pantheon study from 2015⁵ suggested that including private equity in a portfolio of pure public equity can unlock 3.16% of annualised excess returns (“alpha”).

We will look into constructing a private equity portfolio How to build a diversified portfolio?. But - to get a simplified idea of how including private equity might affect overall returns - we can take a look at models of various sample portfolios. The chart below illustrates how introducing private equity to a portfolio affects the risk-return profile, starting from a portfolio of only public assets.

Neuberger Berman, FactSet. The chart shows blended portfolio returns over 25 years, ending June 30, 2018. It assumes quarterly rebalancing to the stated allocation (e.g., 70% bonds, 25% equities, 5% private equity. Bonds, stocks and private equity are represented by the Bloomberg Barclays U.S. Aggregate Index, S&P 500 and Cambridge Associates LLC U.S. Private Equity Index. Indices are unmanaged and not available for direct investment. Source: https://www.nb.com/en/global/insights/investment-quarterly-asset-matters-private-equity-and-your-portfolio

Why are historic private equity returns higher?

We introduced the unique characteristics of private equity in detail in section What is private equity?. These characteristics make the asset class fundamentally different to public equity in ways that can drive returns up at the fund and market level:

Opportunity access. The pool of companies available for investment across public markets is limited and every traded company faces enormous scrutiny. Whether you agree that public markets can ever be truly ‘efficient’ or not, by the time a company has gone public its value s likely to be already recognised, driving up the price.

On the other hand, the best private equity firms have access to an even bigger pool of unknown opportunities that do not face the same scrutiny, as well as the resources to diligence them and identify which are worth investing in. Investing at the ground floor means higher risk, but for the companies that do succeed, the fund benefits from higher returns.

Active, value-adding ownership. When an investor buys shares in a public company, the level of control they acquire is marginal. If they choose not to exercise voting rights, it drops to zero. When a private equity firm invests, they almost always take on a level of active ownership. This ranges from advisory and assistance to fully restructuring and running the company. The larger private equity firms have specialist value creation teams that are dedicated to a singular aim: actively adding value to increase the return as much as possible in the long run.

Alignment of interests. When it comes to active management, the closest cousin of a private equity fund is a public equity fund. Both public and private equity managers commit to investing a percentage of the fund but there remains a well-trodden issue with aligning interests for public equity fund management: the ‘principal-agent problem’.

When an investor (the ‘principal’) hires a public fund manager to take control of their capital (as an ‘agent’) they delegate control to the manager while retaining ownership of the assets. They earn a fee no matter how the fund performs, while the investor retains liability for any losses. In the case of private equity, the General Partner doesn’t just earn a management fee. They also earn a larger percentage of the fund’s profits in the form of carry (usually 20%). This ensures that the interests of the investor are aligned with those of the manager. 

See What is private equity? for a brief overview of what a private equity fee structure looks like and How does private equity work? for a more detailed breakdown of how they work.

Private equity funds also mitigate another form of principal-agent problem. We can also consider the company management as an ‘agent’, tasked with running the company for investors. A public equity investor ultimately wants one thing - for the management to increase the stock price and/or pay out dividends - but company management might choose instead to invest elsewhere or pay large employee bonuses. The investor has little to no control over the decision. We covered above how many private equity strategies - especially majority buyout - take control of the running of the company, ensuring that the long term value of the company comes first, pushing up the return on investment over the life of the fund.

To understand all aspects that contribute to the returns achieved by private equity funds, including illiquidity, please see ‘Key considerations and risks for private equity investors’ below.

Diversification and risk mitigation

Modern portfolio theory tells us that we should reduce business and financial risk as much as possible through diversification, which is best achieved by selecting assets that have low correlation with each other. Private equity can help to diversify a portfolio by mitigating both public market risk and cyclical risk.

Public market risk

The way that the majority of investors access public markets is through index funds, which invest a proportion of capital in every stock in a particular index. The result is that when a public market rises or falls, every stock within that market rises or falls to some extent. Also, the liquid nature of public markets means that many investors trade regularly to “time the market” which exaggerates any changes. As such, public assets are each highly correlated with the overall public market and thus with each other. It follows that we should seek out low correlation with the public market when considering new investments.

Private equity funds, on the other hand, are not necessarily coupled to a particular market. While economic conditions may affect the performance of portfolio companies at a fundamental level, private equity managers seek to create value over the long term and will not rapidly enter or exit investments based on market sentiment.

The same goes for private equity investors, who similarly seek out long term returns. As a result, private equity funds have low correlation with public markets, making them an excellent diversifier. The graph below shows the average correlation between individual buyout funds and the relevant geographic public market since 2001.

Source: https://www.capdyn.com/Customer-Content/www/news/PDFs/diversify-your-portfolio-with-private-equity.pdf Average of 3-year rolling correlation between US buyout funds and S&P 500 TR and average of 3-year rolling correlation between European buyout funds and MSCI Europe TR; analysis based on Colmore data as of June 30, 2016.

Consider the US. Even in such a market that is highly integrated and interconnected, with companies affected by the same economic, fiscal and monetary conditions, the correlation between private equity funds and public equity has not hit 50% since 2001.

In Europe - a far more fragmented market - the correlation between private and public equity is far lower in the same time period, sometimes negative.

Cyclical risk

Since private equity funds have far more control in the companies that they invest in, they can make more active decisions to react to market cycles, whether approaching a boom period or a recession. The result is that private equity funds are more likely to weather downturns.

Past performance is not indicative of future results.

Fiscal Years ending June 30*An equal-weighted average of all 21 state funds who reported private equity returns in annual CAFRs for June 30 fiscal years 2002-2017.** A public equity benchmark weighted 70% to the Russell 3000 Index (6.8% annualized return) and 30% to the MSCI ACWI ex US Index (5.9% annualized return), with assigned weights reflecting Cliffwater's judgment of the US and non-US content of a diversified private equity portfolio.Source: Cliffwater, "An Examination of Private Equity Performance among State Pensions, 2002-2017," updated May 2018. 2017 is the most recent data available. For illustrative purposes only.

Take the chart above. Besides the consistently higher private equity return for these pension funds, the market drop as a result of the 2007-2009 recession is felt later, with a faster rebound. Also, while public markets stagnated during 2011 and 2014, private equity returns continued to see positive performance.

Private equity firms that focus on value creation are well-placed to outperform public equity managers in market downturns. McKinsey research found that firms with value-creation teams meaningfully outperformed others during and after the 2008 global financial crisis, achieving returns around five percent higher (23%) than firms without portfolio-operating groups (18%)⁷.

The effect of private equity on portfolio risk

It is worth pointing out that including private equity is unlikely to reduce the overall portfolio risk. In the sub-section ‘How private equity affects portfolio returns’ above, we saw how including private equity in a sample portfolio increased the overall return while also increasing the overall risk.

That said, if we look at the same type of example put differently, we can see that including private equity increases the return disproportionately to increasing the risk. Take the illustration below: a series of sample portfolios constructed with public equity, fixed income and private equity benchmarks between 1994-2019.

For illustrative purposes only. Source: Evestment, as of June 2019. These hypothetical portfolios are not intended to represent portfolios that an investor necessarily would have been able to construct.

The traditional 60/40 portfolio of equity and fixed income assets had a risk level of 9.4%, over a return of 8.5%. By including an allocation to private equity, the sample portfolio risk increased to 11.1% - but the return also increased to the same figure.

This is just an example based on a theoretical portfolio, but it shows how it is possible to use private equity allocation to diversify a portfolio and allow for greater modulation of  risk and return. 

Key considerations and risks for private equity investors

Just as the characteristics of private equity can lead to the benefits of higher returns and increased diversification - there are certain factors that need to be taken into account before deciding if investing is the right path.

Management fees. When appraising a fund, you can’t just look at the Gross return metrics. You have to consider the Net performance - after fees - since this is the return that you would have actually received had you invested (see How to build a diversified portfolio?) for an overview of the most common return metrics to look at when evaluating fund performance). At Moonfare, we value transparency about fees and aim to present as many investments as we can in net terms.

High minimums. With traditional private equity investing, the high minimums required to invest have been a blocker for most individuals (as we covered in the previous section). This is why, at Moonfare, we have worked to open up private equity access to individual investors. 

Low liquidity and delayed cash flows. The lock-up period of a private equity fund makes private equity an illiquid investment with a long-term horizon. On top of that, the investment and profit realisation schedule of a private equity fund leads to delayed cash flow for investors. The particular shape of the return profile is called the J-curve, which we cover in How does private equity work?, along with how trading private equity stakes on a secondary market can mitigate these liquidity and cash flow issues.

Risk of loss: Private equity investments involve a high degree of risk and may result in partial or total loss of capital. By their nature, alternative investments are complex, speculative investment vehicles and are only suitable for qualified investors who have sufficient knowledge and experience to understand the risks involved.

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Important Information: Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance. Your capital is at risk. Please see https://www.moonfare.com/disclaimers.

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