The longer a bear market drags on, the better the chance that pain will spread beyond stocks. So with the US bear market entering its seventh month, it’s not too soon to think about what other risks might be lurking. Private equity is at the top of the list.
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The private equity industry, which as its name implies invests in shares of private companies, has ballooned into a sprawling, high-powered, moneymaking machine over the past four decades. In the 1980s, it could legitimately claim to be a small club of rich investors, but no more. Data around private equity is scarce because its dealings are, well, private, but available numbers give a clear enough picture of its enormous scale.
According to Preqin, a leading provider of global private equity research, there were 28 private equity firms in 1980 across the industry’s three chief strategies: leveraged buyouts (buying mature companies using mostly borrowed money); growth equity (investing in maturing but still relatively new businesses); and venture capital (betting on startups). Now there are more than 9,200 firms managing close to $7 trillion.
Suffice it to say, the secret is out. Most institutional investors, including pensions and college endowments, allocate a significant portion of their portfolios to private equity, often a third or more. It’s also a core investment at big money-management firms, notably Wall Street banks. Even Vanguard Group, known mostly for its low-cost index funds, now offers private equity to eligible clients. The only investors who don’t own private equity these days are retail investors, who are prohibited from doing so by US securities laws.
The reason private equity is so popular is that it has made a fortune. Cambridge Associates’ widely followed US Private Equity Index, which includes buyout and growth equity funds, posted a return of 14.3% a year over the past 25 years through 2021. That’s 4.4 percentage points a year better than the US stock market and 6.3 percentage points better than the global stock market, according to Cambridge Associates’ calculations. Its US Venture Capital Index performed even better, advancing 28.7% a year over the same time.
But those heady days are almost certainly over. Private equity was blessed with ideal conditions in recent decades, an environment it may never encounter again. Interest rates fell from record highs in the early 1980s to record lows two years ago, allowing buyout firms to borrow and refinance ever more cheaply along the way. At the same time, equity valuations rose to historic highs from historic lows, lifting the value of most companies. That combination of cheaper leverage and rising valuations is unbeatable.
Private equity had other advantages in its earlier days. Most investors had no exposure to private equity in the 1980s, so there was a lot of room for growth. There was also little competition, so managers had their pick of deals. When money began pouring into the space, more companies were suddenly able to raise capital without going public, which further expanded the field of potential investments. And while valuations were still low, existing private equity firms could sell their investments to newer firms for a hefty profit but still cheaply enough that the newcomers could also make money on a future sale.
Read the full article here by Nir Kaissar, Advisor Perspectives.
