Private Markets Stay the course in private equity

Private market investments play a vital role in portfolio diversification and can provide attractive absolute risk-adjusted returns over the long term. These advantages come with less transparency, lower liquidity, and slower reporting compared to public markets.

Private equity (PE) managers have been slow to mark down their portfolios, with US PE dropping around 0.35% in 1Q22 and 5% in 2Q22, according to Cambridge Associates benchmarks (the latest available data). In public markets, the S&P fell 4.6% and 16.1% in the same periods, respectively. We believe there will be additional markdowns through year-end due to further public market deterioration, but we continue to believe that investors should maintain the course of vintage diversification, continue to invest with good managers, and look for opportunities in market dislocations.

It is unlikely that private investments will be marked down to the same extent as public markets. Looking at the past three recessions, US PE markdowns on average only reflected 55% of the S&P 500 drawdown, as measured by Cambridge Associates US Buyout. For example, during the global financial crisis, the S&P 500 started to fall in 4Q07 while US PE fell a quarter later in 1Q08. The peak-to-trough drawdown in US PE was 28.2%compared to 45.9% for the S&P 500. Privates gained back the losses and returned to pre-crisis levels within six quarters, compared to a longer recovery for the S&P.

Private investment managers who have control have greater flexibility to position their companies to weather a recession. They may be able to cut costs, delay capex spending, and use other levers such as securing additional financing or injecting additional equity during difficult times to preserve EBITDA. Looking at historical data from Preqin for the last 10 years, the median US PE entry enterprise value (EV) to EBITDA ratio is lower than the average Russell 2000 EV to next-12-months EBITDA by up to 46%, providing a cushion against drawdowns.

Investing in vintages after public market peaks has historically generated outsized returns. Based on our analysis of Cambridge Associates data stretching back to 1995, investing in private equity vintages in the year of a public market peak has yielded an internal rate of return (IRR) of 14.8% and in those one year after a peak an IRR of 18.6%. This compares with IRRs of 11.4% and 8%, respectively, for vintages one and two years prior to the public market peak.

Looking ahead, existing investors in private equity should expect soft performance in internal rate of return through year-end 2022. In volatile times, it is important to remember that investing in private markets is a long-term strategy.

For investors looking to augment their core private equity exposure, we continue to see attractive returns for value-oriented buyout strategies with a focus on healthcare and technology from a thematic perspective. The trend toward a green economy is also providing new investment strategies in a growing sector. And finally, secondary markets could also offer a timely opportunity for both new investors and existing investors looking to enter the market at a discount. For our quarterly private markets update, click here.

Main contributors - Mark Haefele, Vincent Heaney, Jennifer Liu, Daniel J. Scansaroli

Content is a product of the Chief Investment Office (CIO).

Original report - Stay the course in private equity, 29 November 2022.