August is a good time to kick back and get stuck into some private equity-focused research.
Two papers caught the eye this week; taken together they summarise today's global private equity market nicely.
The first, by the founder of investment consultancy Cliffwater, Stephen Nesbitt, demonstrates that institutional investors – specifically US public pensions and their advisors – consistently underestimate the net returns generated by private equity, while consistently overstating its level of risk.
By analysing the investment performance of 46 state pension systems between 2002 and 2016, Nesbitt shows that private equity performance, relative to public equities, is better in bear market periods compared with bull market periods, though strong excess returns occur in both. Private equity has more than delivered on the promise of 300 basis points of excess return over public markets. His research is well worth a read .
The result, concludes Nesbitt, is that despite experiencing success with their private equity portfolios, US public pensions wrongly persist with “low single digit” allocations.
So more US public pension money needs to find its way into private equity. But therein lies the conundrum.
Accessing the asset class is no mean feat. Running a successful private equity programme is an expensive endeavour (although not nearly as expensive as running an unsuccessful one).
Take this week's discussions at the California Public Employees' Retirement System. Its $26 billion private equity programme is performing “more or less right on the median” of its peers, according to its adviser Meketa Investment Group.
It managed to commit $1.6 billion to managers in the last six months. Hardly an insignificant sum, but still the pension is going to have a hard time maintaining its 8 percent allocation to the asset class unless it ups its pace, according to Meketa.
This is partly down to CalPERS' conscious decision to reduce the number of manager relationships it has. To quote Meketa's Steve Hartt, “If they're not in the market, then it's difficult to deploy capital.”
But it is also a function of the wider market: high levels of distributions have made it difficult to reinvest fast enough. “And there are challenges to being just a fund investor and deploying much more than $4 or $5 billion a year,” Hartt told the CalPERS board on Tuesday. “It's hard to do.”
To maintain the requisite exposure to the asset class, CalPERS and its peers need to make commitments in the hundreds of millions, which naturally pushes them to the large buyout funds that have the capacity to absorb them. This brings us to the second study.
In Is there too much capital in leveraged buyouts? Cyril Demaria, head of private markets for consulting firm Wellershof & Partners, notes that the capital raised in each segment and geography of the private equity market in recent years has been roughly equal to the amount invested. Except among large US buyout funds, which have deployed just $111 billion of the $572 billion they have raised in the past five years. The 'over-capitalisation' of these funds is reflected in asset prices.
So what is a pension to do?
Despite the red flags raised in Demaria's study, LPs are choosing to stick with the big names. One pension fund investor which, like CalPERS, has made commitments to both Apollo's and Silver Lake's latest mega-funds, noted that while the fund size for each increased significantly compared with predecessors, both firms have been able to deploy capital “rationally”, have a global remit – hence a very large playing field – and have generated returns on a par with all other segments of the markets. “We expect this to continue,” he tells PEI.
Nesbitt says that, while absolute returns may have changed over time, the “hierarchy” of returns among the asset classes has not. Public markets +300 bps is what it is all about.
PS. As some of you may know, PEI editor Isobel Markham has now relocated to our New York office, where she will be working alongside our Americas editor Marine Cole. If you are in the city, drop them a note on firstname.lastname@example.org or email@example.com.