Insights Chart of the Week

Does Fund Size Matter?

Breaking out buyout returns by fund size reveals several key observations that might shape how investors allocate capital. On the smaller end (<$1B) we observe the greatest dispersion of outcomes within the peer set. This is likely attributable to small fund managers having emerging backgrounds (often with a short or unproven track record) and running more concentrated portfolios. We believe mid-market funds offer an attractive balance of risk and return: Those funds have less downside than smaller peers by virtue of slightly more diversification but can still capitalize on niche opportunities. In contrast, larger funds tend to demonstrate a narrower dispersion of returns, likely because they are generally more diversified across sectors, and often contain more deals.

We believe the mid-market opportunity offers the best experience for most investors, given the slightly higher average return, lower downside dispersion, and ample upside for skilled fund pickers to differentiate themselves. A core mid-market exposure can be complemented with exposures to small, specialist funds in niche sectors. Larger funds can be an attractive option for investors seeking a diversified exposure through a single commitment. Investors may also find added comfort in larger funds during market headwinds given the lower risk profile. Although the median returns across all fund sizes are similar, each have a slightly different risk profile that investors should be cognizant of when crafting a portfolio strategy.

The Zombie Fund Era

The NAV trajectory of private equity funds in the last five years has generated concern about a shift in the private equity landscape. A prevalent perception suggests a surge in capital residing within "zombie" funds, loosely defined as funds that hold assets well past their intended life cycle with little hope of exiting those assets. This week we examine the NAV in funds 10+ year old funds, as a proxy for so-called “zombie fund” NAV.

While the absolute dollar value of such funds has increased, this is partly attributable to the industry's overall growth. It's essential to contextualize this increase within the broader landscape of the private equity sector. As a percentage of total NAV, 10+ year old funds reached their zenith between 2016 and 2018, largely influenced by funds originating during the Global Financial Crisis era. Since then, the landscape has witnessed robust fundraising and increased investment activity, resulting in a notable decrease in the share these elder funds occupy in the average LP portfolio. That is welcome news for most LPs.

Navigating Middle-Market Investments

A common question we hear from LPs is how fund size and sector, as it pertains to portfolio construction, should take part in the allocation conversation. We believe that, for most investors, middle-market funds offer the best risk and return trade off, and offer a deep opportunity set.

The sector allocation of these middle-market firms, in aggregate, has experienced notable shifts over time. Noteworthy trends include a discernible increase in emphasis on information technology-related sectors, coupled with a relative decline in consumer discretionary sectors. This evolution reflects the dynamic nature of market conditions and the varying returns generated by different sectors. It's evident that middle-market GPs often concentrate on just a few sectors, a strategic choice that aligns with their expertise and maximizes returns. Consequently, LPs engaging with middle-market funds should carefully consider these sector preferences when constructing their portfolios, recognizing the potential impact on overall fund performance. This nuanced approach to portfolio construction is essential for LPs seeking to navigate the evolving landscape of middle-market investments.

Turn of the Millennium

Private markets have undergone tremendous growth since the turn of the millennium, expanding their reach into new strategies like credit and infrastructure. This week we look at both the growth of the asset class and total exposure by strategy since 2000.

While private markets have grown rapidly since 2000, we can’t forget that they are still very small relative to the MSCI World. From a strategy perspective, private markets were dominated by equity in 2000, which encompassed 80% of all private market exposure. However, over the past decade credit, infrastructure and natural resources have taken more market share, which has remained consistent over the past two timeframes (though keep in mind the size of the total pie has grown!). What does this mean for investors? It means more choices available to them, a positive thing for those willing and able to invest the time and resources to sift through those choices.

The Tradeoff Between Risk & Return

Risk versus return: a constant tradeoff that investors look to while determining allocation percents. Here we look at the 15-year annualized returns for various private markets assets classes compared to their annualized de-smoothed volatility (a better estimator of “true” risk). The bubbles are sized according to their total industry net asset value.

Over the last 15 years, equity strategies have offered more premium returns, with buyout lower on the risk spectrum than other equity strategies. Growth equity, however, can help offer higher returns with only slightly more risk than buyout offers. Credit exhibited the lower volatility expected of that strategy, though it did not yield returns as comparable to equity. Over this timeframe, real estate is heavily influenced by the GFC-era funds. We’d expect the real estate volatility measure to continue to come down as we shift further from that timeframe. Overall, it’s important for investors to understand the risk-return tradeoffs each strategy can have and use that information during portfolio allocations to layer multiple strategies to get the risk-return profile desired of the portfolio.

Different Strategies, Same Outperformance: IRR vs. PME Spread

Different asset classes can have very different return profiles, but outperformance remains a focal point regardless of strategy. This week’s chart shows the pooled IRR versus Public Market Equivalent (PME) spread by vintage year for each asset class. The public index used for each PME differs by asset class to better serve as an appropriate benchmark for each. Overall, across strategies, private markets tend to outperform their public PME. We’ve seen that to be true especially in the past decade. While real estate struggled during the GFC, it has seen the largest relative outperformance against REITs since 2010 of all the strategies, averaging over 1000 bps of outperformance. Infrastructure and credit have been more muted since 2010 but still averaging a nearly 400 bps premium to their benchmark PMEs.

There has been relative consistency over the past decade of outperformance across all strategies. While return profiles differ across asset classes, the historical spreads can help choose appropriate benchmark premiums across various asset classes.

It’s Not Periodic Performance: Sector Allocation Can Drive Return Potential

Sector allocation can be a critical driver of private equity returns. This rather colorful chart shows median performance by sector and vintage year. Across sectors and deal vintages, gross returns have proven attractive, with only one case of a negative returning sector. Even the sectors that had been consistently at the bottom (such as energy & utilities) have recently shifted to some of the best performing sectors in recent deal years. There has been no sector that is always in the same location on the periodic table. Even sectors that have remained lower on the table have shown positive performance. The average return across all deals has remained strong, consistently nearing the mid-20 percent range. The returns have remained healthy year over year, with no evidence of performance declining.

Co-investors take note: Sector allocation should be another element to consider when building a portfolio.

Clocking in Ahead: Buyout IRR Outperforms Global Equities

We’ve looked at buyouts in aggregate over various time horizons before, but one question remains: Are there only certain vintages driving the outperformance while others underperform? This week, we examine the pooled buyout IRR by vintage year compared to the MSCI World Private Market Equivalent (PME). While some bars show higher absolute returns than others, one thing has remained consistent: Over the last 22 vintages buyouts have outperformed global equities in every vintage. They have also done so quite handedly, outperforming with an average margin of 940 bps across vintages. Regardless of economic cycle or vintage age, buyouts have continued to show strong performance, both standalone and compared to their relevant PME. 

This consistent historical outperformance can help investors when choosing an appropriate benchmark and premium to compare returns to and suggests that it’s a good time for new investors to consider an allocation to the private markets for the consistent premium that we’ve historically seen.

Measuring Risks: Public vs. Private Market Tradeoffs

Market volatility is an inevitable consequence of investing, but just how bad is bad when the markets take a turn for the worse? This week we examine both the lowest and the highest annualized five-year returns across various private market strategies as well as comparable public indices. Impressively, we see positive returns for developed markets buyout, credit and infrastructure, even in the worst-case scenario. Public equity and credit strategies exhibited more downside risk, generating negative returns in their worst-case scenarios. Private real estate and private natural resources historically have had negative worst-case returns but still experienced smaller losses than their public benchmarks.

Switching to the highest annualized five-year returns, private markets unsurprisingly posted impressive historical performance in the “best-case scenario” with the majority of returns exceeding 20%. While VC/Growth had the lowest worst case, the data shows the massive upside potential in that strategy as well, which can be achieved with proper manager selection. Overall, looking at the worst-case scenarios can be a useful indicator of risk in an asset class where risk is hard to measure. This would appear to suggest the downside risk is lower than the relative public benchmarks while also showing a higher upside potential. We think that is a good tradeoff for the private markets!

Return of the Premium? Charting Private Markets Performance

We all know that the private markets are a long-term asset class, so this week let’s focus on long-term returns. Here we’re showing 15-year asset class performance of the private markets against their closest public market comps. The green bars show that private markets are outperforming their benchmark index by more than 300 bps. The yellow bars show outperformance from 0-300bps and the red bars show where public markets are outperforming the private markets.

We’ll state the obvious here, but the data shows a lot of yellow and green. Yellow and green = outperformance almost entirely across the board, and in some cases quite substantially. The one exception to that would be what we’re seeing in real estate. That particular strategy is heavily influenced by GFC-era funds that weigh on longer-term performance. Overall, the long-term private market returns have historically generated meaningful return premiums over public benchmarks.

Tug of War: Private vs. Public Markets

While absolute performance has been volatile recently, we like to view private equity returns on a public market-relative basis, as that tends to provide more context for returns. This week, we examine the spread between private equity since-inception IRR and their public market equivalents (PMEs). We’ve looked at since-inception returns for 2016 – 2020 vintage years, as these were the funds that drove private market performance prior to the drawdown that began in 2022, and we’ve compared each private equity strategy against an MSCI World PME for each quarter since Q4 2021. A positive spread indicates the strategy is outperforming its PME. 

Here's the bottom line: Relative performance, especially for buyout funds, rose during 2022. That may seem counterintuitive, but in periods of volatility, historically public markets fell more sharply than private equity. Venture capital and growth equity, however, saw less of an uptick in their return premium given those strategies experienced larger markdowns. But volatility works both ways and public markets rebounded more sharply. In 2023, public markets moved up more sharply than private markets, indicating a closer spread in performance. 

Does Private Credit Pacing Deserve a Rethink?

Private credit has shown consistency in performance across vintages. This is true for both end-of-day returns as well as the J-curve (or lack thereof). Here we look at the J-curve of private credit median net IRR by vintage grouping. There has been little variance in the vintage groupings throughout their life cycle. The asset class has historically shown resilience in keeping the time to break the J-curve and the depth of the J-curve low. Additionally, we see that most vintage groupings have achieved their end-of-day return fairly quickly and with a tighter band of end-of-day returns throughout vintages. This shows a lot of historical consistency for this asset class and could make the argument that, with less variance in vintages, consistent commitment pacing might not be as crucial to private credit as we see with other strategies.

The End of the J-curve?

Private equity funds are notorious for their J-curves: An initial period of negative returns early in their life. Have fund managers gotten better at mitigating the J-curve in more recent years? The trends have shifted in a similar manner to the exposures we showed last week. Historically, private equity funds took two to three years to break the J-curve, but data for the most recent vintages show J-curves being broken during the first year. 

Not only has this trend shifted in how quickly the J-curve is broken, but how quickly performance may accelerate after the J-curve is broken. Newer vintages are hitting historic end-of-day returns in just over a year and then have been continuing to increase from there. This invites the question, “Has the J-curve of private equity been vanquished?” We think it’s unlikely the J-curve is gone for good, but the adoption of fund management best practices means there is potential for shallower and shorter than at the turn of the millennium.

Pace Yourself

Closed-end private equity fund investors must carefully plan a series of annual commitments to achieve and maintain their target exposure. Here we examine private equity net asset value (NAV) as a percentage of fund size – or how many dollars of NAV are being generated per dollar of commitment. One dollar of commitment does not necessarily yield one dollar of exposure. In fact, in many historical vintages, for every dollar of commitment, about eighty cents of exposure was generated. This has changed in newer vintages, now yielding about $1.10 - $1.20 for every dollar committed.

This change could lead to overallocation challenges, impacting portfolios differently depending on the maturity of the portfolio. In a mature portfolio, the impact could be smaller, as the other more established vintages may help to mute the impact of younger commitments (which will account for a smaller percentage of the portfolio). Younger portfolios, or those that have ramped up commitment pacing, may find themselves with much more exposure than anticipated. This may impact their ability to make new commitments going forward.

Leveling Up: Asset and Fund Liquidity

Liquidity is a fundamental characteristic of the private markets, yet liquidity risk is forgotten more often than not. This week we examine the trade-off between asset level and fund level liquidity. In the first chart we see asset level liquidity by strategy in terms of hold periods and the expected yield. Yield can be a meaningful component of returns and can help reduce liquidity risk for strategies such as private credit. Private equity, on the other hand, shows a longer duration around four years and with no yield showing more liquidity risk at the asset level.

In reality, many investors don’t directly hold assets, but rather invest in funds. The bottom chart examines fund level liquidity in terms of DPI at each fund age. This shows how quickly fund investors receive cash back. Similar to the asset level, we see the duration of private credit has historically been the quickest to hit that 1.0x mark, though at the fund level this duration is much longer than at the asset level. Perhaps more surprising, private equity has historically hit 1.0x around nine years, which isn’t much longer than private credit.

It’s important to understand the liquidity risks of the strategies for thoughtful portfolio management but also to keep in mind what structure you’re investing in, as there are many differences from asset liquidity to fund liquidity.

Diversification: Increasing the Likelihood of Success

Appropriate diversification can play a major role in successful portfolio management. It may help mitigate downside risk that arises from the wide spread of returns among private markets funds. Here we see return distributions of portfolios of varying diversification. The first chart shows the return distribution of portfolios investing in a single fund each year. Even this minimum diversification can help limit downside risk for risker strategies - while retaining upside potential. However, minimal diversification may mean limited probability for any single occurrence of returns, which of course, can pose a challenge for investors with limited selection resources.

As we see in the second chart, increasing portfolio diversification to five funds per vintage year may tighten the portfolio return distribution for each strategy. In addition to narrowing the spread of outcomes, it has the potential to  increase the portfolio return. This does not imply optimal diversification, but rather illustrates the impact of large diversification across equity strategies:  adding slightly more funds per vintage may minimize the downside risk and achieve target returns. While we believe appropriate diversification is optimal for achieving benchmark returns, active manager selection may also increase the ability to drive upside returns of the portfolio.