Global trends lend support to the long-term case for private equity as part of a diversified asset allocation.

Private equity has for many years been a niche area of the investment universe, dominated by institutional investors and very wealthy individuals. Today, however, we are seeing trends that are greatly increasing the prominence of the asset class and reinforcing the case for including it in long-term-oriented portfolios across all types of investors.

For many years, the universe of U.S. publicly owned companies has been shrinking. Fewer companies are choosing to list, and those that are listed have been issuing debt to finance share buybacks at unprecedented levels. The path has been quite different for private assets. As the number of public companies has declined, the number of those that are going private or staying in private hands has been steadily on the rise—from about 1,500 in the U.S. 18 years ago to roughly 7,500 today, or some 3,200 more than the number of U.S. public companies.1

Although the private investment universe remains a small portion of global market capitalization, private equity and debt are increasingly important in financing a broad range of companies of varying sizes across an array of sectors. Private investors historically focused on leveraged buyouts of low-growth, asset-intensive businesses at depressed valuations. Since then, the opportunity set has increased to include early, mid- and late-stage companies with varying profiles, including high-growth technology firms.

A significant chunk of the expanding private equity opportunity is coming as a result of the diminished role of banks, which are being curbed by post-financial-crisis regulation and technology. For example, direct (non-bank) mortgage lending is growing as many high-quality borrowers are unable to meet new underwriting standards for bank loans. And where banks are involved, private equity firms are increasingly arranging private debt to fill out the capital structure. Private equity firms are funding many of the new lending platforms such as crowdfunding and non-bank payment systems that are disrupting banks’ longtime role.

Traditional Appeal and Advantages

All told, the array and volume of opportunities is surging, suggesting that private equity is gradually becoming less niche and more central to portfolios. However, the mere expansion of an asset class does not justify its inclusion in the portfolios of individual investors. Private equity’s appeal is more tangible than that, as the asset class has a history of outperforming traditional assets over time while providing valuable diversification, as shown by the displays below. Not only has private equity outperformed public equities, but the addition of private equity has had a tendency to enhance portfolio returns and reduce risk.

Private Equity’s Appeal: Return and Diversification

Annualized Performance vs. Traditional Equities

Risk and Return of Stock/Bond/Private Equity Portfolios (Past 25 Years, Ending June 30, 2018)

Source: Cambridge Associates (top); Neuberger Berman, FactSet (bottom). The top chart shows the MSCI Equity Index alongside the internal rate of return for the Global Private Equity Index (pooled return) from Cambridge Associates as of June 30, 2018, annualized over 5-, 10-, 15- and 20-year periods. Pooled return aggregates all cash flows and ending NAVs in a sample to calculate a dollar-weighted return. The bottom 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. Past performance is not indicative of future results.

What’s behind these outcomes? In our view, they are driven by several key advantages inherent to private equity investments:

Information and Control: Private equity managers generally have deeper access to information and more direct and transparent governance control, and thus have the ability to create value through strategic and operational improvements.

Timing: Private equity managers often spend months sourcing and completing investments, and can choose between trade sales, sales to other private equity funds and IPOs upon exiting. The flexibility around both the timing of their entry into and exit from positions can provide for advantages over most public market managers.

Distinct Opportunities: Private companies are very different from the larger firms that can cope with and thrive on the demands of public ownership. It is much more difficult for a company that is in a changing industry or early in its growth cycle to do well in the public markets, where investors increasingly demand consistent, linear growth in earnings. Often private companies just don’t have a publicly investable equivalent. In a public setting, they might be hidden from view as very small divisions of larger companies; as private holdings, their value may be apparent more readily.

Fitting Private Equity Into a Portfolio

The time horizon, lockup and different nature of opportunities have tended to generate attractive performance and lower correlation to traditional assets. Despite these benefits, however, private equity often will constitute a fairly small allocation within a diversified portfolio—for example, a sample moderate to aggressive profile might have a target allocation of approximately 10% for private equity.. Moreover, it’s important to consider the investor eligibility requirements, risks and characteristics of private equity in assessing whether it is appropriate for your portfolio.

There are a variety of factors to consider when exploring private equity. First, there is illiquidity. It can take time for private equity investors to identify appropriate investments, and then formulate and execute on an investment thesis. Unlike public markets, where investors can regularly buy or sell their holdings, traditional private equity has lockup periods that can last for years. (It’s worth noting that the growth of the secondary market in private equity is making the asset class more liquid, potentially providing liquidity before lockups expire.)

Another factor is what’s known as the “J-curve.” Investments do not occur all at once; rather, cash is “called” from investors as the manager puts it to work and time is needed for the investments to generate returns. As a result, private equity funds can have negative net returns in the early years. Later, if the investments are successful, they appreciate and are realized, and the fund’s net returns become positive.

High investment minimums may also make it difficult for investors to commit to the asset class, particularly steadily over time to provide for vintage year diversification. Thankfully, we are now seeing the release of lower minimum strategies that open up private equity to more individuals, but requirements remain relatively high.

Other Considerations

Readers may wonder whether this may be an opportune time to invest in private equity given the current high-priced market environment. However, valuations remain lower than for public equities generally (see display).

Private Equity Retains a Valuation Discount

Enterprise Value/EBITDA

Source: S&P Leveraged Buyout Quarterly Review, S&P Capital IQ. Public multiples are for the Russell 2000 Index. EBITDA refers to earnings before taxes, depreciation and amortization over the last 12 months.

Moreover, pricing should be viewed in the context of private equity’s unique qualities: the opportunity for operational/financial improvements and strategic changes facilitated by the private owner’s controlling interest, a typically long-term approach, and often specialized experience that can provide competitive advantages. It stands to reason that if an investor maintains exposure to public equities, it may be appropriate to have a strategic weighting in private equity as well.

Of course, investing with a quality manager is crucial. Access to deal flow, information and resources are all things to look for in a private equity firm, allowing for informed investment decisions and selectivity, which is of particular appeal today. Experience across multiple asset classes and market cycles is also important, as well as an attractive track record both in absolute terms and relative to peers. In our view, these qualities are essential in seeking to capitalize on the potential of private equity.

Private Equity Sectors

Venture Capital: Investment in new, potentially high-growth, businesses alongside company management. Venture-capital financed companies may carry more risk than the other private equity segments due to the early stage of the business.

Growth Capital: Typically working in partnership with a founder or entrepreneur, the private equity investor provides capital to help a company grow.

Buyouts: Investment in relatively mature, established companies, using a combination of debt and equity financing. This group is divided into small-, mid- and large/mega-cap buyouts.

Special Situations: Involves restructuring of companies both from a financial and operational standpoint, and may involve the purchase of distressed assets or debt.

Private Equity Vehicles

Primary fund investment: An investor makes a commitment to a private equity fund that, via a general partner, makes investments in companies. This provides diversification of underlying holdings across the private equity portfolio.

Fund of funds: In this case, an investor makes a commitment to a vehicle or a fund that in turn makes commitments to individual private equity funds. These commitments are typically quite diverse, with investments across managers and portfolio companies.

Secondary fund: In a secondary fund, the manager buys more mature or seasoned limited partnership stakes from other limited partners, often at a discount.

Co-investment: The investor makes an equity co-investment in an operating company, alongside the private equity manager, in a leveraged buyout, recapitalization, growth or venture capital transaction.

Private Debt: Investment in the debt of private companies that provide fixed income returns with an illiquidity premium.