Private equity funds are becoming more mainstream as investors seek an alternative to uncertain stock markets, low interest rates and concerns about a bond bubble.
With growing concern spreading about a bond bubble, interest rates at historic lows and an air of uncertainty as a new President takes the reins, some investors are on the hunt for alternative investments. Lured by attractive performance and low correlation to traditional equities, a growing number are turning to private equity.
Once considered a boutique investment, private equity assets under management have swelled fivefold in the last 15 years, to $2.4 trillion as of December 2015.
"There's been an explosion in private equity in the last decade or so," says Rafique DeCastro, Vice President for Morgan Stanley Wealth Management. "Historically, it was okay to have more allocated to bonds, but as rates have gone down, pension funds have had to shift more to alternatives to help them reach their target returns. As a result, billions of dollars have poured into the asset class."
At the same time that private equity's popularity is rising, there are signs that one of its salient characteristics—a lack of liquidity—is abating. Private equity investments—sometimes called "patient capital”—are typically tied up for seven to 10 years, if not longer, with no redemptions during that time, but a growing secondary market is opening up the option to buy and sell existing private equity commitments.
That's not to say investors are unwilling to sacrifice some liquidity in order to diversify away from public markets, as the benefits can make the wait worthwhile. "Historically, private equity has demonstrated a competitive track record compared to equities," says Al Troianello, Executive Director at Morgan Stanley Wealth Management. "And that's including both up and down markets."
As private equity has grown as an asset class, it has expanded to include a wide range of strategies and specialties. Among them: venture capital, buyout funds, distressed or special situations, infrastructure, real estate and energy, to name a few. There are also co-investment vehicles and a fast-growing secondary market, which capped at $40 billion in 2015, after reaching a record volume in 2014.
How Private Equity Secondary Market Volume Has Grown
Secondary investments are appealing for several reasons. First, there's a shorter investment period. Secondaries give investors the opportunity to bypass some illiquidity by jumping in near the end of the life of a fund, when investments start bearing fruit.
Outflows typically exceed inflows during the early years of a private equity fund as money is put to work in investments. Only during the fund's later years will those investments hopefully start generating returns. This clustering of gains toward the later years of the fund is called the 'J-curve.' Secondary investments potentially allow investors to jump right into the fruit-bearing period, generally around the 7th to 10th year.
Secondary investments "can make a lot of sense since investors have the potential to generate attractive risk adjusted returns, get instant diversification, and mitigate the J-curve " says DeCastro. They are also more transparent. Since most investments have already been made, secondary investors have a pretty clear picture of what's in the fund's portfolio.
Another area to watch in private equity is the small- and middle-market buyout market, which may now be more attractive than large-cap buyouts. Because private equity experienced such rapid growth in recent years, deal multiples have gone up and there's more capital accumulating on the sidelines as managers look for deals. That's less true on the lower-to-middle end of the market, where deal multiples have historically been fairly priced, relative to the large end of the market. As a result, investors can take advantage of the greater inefficiencies in the pricing of underlying assets, potentially resulting in higher returns.
The increase in "dry powder"—cash or liquid reserves waiting to be deployed—is not a bad indicator and usually leads to outperformance. For investors it should lend peace of mind: Capital can act as a liquid safety net for the fund in the event of unanticipated financial obligations or an economic downturn.
Estimated Dry Powder is High, Making Managers More Selective
Though private equity is an increasingly attractive asset class, manager selection is a key consideration before parking your money in a fund.
"None of this matters if you don't select the right manager," Troianello says, noting that difference in performance between top and bottom quartile is significant. Data shows that good managers tend to stay at the top quartile, while weaker ones consistently underperform. Since manager selection is a key aspect of investing in private equity, Morgan Stanley’s Global Investment Manager Analysis team (GIMA) looks for managers who have consistently performed well against their peers.
"It's more than just track record, it's the people and process they have. If a manager has a good track record, hopefully they weren't just lucky but rather there was a solid reason behind that track record," Troianello adds. Some managers, for instance, do well in certain markets but not others. Investors also need to look at various funds and vintages and compare how well they performed in certain sectors or targets.
Private equity may be a valuable tool for your overall strategy, but they aren’t necessarily the right one for every investor. Talk to your Morgan Stanley Financial Advisor today about private equity and other options that can be an integral part of your wealth management strategy.