Economy & Markets Jun 28, 2021

Food Fight: 2021 Private Equity Update

Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management

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Every two years, we take a close look at the performance of the private equity industry given its rising share of institutional and individual portfolios. Our findings this year: the private equity industry is still outperforming public equity, but this outperformance narrowed as all markets benefit from non-stop monetary and fiscal stimulus, and as private equity acquisition multiples rise. We examine manager dispersion, benchmarks, co-investing, GP-led secondary funds, the torrid pace of industry fundraising and manager fees in this year’s piece.

Introduction

The question of whether private equity outperforms public equity continues to be a hotly debated issue in investment finance. In the latest food fight, Steve Kaplan at the University of Chicago takes on Ludovic Phalippou from the University of Oxford. Phalippou is the author of “Private Equity Laid Bare”, has a podcast with the same name, and asserts that private equity managers have not outperformed net of fees. Kaplan takes issue with Phalippou’s time period selection, his definition of private equity and choice of small/mid cap benchmark and cites consistent (albeit narrowing) outperformance of venture capital and buyout funds over time. In this Executive Summary, we discuss the high-level conclusions from our biennial private equity review. The full private equity paper contains our complete analysis with a broader discussion of topics, including the Kaplan-Phalippou debate.

Buyout performance

The charts below show average and median multiples of invested capital (MOIC) and internal rate of return (IRR) for buyout funds since the early 1990’s. MOIC is a simple measure of cash-in vs cash-out, while IRR is a time-weighted measure of return. Note how there’s only a small gap between average and median buyout manager results.

Before 2009, average MOICs and IRRs generally moved in tandem with each other. Since 2009, MOICs have been declining while IRRs have been rising. The primary reason: increased use of subscription lines, which allow managers to finance investments with bank loans and delay capital calls to LPs until later in the investment period. This practice increases the IRR of a fund at the expense of a small rise in MOIC, since LPs end up paying subscription line interest.

MOIC is not time weighted and neither MOIC nor IRR measures performance vs public equity. Analysts have converged on two concepts that address these shortfalls: the Public Market Equivalent ratio (PME) and Direct Alpha. PME compares private equity commitments and distributions to investments in public equity markets in the exact same time periods. The result is essentially an MOIC ratio of private equity performance vs the public equity benchmark used. Direct Alpha converts the PME into annualized outperformance in percentage terms. Note how average and median results for buyout are similar, as they were for MOIC and IRR. Since subscription loans impact the timing of upfront cash flows, they can materially boost Direct Alpha as well as IRR.

Why have relative buyout returns declined? After the financial crisis in 2008-2009, the Fed and other central banks adopted “maximum accommodation” policies. These policies led to a sharp rise in public equity valuations. In addition, buyout acquisition multiples have increased as the food fight over private companies continues, propelled further by the SPAC boom which we wrote about earlier this year. So, higher buyout purchase prices and better-performing public equities have reduced buyout outperformance.

Are the recent annualized 1%-5% excess returns over public equity markets since 2009 enough given the illiquidity of private equity? Rather than apply an abstract derived cost of liquidity, most investors will judge for themselves whether these returns suffice based on their consistency and magnitude.

Buyout funds: what is the “right” buyout performance benchmark?

Some analysts are reluctant to use the S&P 500 as a benchmark for buyout managers that invest in smaller companies. While US buyout deal sizes have been rising, the average buyout is still much smaller than a typical large cap company. The median S&P 500 market cap is $21 billion, the average US buyout is $2.5 billion and the median Russell 2000 market cap is $1.1 billion. In any case, the chart below shows PMEs using the Russell 2000 instead. The results reflect the relative performance of the S&P 500 vs the Russell 2000 over time.

Buyout manager dispersion

Average/median managers have consistently outperformed, but what happens if you pick a below-average buyout manager? Since 2010, the gap between top and bottom quartile managers has narrowed compared to prior decades, and the degree of underperformance for bottom quartile managers is pretty modest.

Drivers of buyout performance

While cash flow data sourced from limited partners is a reliable way to measure performance of private equity funds, it does not allow a closer look under the hood to see what drives that performance. We asked one of the larger buyout managers we know for company-specific data for three consecutive buyout funds they managed. We decomposed the change in enterprise value into three sources: cash flow (EBITDA) growth, changes in valuation multiples and change in debt levels. In each case, operating cash flow improvements at the company accounted for more than half of the total change in enterprise value, and for more than the impact of multiple expansion. This is not meant to be indicative of the industry as a whole, but it does illustrate that operating improvements can play a primary role in generation of returns.

Venture capital performance

As with buyout managers, VC manager MOIC and IRR also tracked each other until 2012 after which a combination of subscription lines and faster distributions led to rising IRRs despite falling MOICs. There’s a larger gap between average and median managers than in buyout, indicating that there are a few VC managers with much higher returns and/or larger funds that pull up the average relative to the median.

VC managers have consistently outperformed public equity markets when looking at the “average” manager. But to reiterate, the gap between average and median results are substantial and indicate outsized returns posted by a small number of VC managers. For vintage years 2004 to 2008, the median VC manager actually underperformed the S&P 500 pretty substantially.

Venture capital: performance benchmarks and manager dispersion

One could make an even stronger argument that the S&P 500 is not the right benchmark for venture capital given much smaller deal sizes. The first two charts show average and median PME ratios for VC using different benchmark options. Since the S&P 500 outperformed the Russell 2000 Index, the Russell 2000 Growth Index, the Russell Microcap Index and most other US equity benchmarks since 2010, using a different benchmark than the S&P 500 would simply make venture outperformance look larger since that date.

As for manager performance dispersion, VC trends are similar to buyout. Since 2010 the gap between top and bottom quartile VC managers has narrowed and bottom quartile VC manager underperformance vs public equity is very modest. To be frank, I was expecting much worse from bottom quartile VC managers.

Fundraising and the pace of investment

Since the pace of new investment has trailed fundraising, global “dry powder” has exploded since our last analysis, rising from $2 trillion to ~$3 trillion. However, this figure includes all private equity categories and not just buyout and venture capital. For the latter two categories, dry powder is closer to $1 trillion
Increased use of subscription lines also overstates the “real” amount of undrawn and committed capital. The latest estimates indicate $500 billion in subscription lines outstanding, which is a meaningful portion of the increase in global dry powder since 2012

The full private equity paper contains our complete analysis, including the following:

Growing size of average buyout and venture capital transactions
Return dispersion of buyout vs venture, real estate and private credit
Detailed decomposition of buyout fund drivers of enterprise value
Secondary private equity funds and the rise in GP-led transactions
How are gains on venture-backed companies split between VC investors and post-IPO investors?
Return and downside risk benefits from co-investments
The pace of capital calls vs distributions
Fundraising vs market capitalization for buyout and venture capital
Discussion of private equity fees and incentives
The latest academic private equity research (performance persistence, investor timing and post-IPO holding periods)
Return dispersion on buyout and venture transactions within commingled funds
Sources of private equity performance data
Appendix on methodology for IRR, Direct Alpha, cash flow timing and subscription lines

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Food Fight: 2021 Private Equity Update

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FEMALE VOICE 1: This podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST: Good morning, everybody, and welcome to the June Eye On the Market podcast.

In terms of public equity markets, the stall we've seen since April is consistent with the data that we're seeing. There's a really robust recovery underway in earnings, capital spending, and other activity.

But there's a disconnect between that kind of recovery, exhaustible supplies of labor, and ultra-accommodated Fed policy. That's what we wrote about last March, and the latest comments from the Fed on the gradual normalization of monetary policy are pretty consistent with a market pause.

The next hurdle for equities is going to be the rising domestic and international taxes. Um, the blueprints are still being worked out so there's more to come on that front.

And a quick comment on Covid, which you can continue to track on our virus portal. Infections and mortality, as everybody knows, are plummeting in the developed world. And Latin America is really the last unrelenting hotspot on the planet.

But in the U.S., you now have to divvy up the population into the vaccinated and the unvaccinated. And U.S. vaccination rates are now being eclipsed by Europe, Canada, and China. And the pockets of unvaccinated people in the U.S. are still heavily affected by the disease.

And we look at hospitalization and infection rates among the unvaccinated, and they are two to three times higher than reported levels for the entire population. So, um, still more to come on this whole question of the risks embedded in the unvaccinated population.

Okay. So onto the main topic for today. Every two or three years we take a close look at the private equity industry, not specifically our funds but the private equity industry, given its rising share of the portfolios for our institutional and high net worth clients.

And this year's update finds, unsurprisingly, that the private equity industry is still outperforming public markets, but this outperformance has narrowed a bunch, as all markets of all kinds are benefitting from non-stop stimulus and also as private equity acquisitions multiples rise.

So in the piece we get into this question of absolute and relative buyout and venture performance, what are the right benchmarks to use, what's going on with cone vesting, GP-led secondary funds, fund raising, manager fees, et cetera, et cetera.

On this--on this podcast I'm just going to point out a few of the main points. One of the interesting things in here is we have the main arguments of the debate about private equity performance. And, you know, Steve Kaplan at the University of Chicago and Ludovic Phallippou from Oxford take opposite sides of the argument.

We lay out their main arguments in terms of which benchmarks to use, time frames, and things like that. The gap between them isn't that huge but there are a few points of contention that are interesting to look at.

The best news from this whole debate is that when I started doing this a few years ago, we were relying on venture economics and other databases for private equity performance that were voluntarily reported by the general partners. That obviously has stale data, survivorship bias, and all sorts of other nonsense and garbage in there.

And for the last two rounds of this private equity review, including this one, we're now using a new dataset that is basically coming from the custodians to the limited partners. So that data comes through good weather or bad; in other words, you know, whatever's going on, those cash flows are getting registered with the custodians and make their way into this database.

And so we no longer have really any questions about breadth, data quality, stale data, stuff like that, so that's a good thing. So there are some concepts that you have to be familiar with when you're talking about private equity which is public markets.

Most of the people listening to this broadcast are familiar with them, but just to take you through them, multiple uninvested capital is a simple measure of cash in versus cash out. In other words, what distributions do I get versus what I put in. It's not time-weighted but it's a crude multiple of how much money you made.

Internal rate of return is a time-weighted measure of return. There are shortfalls with that in terms of that it assumes the interim distributions are reinvested at that same rate. Sometimes that's true, sometimes it isn't.

You know, we have all the information on multiples, on invested capital, and internal rates of return for buyout and venture.

The more interesting question gets into how do you compare it to public markets. And there are some techniques that have evolved over the last few years that essentially time-weight a comparison portfolio and whether it's the S&P 500 or the Russell 3000 so you can get a sense for how your private equity or venture fund is doing relative to what you would otherwise have achieved vesting in public markets and so we've got that in here too.

One of the important things that has complicated life a little bit is the enormous use of subscription lines. And subscription lines are used by managers essentially to defer their capital call.

So they're making investments, um, but they're financing them with short term bank lines, subscription lines. And so then they're going to call capital later in the investment period.

What that does is it compresses the distance between the distributions and the capital calls, and so you're IRR goes up but at the cost of the interest charge on the subscription line. You know, which is pretty small.

But what we've seen recently is that you--multiples on invested capital and internal rate of return used to move together. Now, even though MOIC has been declining, IRRs have gone up because managers have been boosting their performance on an IRR basis with the subscription lines. So you do need to understand that nuance if you're going to start looking at stuff like this.

So when we talk about declining outperformance of private equity, what are the two major drivers of that? Well, you know, monetary and fiscal policy have boosted the multiples on public equities so that's narrowed the outperformance.

And also buyout acquisition multiples have increased. There's been a food fight for private companies. The SPAC boom has propelled that even further, and so the combination of really high multiples on public equities and higher buyout purchase prices have--is what has narrowed that private equity outperformance.

And when we do this kind of analysis, we have to stop the clock at some point. In other words, we can't be looking at 2020 vintage years because not enough time has passed for distributions to come in and you'd be relying too much just based on the theoretical NAV.

So the last vintage year included in this analysis is 2017 with valuations and distributions all the way through the end of 2020.

So some of the other stuff that's in here that you might find interesting has to do with the dispersion of managers, like what happens if you pick a bad manager? How much could you lose?

And what's interesting is the bottom quartile buyout and venture managers relative to the market have not done nearly as poorly as I suspected that they might. So that's a good thing. We also get into this question of where do the buyout returns come from and we look at three specific funds.

There's a perception that financial engineering and multiple expansion drive the vast majority of private equity returns. In certain transactions that's true. But when we look at aggregate results for entire funds, the ones we looked at - changes in operating performance, vendor relationships, pricing, supplier delivery times, you know, the actual operating characteristics of the company - improvements in those characteristics were the majority of the fund performance in each of the funds that we looked at which I thought was also interesting.

We do look a little bit at these GP-led secondary funds. It's been an interesting phenomenon over the last few years. Private equity funds will emerge for the sole purpose of buying deals late in the cycle from other private equity funds as they're wrapping up.

And the idea is instead of those funds just kind of rushing out of those investments of whatever they can get at the end of the fund life, these funds will take those straggler investments, reinvest them if necessary, and give them a new lease on life and a chance to mature to some proper level before they're monetized.

The returns so far on these funds look good but, you know, be aware that they--these funds are using 30 to 50 percent leverage at the fund level on top of the leverage that already exists in the--in each one of the companies that they're buying.

So that's a lot of leverage to carry into a potential downturn one day and part of the reason why those funds have performed as well as they have.

We're continuing unsurprisingly to see venture outperform buyout, but with a large dispersion of managers, so to some extent you get what you pay for. And we take a look at the--at how gains on IPOs of venture-back companies are split between the investors and the post-IPO and pre-IPO investors.

Sometimes there's a sense that--that the pre-IPO investors are walking away with all the gains, and actually the opposite has been true most of the--in most of the--in the tech, interactive media and internet retailing IPOs over the last decade. The majority of value created has gone to the post-IPO investor rather than pre-IPO investor. So I thought that was interesting too.

We take a look at tow investment funds. As you might suspect, the not having any fees charged is a boost to performance and the security selection is generally similar to the rest of the big commingled funds. So if you subtract fees from the main equation, your performance goes up and your downside risk goes down. That's pretty straight forward. And, you know, the torrid pace of fund raising just continues.

You know, we've written many times in the past about the issues with under-funded defined benefit state, local, and county pension plans. A lot of demand for private equity ventures is coming from that community and there doesn't seem to be any let up.

So we look at some of the academic papers that have been written and some other industry data in here. Return on, uh--return dispersion on transactions within the funds. We get into some questions on the methodology for some of these things.

And so anyway, that is our private equity roundup for this year and thank you for dialing in. And in May we're going to take a closer look again at what's going on between the U.S. and China, and what the Fed has been up to.

The latest chart I saw shows that--that Fed purchases are now equal to treasury issuance. So everybody afraid of federal monetization of the treasury debt, it's actually happening at 100 percent right now. And then also at some of the things that are going on in the housing market.

So thanks again. We'll talk to you soon.

FEMALE VOICE 1: Michael Cembalest's 'Eye on the Market' offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management.

Michael Cembalest is the chairman of market and investment strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.

For more information, please subscribe to the Eye on the Market by contacting your JPMorgan representative. If you'd like to hear more, please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Incorporated.

Views may not be suitable for all investors and are not intended for personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research.

Please read other important information which can be found at www.jpmorgan.com/disclaimer-eotm.

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Food Fight: 2021 Private Equity Update

Introduction

Buyout performance

Buyout funds: what is the “right” buyout performance benchmark?

Buyout manager dispersion

Drivers of buyout performance

Venture capital performance

Venture capital: performance benchmarks and manager dispersion

Fundraising and the pace of investment

Listen to the Podcast

Food Fight: 2021 Private Equity Update

TAGS

More Eye on the Market

Mad Libs: just fill in the blanks

The Blob: Capital, China, Chips, Chicago and Chilliwack

Fair Shakes

Important Information

You're Now Leaving J.P. Morgan

What's Trending

What's Trending

What's Trending

What's Trending

How can we help?

Food Fight: 2021 Private Equity Update

Introduction

Buyout performance

Buyout funds: what is the “right” buyout performance benchmark?

Buyout manager dispersion

Drivers of buyout performance

Venture capital performance

Venture capital: performance benchmarks and manager dispersion

Fundraising and the pace of investment

Listen to the Podcast

Food Fight: 2021 Private Equity Update

TAGS

Share

More Eye on the Market

Mad Libs: just fill in the blanks

The Blob: Capital, China, Chips, Chicago and Chilliwack

Fair Shakes

Important Information