THE PRIVATE EQUITY DELUSION: INVESTORS HAVE COME TO SEE PRIVATE MARKETS AS A CASH COW / THE ECONOMIST

The private-equity delusion

Investors have come to see private markets as a cash cow

They need to temper their expectations

Everyone who has an investment portfolio or is in a pension scheme knows that they are exposed to the gyrations of the stockmarket. 

Only some are aware that a rising share of their savings pot has been invested in private assets, including private equity (leveraged buy-outs), privately held debt and infrastructure and property holdings. 

And most would be surprised to know how big this exposure has become. 

Private equity and property alone make up almost a fifth of American public pension funds’ portfolios. 

A whopping 39% of large American endowments sits in buy-outs, venture capital and real assets. 

Private assets have become the opium of the savings industry because they are assumed to generate high returns. 

As our special report this week explains, this belief may be a delusion.

Private investments have gone mainstream in part because the best private investment firms have been well run and made the most of their opportunities. 

For example, while private equity has gone through two boom-and-bust cycles since taking off in the 1980s, its blend of financial and operational engineering has added genuine value to thousands of firms. 

Since the mid-1990s private-equity funds have outperformed comparable share indices over various time periods by two to six percentage points a year. 

As banks have withdrawn from risk-taking because of post-crisis regulation, private firms such as Apollo, Blackstone, Carlyle and kkr have filled the void by expanding into debt markets. 

This has helped private markets to more than quad ruple in size since 2008, to over $10trn.

Meanwhile, the clients—institutional investors such as pension funds—have been desperate to pep up returns. 

The prices of shares are already high, the income you get from bonds has become puny as interest rates have dropped, and an ageing population is putting pressure on the solvency of pension funds. 

In these circumstances, private markets’ record of decent returns is hard to resist. 

Public pension funds with large deficits, including Calpers, a Californian giant, are praying that punts on private markets will save them.

You might think this colossal bet would get lots of scrutiny. 

In fact most criticism of private funds has been directed elsewhere. 

Left-leaning politicians, for example, worry about barbarian owners destroying jobs, when the evidence of this is patchy at best. 

Meanwhile the risk that returns will be mediocre is growing.

One reason is the law of large numbers. 

As cash saturates the industry, it will tend to push down returns. 

America now has 18,000 private funds, 50% more than five years ago. 

The jostling will intensify further as large equity managers such as BlackRock and Vanguard push deeper into private markets in response to a clamour from yield-hungry clients. 

There is even a fast-growing market for second-hand private-equity stakes. 

For investors this secondary market is double-edged: it makes it easier to trade, but should reduce private assets’ “illiquidity premium”—the extra return investors enjoy for sacrificing ease of selling.

Another worry is rising interest rates. 

Cheap debt is the lifeblood of buy-outs. 

Not everyone in private markets will suffer from higher rates: they are a fillip for some private-debt strategies, not least those that specialise in restructuring companies in trouble. 

But dearer borrowing is a net negative for the private-capital industry. 

A final concern is that governments will, belatedly, clamp down on the tax wheezes that private investment firms have long exploited, such as the deductibility of interest payments and the “carried-interest” loophole, which allows them to book profits as capital gains.

None of this means the industry faces an immediate crisis. 

Most funds lock up money for years. 

Some will continue to do well by hunting for bargains, and the evidence suggests that it is easier for skilled investors to outperform in private markets than it is in public ones. 

Nonetheless the overall pot of money invested in private assets seems likely to face a slow-burning deterioration in performance that leaves returns looking humdrum.

What to do? 

Most big private investing firms have shifted from becoming niche, hands-on investors to being financial supermarkets, focused most on growing the asset base from which they charge fees. 

They may need to reinvent themselves, by, for example, finding opportunities that public markets neglect, from building infrastructure to creating renewable energy assets. 

And they will have to cut high fees as returns become more pedestrian

The ultimate investors in private markets, such as pension funds, can do their bit by insisting on lower fees and greater transparency, or trying to bypass fees by investing in private assets directly. 

Even so, it will become harder to avoid the reality that private markets are not a magical solution to an era of low investment returns and insolvent pension schemes. 

It is time to get real about what private markets can and can’t accomplish.