Investing with eyes wide open
Successful private equity investors have similar traits. From the start, these institutional investors understand the differences between public and private investments and their respective roles. Further, they understand the unique requirements for implementing private equity without being consumed by the complexity and time required to make partnership investments1.
On average, large US institutional investors have private equity allocations above 7% overall and 10–25% of overall equity. A number of European investors are now moving toward these levels. Investors can treat private equity as an enhancement to the equity portfolio or as an asset class. Leading funds consider private equity as an enhancement to the overall fund’s return and specifically to the equity component. However, it is often useful to include private equity in the asset allocation exercise for management purposes and thus forecasts of return and risk are useful for setting expectations and internal hurdle rates of return.
Investors should view return assumptions for private equity as a required return rather than as an expected return. A required return is a risk-adjusted approach using corporate finance principles to require each investment to stand on its own merits. This approach is necessary in an inefficient and opportunistic market. This stands in contrast to public equity, where most investors develop expected returns based on long-term relationships between asset classes.
The required return, net of all fees, for a globally diversified portfolio of private equity should be about 3% above the expected return for public equities. This objective, described below, should compensate the investor for the additional risks and provide for a long-term return above public equity.
Our private equity return forecasts are shown in Table 1. We have studied actual returns earned by large institutional private markets portfolios over 15 years using our own databases and Venture Economics, a firm specialising in measuring private equity returns. Our forecast returns are based upon past results as well as a financial assessment of the added risks in private equity.
Our risk forecasts are also reported in Table 1. These are expected standard deviations of annual returns. Risk forecasts for private equity are especially challenging because short-term returns cannot be calculated due to infrequent partnership valuations. Risk estimates based upon accounting data consistently understate risk. The best approach has been to estimate risk by drawing parallels to the public markets and adjusting for added risk contributed by financial leverage, the absence of liquidity, or greater business risk.
The US buyout forecast return is 12.25%, which is lower than prior years as the amount of leverage, which increases required return, has declined over the past year. Also, a much higher fraction of buyouts are now categorised as growth-oriented and require greater equity capital.
Buyouts is the largest private equity segment. Opportunities for buyouts and subsequent returns are created, in part, by barriers to corporate ownership. Since efficient public markets for capital shares have only limited influence on corporate management, much of corporate ownership and management control is protected by corporate, bankrupt and securities law. These barriers allow for the survival of mismanaged companies that operate inefficiently or are in financial disorder. In the face of these barriers, an investor can bring about change and create value by taking control of the company. This control is frequently obtained through acquisition prices that are below the public markets with more efficient financing arrangements.
Our risk forecast, expressed as standard deviation of annualised return, is 30% for buyouts. This forecast is considerably higher than the 17% risk for public stocks and is attributable to greater financial risk due to a more leveraged capital structure in buyout companies. We measured risk by simulating historical buyout returns using our buyout index, which adjusts public stock returns for the capital structure found in buyouts.
Venture capital has been a financing source for decades in the US. It became an institutional strategy in the 1970s, when pension fund legislation changed to allow it. Venture capital remains primarily a US opportunity with $70bn raised last year for investment. Technology and healthcare are the two most appropriate industries.
To gauge the risk characteristics of venture capital investments we examined three public market proxies: the Hambrecht & Quist (H&Q) Growth index, the Wilshire Internet Index, and the performance of aggressive growth mutual funds investing primarily in post-venture technology and biotech companies. Historical return standard deviations for the H&Q index and the mutual funds were approximately 37%. The Wilshire Internet Index had a higher 45% standard deviation. We increased the 37% measure for public post-venture companies by a factor of 1.2 to estimate a 45% risk for private, earlier stage, venture capital. This would give venture capital the same risk level as pure internet stocks.
This methodology enables us to calculate a correlation of 0.6 between venture capital and US stocks, which is high because of the dependence of venture capital returns on a strong IPO market. This is clearly demonstrated by events over the past three years.
The forecast return for a diversified private markets portfolio is 12.5%. This level of return is 3% above the 9.5% expected return for US stocks. The forecast risk for the diversified private markets portfolio is 32%, almost twice the forecast risk of US stocks.
The makeup of the private portfolio is: US buyouts 50%; venture capital 40%; non-US buyouts 10%. The weightings were chosen because they represent private market allocations by large institutional investors and the universe of global private equity. The weightings result in return and risk assumptions that help institutions set the right expectations for and the role of private equity.
Daniel Allen, Thomas Lynch and Stephen Nesbitt are in the private markets group of Wilshire Associates
1 A majority of pension funds implement private equity programmes through partnership investing