Performance varies far more for private equity funds than for publicly traded stock funds. For example, the internal rate of return for the 25th percentile of global buyouts was more than 15 percentage points higher than the 75th percentile between 1988 and 2008. Furthermore, the top private equity fund for the year outperformed the 25th percentile by a median of over 27 percentage points during that same period.
Performance varies less for mutual funds of publicly traded stocks because many of their managers have become de facto indexers. In private equity, managers still have opportunities to discover new information and freedom to develop original strategies. Furthermore, we anticipate that disparities in private equity manager performance will increase as regional economies move in different directions and new technologies emerge.
Many investors would expect private equity funds to be more volatile, but they are actually less volatile by some measures. For instance, private equity investments declined only 23.6% in 2008, while global stock markets dropped 41.9%. It is true that some of this lower volatility comes from using different metrics. Private equity is often priced closer to the way value investors claim assets should be valued. The animal spirits that drive publicly traded security prices are less influential.
There are also deeper reasons why private equity volatility is lower than most investors expect. While individual private companies usually have higher idiosyncratic risk than listed firms, collections of such private companies often display lower volatility. The greater variety of investing styles and asset classes in private equity can also provide more diversification.
It is essential to select the correct private equity managers to achieve this diversification. The best private equity fund managers are not easy to access, and full diversification can never be accomplished in one place.
Gaining access to managers with true alpha is perhaps the most crucial practical problem associated with private equity, but there are other issues as well. Some of the most successful manager strategies do not scale well, so investment opportunities are limited. Consequently, new private equity investors might not be able to choose many managers with impressive track records. Access to managers is critical because studies have shown a substantial amount of performance persistence in private equity.
Another set of practical considerations revolve around the liquidity and complexity of private equity. As a rule, private equity investments tend to be illiquid. Holding times of one year or more are typical. The greater freedom afforded to managers and the nature of certain asset classes can also lead to irregular payouts. This combination of complexity and illiquidity often creates a need to diversify among fund managers to distribute overall payouts more evenly.
Environmental, social, and governance (ESG) concerns are an increasingly important part of manager selection in private equity. Institutional investors play a significant role in private equity markets because they are better equipped to deal with illiquidity. However, they also have a responsibility to uphold the values of their institutions. This responsibility is magnified in private equity because it is much more common for managers to hold meaningful stakes in companies. Private equity fund managers should be aware of ESG issues and know how to deal with them in real-world situations.
Using Private Capital Efficiently
Capital invested more efficiently will produce higher returns, but that requires selecting better private equity managers. The impact of manager selection on returns is higher than for mutual funds, and the potential for reducing volatility through diversification is also higher. As a practical matter, even getting access to the best managers and dealing with liquidity concerns can be challenging.
It is often necessary to incorporate ESG factors into the manager selection process. At Ashton Global, we combine these considerations to match investors with the private equity managers who are best qualified to achieve their unique goals.
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