Private Equity Looks Set To Disappoint

Written by Alan Hartley, CFA of Black Cypress Capital 

Over the last three or four months, we’ve received countless in-bound calls from consultants and third-party managers offering access to late-stage venture capital and traditional private equity (PE). We view these unsolicited pitches and others like them as anecdotal signs of sentiment and supply/demand imbalances.

We’re by no means opposed to the strategic use of private equity. In fact, under the right circumstances, it’s a terrific addition to a high-net-worth-investor or institution portfolio. The asset class has, at least historically, added a couple percentage points of performance above public stock market indices. So, assuming an investor has a reasonable distribution policy, a sufficiently long time horizon, and the financial discipline necessary for material portfolio illiquidity, an allocation to private equity can be appropriate.

A private equity fund raises capital from investors, locks it up for 7 to 10 years, and then, depending on the type of strategy, invests in the stock or debt of private and publicly-traded companies. At its core, private equity buys-to-sell. A PE fund purchases the securities of a company, steers the firm to improve its financials, and then, if all goes well, the fund sells in 2 to 6 years to realize a onetime, outsized profit.

With interest rates near historical lows and U.S. public equity market valuations stretched, investors are looking for ways to generate higher returns — thus the draw to private equity and its track record of excess returns. Pitchbook, a data analytics firm that tracks the M&A, private equity, and venture capital industries, reports that U.S. private equity fundraising is at record levels and is on track to rise 16% this year. There’s a lot of capital chasing private equity today.

But private equity isn’t a panacea. According to Cambridge Associates’ U.S. Private Equity Index, PE funds have underperformed broad stock markets since the 2008/2009 financial crisis.  And now, private equity, like its public market counterpart, looks priced to generate subpar returns compared to its historical rate. In fact, it may be one of the worst times to add fresh capital to the industry.