Over the past decade, private equity has seen outstanding returns and levels of interest from investors, moreso than public market index funds and even managed funds. This interest has amalgamated into the form of $2 trillion invested into private equity over the past decade, and that's a strong contrast against investor allocation in the public markets.
In 2019, managed public market vehicles, hedge funds, made up about a third of institutional investors' allocations into alternatives. That's roughly 7% lower than the year prior. Take private equity on the other hand, the asset class has seen a 7% increase from the prior year as investors allocated roughly 25% of their alternatives allocations to the asset class. As a whole, alternatives constituted 25% of investors’ portfolios, a tick higher than the prior year.
With all that said, the last decade has seen public market indices do about as well as private equity (source: Bain & Company):
This shows, on a "net of fees" basis, that private equity and public markets have converged on a ~15% return over the past decade. In both cases, that's a great return, but in private equity's case, that comes with the downside of illiquid funds and higher risk, which is not ideal...so why the higher allocation?
Quite simply, the public market performance is not here for the long haul. Available data allocates this impressive performance to a bullish cycle terminus; the rebound in public valuations after the Great Recession is to be expected. The massive selloff following the recession laid the groundwork for a bull market for stocks. A number of points of have echoes of what we're seeing today. For example, the decade ending in March 2000, when a dovish monetary policy and ".com" technology bubble drove a ~19% return for S&P 500 indexed funds (source: Bain & Company):
If we look a bit more broadly we can see that over the past ~140 years, the public market returns have been solidly closer to 8% than roughly double that. In fact, ~30% of the time, the annual returns of indexed funds were negative. The odds of this pattern altering into a "new normal" are slim, long term double-digit returns remain the bread and butter of private equity and LPs are backing that thesis with their wallets (source: Bain & Company):
As you can see in the figure above, private equity NAVs have far outperformed public equity market peers ...since the dot com bubble collapse, buyout NAVs have grown more than 3x their public market peers.
However, private equity can't quite relax yet...
IRRs are trending downwards as a continuingly large pool of capital competes for similar assets. In fact, since 1999, we've seen a loss of 6pts worth of IRR among global buyout funds (source: Bain & Company):
Funds that are able to maintain an outperformance have tended to have some edge, both in operations and in focus. On the operational side of things, private equity firms are starting to consider the implications of digital transformation within their industries, from mid and back-office software, such as fund administration software and expense management software, to front office tools, such as Orion, Cais Group and AltoIRA, which helps investors enter the asset class.
As more and more money is poured into private equity, these technological differentiators add up, as investors expect the very best, from detailed reporting and updates, to best-in-class capital stewardship, down to the very pennies allocated to expenses.
On the focus side, firms need to pick a side, and stick to it, build a story that resonates as a focus...from software investing to secondaries (source: Bain & Company):
Matthew Markham is the COO of aXpire, a digital transformation software company. For more information, reach out to [email protected].