Private investing set to maintain investor interest
Over half of the global value of private assets is clustered in private equity, according to Pitchbook data for end December 2021. And within private equity around half of fund raising over the past decade has been for corporate buyouts (i.e. buying a controlling stake in a target company).
In the past 10 years, private equity has outperformed global equities by an average 3.9% annually. We expect this outperformance to continue. Our expectation of an average annual return of 9.2% for private equity over the next 10 years (compared to 6.2% for the MSCI AC World) is conservative, but takes into account both opportunities and challenges for the asset class going forward.
Among the most important factors behind private equity’s outperformance is sector allocation. Even more than stock pickers in listed markets, private-equity managers target investments in growing areas and/or companies that can be turned around or improved. Another important factor is the influence private-equity managers have in the way companies are run and in making them more efficient. But the most important factor of all explaining private equity’s superior returns remains financial leverage. The better a company is managed, the more debt it can support and so the greater the potential for a private-equity fund to amplify investor returns.
Financial leverage in global private-equity buyouts is structurally higher than the levels one sees in listed markets: on average over the past decade, private-equity deals have been financed 50% by debt and equity by 50%. While general rise in interest rates we expect over the next decade might imperil debt-funded deals, we are not too concerned for three main reasons : First, the amount of debt in the financial system will cap the increase in rates. Second, the percentage of debt used to fund global buyouts has remained unchanged at 47% since 2019. Third, while they have marginally increased since 2018, unlike valuations in listed markets buyout valuations did not skyrocket during the pandemic. In a nutshell, private-equity firms remained disciplined before, during and after pandemic even when interest rates sank.
"Venture capital does not always outpace private equity"
Venture capital (VC) deal volume reached around USD700 bn in 2021. This, an all-time high, was twice as much as in 2020. Since 2008, the lion’s share of VC deals has been in information technology, which has accounted for 40% of deals and 36% of deal value. Average deal size increased substantially in 2021, to USD16.2 mn from USD10.9 mn in 2020. Corporate venture capital (CVC)—the term used to describe moves by existing companies to buy into innovative start-ups in their search for profitable new investments—was also extremely active in 2021. Average deal size in CVC is twice as large as in VC in general and CVC represents about half of VC deal flow.
Over the past 30 years, venture capital has rarely performed in line with private-equity buyouts. This is because investment in VC is closely linked to innovation waves. When innovation is buoyant, so too is VC. This helps explain why VC massively outperformed during the TMT boom of the late 1990s. The growing share of US tech giants in US blue chip indices explains VC’s renewed outperformance since 2018. Most of this outperformance was achieved in 2020 and 2021. Some large university endowment funds, including the Yale fund, have greatly benefited from having a significant allocation to VC (it had a target VC allocation of 23.5% of total assets under management in June 2021).
VC thrives on innovation but the current innovation wave is fading and it may be some time before the next one gains traction. Given the circumstances, instead of outperforming, VC may be conservatively expected to perform in line with private equity in the next decade. More so in VC than in any other private-asset class, manager selection can result in a wide dispersion of returns.
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