Since it first dawned on Wall Street that Henry Kravis and his cousin George Roberts were “real people with real money” during the leveraged buy-out of RJR Nabisco in 1989, private equity has grown by leaps and bounds. By sheer size, private equity is now a significant component of overall equity markets – at the end of 2019 there were nearly 1,900 buyout firms with $1.4 trillion dollars in assets under management and an additional $455 billion managed by venture capital fund managers. By comparison assets under management for equity mutual funds totaled $8.4 trillion and $2.8 trillion for equity index funds. In addition, the number of firms owned by private equity in the U.S. is roughly 7,200 which is close to double the 3,640 publicly listed companies in America, according to a recently published meta analysis of the industry by Michael Mauboussin in August of this year.*
The key reason for the growth is returns. Over the last 30 years the median public market equivalent (PME) return has been approximately 1.2x for buyout funds in aggregate and 1.0x for venture capital, which is the preferred metric used by institutional investors that is calculated by taking the ratio between private equity and public market returns. A PME above 1.0 denotes relative outperformance and a PME below 1.0 denotes relative underperformance. Key drivers of performance have been identified as financial leverage, in addition to highest and best use of capital since the boards of directors of firms made up of private equity investors are typically much smaller, more sophisticated, and have more skin in the game.
While in aggregate, buyouts have added significant performance and venture capital has returned similar returns to public equity markets, the average covers up significant performance dispersion. As Howard Marks once eloquently said: ““Never forget the 6-foot-tall man who drowned crossing the stream that was 5 feet deep on average.” The flipside is also true in that many investors like Yale’s endowment fund have produced incredible returns consistently over a long period of time, which has created an allure for many institutional investors. Since David Swensen took the helm at the Yale Investments Office and rotated the portfolio out of public equities and into illiquid alternatives like private equity and venture capital, the Yale endowment has generated an astounding 12.6% return per annum over the past 30 years. The approach was popularized in the book Pioneering Portfolio Management, which has become the bible for institutional allocators.
“Barbarians at the Gates” no longer, private equity managers have become a mainstay of institutional money management. While many investors remain sceptical about the diversification benefits of private equity, given performance has empirically been highly cyclical and smoothing effects from the managers having partial control of the valuation process (leading to artificially low volatility) have been well documented, the possibility of higher returns has continued to attract institutional capital. The strong attraction of higher returns is most likely due to a strong incentive resulting from many pension funds being underfunded and endowments making up an increasingly larger part of the operating budget of their universities. As it stands, many endowments have very large allocations to alternative investments and increasingly so do many pension funds. Based on publicly available data, a large part of pension funds’ alternative investments is in private equity. For example, 25% of the Canadian Pension Plan’s Investment Board’s (CPPIB) portfolio was invested in private equity at the end of Fiscal 2020 according to their latest annual report. In the future, most institutional investors expect to increase or maintain their allocation to private equity according to a recent survey by Preqin.
Also helping the growth of private equity investing are several headwinds which have emerged for public equity markets. While the cost of going public and required disclosure has gone up significantly, the benefit of going public has gone down significantly as well given most new companies do not require the same amounts of capital as they did historically. This is due to the importance of technology today, illustrated by intellectual property representing a much larger proportion of assets for both public and private companies in today’s economy as opposed to the large share of assets made up of labour, property plant & equipment and working capital in previous decades. This has led to new companies staying private for much longer with the majority of their value being created before they go public.
A great example of the trend is illustrated by some of the most well known and successful technology companies – Amazon went public in 1997, 3 years after it was founded with a market capitalization of $660 million (in today’s dollars) allowing investors who bought the IPO and held their shares to make 1,800 times their money. Google had its IPO in 2004, 6 years after it was founded and IPO shareholders have made 33 times their money, while Facebook had its IPO in 2012 which was 8 years after being founded and made IPO investors 6 times their money, and finally Uber had its IPO in 2019, 10 years after being founded. While it is still early, investors in Uber have yet to break-even! To sum up this trend, since the late 1990’s, the most successful new companies have been waiting until they are more mature before accepting public money which has had the effect of greatly reducing the rewards to investors who have bought equity in their IPO’s. These benefits have instead been captured by the private investors (founders, venture capitalists and private equity investors) who invested at earlier stages.
This trend has led to valid concerns of preferential access by larger more sophisticated investors and insiders who use the public markets as a source of liquidity only after the majority of gains have been made. As a result, there is a push to democratize the industry, with the U.S. Department of Labour clearing the way in June of this year for 401(k) plans to invest in private equity. The SEC is also looking at ways to make private equity investments more accessible, likely by relaxing the requirements for accredited investor and qualified purchaser status. This points to continued growth of the industry and public and private equity markets converging – which begs the question of how will there be excess returns from private markets once their size begins to rival public markets? The answer may be that there will not be any, or only a small premium that waxes and wanes. If that comes to pass, new forms of segmentation are likely to arise as industry insiders erect new garden walls to preserve their advantages.
Certainly, private equity should not be overlooked by sophisticated investors given its growing size and the fact that for now it remains the primary source of funding for what are likely to be the next generation of the world’s most successful companies.
Author: Isaac Lemprière
* Michael J. Mauboussin (2020), Public to Private Equity in the United States: A Long-Term Look, Morgan Stanley Investment Management