Since the mid-1990s private equity, including buy-outs and venture capital, outperformed stocks over all time periods. But the performance gap has narrowed
The revolution Swensen started has spread to other endowments and foundations, and then to sovereign-wealth and pension funds and money managers for the super-rich. Academic institutions remain the trailblazers.
In the 2020 fiscal year, leveraged buy-outs,and real assets made up an average 39% of the portfolios of American university endowments with more than $1bn. Yale has 45% in buy-outs andalone. But institutional investors of all stripes have been gradually raising their allocations to private markets, typically to percentages in the high teens or low 20s. Many plan to go higher: in a survey last year by Preqin, a research firm, around 90% said they expected to commit the same or more to, America’s largest public-pension fund with around $500bn under management, signalled plans to increase’ expected returns above its long-term target of 6.8%; falling short would matter to a fund whose obligations to pensioners already exceed the current value of its assets by over $160bn. “Mosts just wish their boards would give them more access to private markets,” says a consultant to big investors.Their investments are mostly made through-sponsored funds with a set lifespan. A growing share of funds buy investors’ existing commitments in the “secondary” market forstakes. This has boomed recently: 2021 saw a record $126bn in trans actions, 50% higher than in 2019, the previous peak. Big private-markets firms like Ares ands used to sell stakes into the secondary market only in a cash crunch. Now they do so freely, as a tool of active management, eg to increase exposure to a sector or reduce it to a region.s have become big secondary players, too. One popular innovation is a “continuation fund”, essentially a vehicle for ato sell stakes to itself. One aim is to delay selling prized assets that might have to be divested as an old fund winds down.s have used their clout to invest differently. Some make half their private-markets commitments outside fund structures, either “directly” or as “co-investors”, alongside a fund . The busiest direct and co-investors are Asian sovereign-wealth funds, such as Singapore’sInvestments and the Ontario Teachers’ Pension Plan . Institutions that do a lot of freelance investing can bring “blended” management fees down to 1-1.5%. The Universities Superannuation Scheme, an £82bn pension scheme in Britain, has saved its members “hundreds of millions” by investing directly, says Geoffrey Geiger, its head ofA good deal?s are ambivalent about this. It means forgone fees, but it can still be useful. Some funds would find it hard to make large investments without co-investors, because of risk limits on single holdings as a share of the total. Blackstone and its partners would have struggled to complete the $34bn purchase last June of Medline, a medical-supply giant, without co-investors, including, said last year that averagemanagement and performance fees in 2018-19 were 1.76% and 20.3%, respectively, “not that different from when I was on Wall Street” in the 1980s. Other expenses can push overall fees, including carried interest, up to 5% or more per year over the life of a fund. These include charges for “monitoring” portfolio companies, for administrative expenses, or even for use of private jets. StepStone, a private-markets advisory firm, memorably describeds don’t kick up much fuss about fees partly because they fear being excluded froms’ future funds or co-investment opportunities. Some keep quiet because they get rebates under side agreements. Still, many complain that fees are too high and that the fee structure is rigid even though funds’ performance varies. Others grumble that fees are charged on all committed capital, not just that actually deployed.s seek to assuage such concerns. A few have switched to charging based on funds deployed. One large investor predicts thatwill eventually follow hedge funds: when relative returns sagged after the financial crisis, some hedge funds closed, others turned into family offices, and many of the rest cut fees.’s reference point. “The way the buy-out and venture-capital markets are rationed is that managers of underperforming funds struggle to raise more money and fade away rather than staying in business by slashing fees,” says Steven Kaplan of Chicago University’s Booth business school. The head of one American endowment’ss to pay more than 20% carried interest for good results than to pay less than 20% for below-average results. Some investors will pay 25% or more if the manager delivers something special, such as four times the original investment.s for lower fees is their faith that unlisted investments will continue to outperform public markets.firms tout dizzying returns over the past 20 years. Academics who crunch the data are split, though not down the middle. A small, vocal minority, led by Ludovic Phalippou of Oxford’s Said Business School, argues that’s outperformance is an illusion created by an industry that has mastered ways to massage the numbers. Over the past decade, Mr Phalippou calculates, returns have merely matched those of stockmarkets. ForMost other boffins disagree. They acknowledge that the “internal rate of return” measure favoured by the industry is flawed: it can be gamed by playing around with cashflows or by taking out “subscription lines”, loans that managers get from banks to delay calling capital froms. However, the academics have developed their own, more solid metrics. The best of these is “direct alpha”, a less manipulable, market-adjusted version ofKenan-Flagler Business School calculated direct alpha since the mid-1990s for funds in the 1986-2016 vintages. It found that, outperformed shares over all time periods by 2-6 percentage points. It beat them regardless of the benchmark used; the authors tested among others theThe less good news is that the performance gap has narrowed. As private markets get more crowded, competition for stand-out investments intensifies. And as the industry gets bigger, it learns the truth of Warren Buffett’s dictum that “no one in the world can earn 20% with big money.” The real question, says Gregory Brown, the study’s lead author, is whether private assets are worth it once returns are adjusted for risk.’s “beta” is 20-30% higher than that of equities. Investors also demand a premium for illiquidity . Against this, investors must weigh the diversification benefits of holding private assets.pays, average returns are just an average. Pick a below-average fund and you can be soaked in red ink. The gap in performance between top- and bottom-quartileinvestments return less than was put in, reckons one private-markets adviser. Picking winners is made harder by a weakening of the link between past and future performance. The odds that amanager’s next fund will be in the top quartile if its previous one was have fallen over time, to “not much better than 25%”, as the industry has grown, says Mr Jenkinson. And information about past performance is often incomplete: investors must decide whether to back a manager’s next fund three or four years after the previous one started investing, long before its final returns are clear. Even in the highest reaches of private markets, investing is as much about keeping the faith as studying the form.
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