Investor worries tied to the banking system, monetary policy and inflation have contributed to market volatility this year. In light of ongoing uncertainty, we believe the characteristics of the private equity asset class stand out in terms of its ability to weather market storms and to add value when public counterparts may be challenged.
Resilient in Volatility
Although private markets are not impervious to market dynamics, the impact of volatility can be more muted, as they tend to reflect longer-term views, and managers can often hold onto assets that they might seek to sell in a better climate.
In the recent environment, our private equity team has found that existing private equity investments have generally not been marked down despite a slowing economy and higher interest rates. This is because deal flow has been slower with only the highest-quality assets being sold, most of which buyers believe still warrant a full price. In addition, operating performance of many private equity-backed companies has held up surprisingly well, with many still growing.
Importantly, private equity managers are capable of being highly adaptable. Many can be quicker than public counterparts to manage costs, conserve cash, change management or inject equity into portfolio companies. Private firms also aim to have ready access to capital in turbulent times, so they can inject more equity into businesses that may be temporarily affected by external weakness.
This resilience is evident in historical performance data. Our private equity team compared peak-to-trough valuations of public and private markets in three significant periods of market distress—the economic downturn of the early 2000s, the 2007 – 2009 Global Financial Crisis (GFC) and the 2020 COVID-related market events—and found that private equity experienced a less significant decline in valuation and a quicker recovery than public equities in all three cases. For example, during the GFC, the U.S. buyout sector experienced a peak-to-trough net asset values (NAV) decline of 28%, compared to roughly 55% maximum drawdown for the S&P 500 (quarterly returns are shown below). Last year’s dynamics reinforce this view: While public markets fell about 20%, private equity buyout valuations, based on the team’s estimates, were flat.1 The impact of any slight multiple correction in sponsor valuation models was essentially offset by underlying company growth.
Return Comparison: Global Financial Crisis and Its Aftermath
Source: Cambridge Associates, FactSet. Nothing herein constitutes investment advice or recommendation. It should not be assumed that any investment objectives or client needs will be achieved. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. These figures are based on expectations, estimates, and projections and no party provides any guarantee or assurance that these projections are accurate. Such figures involved known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Actual events or results may vary significantly from those reflected or contemplated. Assumptions are for modeling purposes only and alternative assumptions may result in significant or complete loss of capital. There can be no assurance that the strategy will achieve comparable results, that targeted diversification or asset allocations will be met, that the strategy will be able to or will ultimately elect to implement the assumptive investment strategy and approach described in the model. See disclosures at the end of this paper for definitions of Indexes. Past performance is no guarantee of future results. See additional disclosures at the end of this article, which are an important part of this display.
Long-Term Lessons
Importantly, private equity firms have learned many lessons from the events of 2008, which have driven meaningful transformation for the asset class. These managers have invested heavily in resources to navigate turbulent markets and economies, the results of which were evident during the COVID-19 pandemic. At that time, when public markets were falling and liquidity was seizing up, private equity firms often took decisive action around their businesses and portfolio companies, helping to insulate them from uncertainty.
The investment emphasis of private equity managers has also changed over time. While historically firms tended to seek higher multiples and increase leverage, today they often make investments with plans for strategic operational improvements, working toward organic growth as well as accretive mergers and acquisitions to generate value. Such an approach seeks to limit vulnerability economic and market turbulence, while the ability to deploy capital in those times potentially can actually improve long-term return prospects.
Strategic Appeal
In our view, all of these elements reinforce the strategic appeal of private equity within the defined contribution space, particularly as a component of customized target-date funds. Plan sponsors have long acknowledged the appeal of the private markets and their differentiated returns, which seek to improve overall diversification. Moreover, as we have noted previously, structural innovations are increasingly enhancing the viability of private market elements within target-date funds, for example, through the issuance of more frequent valuations and the reduction of liquidity constraints via inflow and outflow rebalancing holistically for the target date fund.
The use of private market products within the DC space does require a certain level of expertise, making it important that plan sponsors are able to navigate the technical and regulatory issues. However, we believe that in an environment of increased market and economic uncertainty, pursuing an allocation to private equity is worthwhile in order to potentially enhance opportunities for additional risk-adjusted return and help seek to achieve the investment goals of plan participants.
