Wednesday, October 12, 2016

Should private equity be part of an investment portfolio?

Lately the industry has been abuzz about the increased allocation to private equity by ultra-high net worth (UHNW) families. This is unsurprising, given that they have the ability to be patient investors. Additionally, domestic market equity returns continue to be uninspiring, while hedge funds suffer through a prolonged period of underperformance, versus low-cost ETFs and other alternatives. Given this context of low interest rates, fully valued equity markets and disappointing hedge fund returns, there is little wonder as to the increased appetite for private equity.

Historically, private equity has out-performed comparable public markets; Cambridge Associates’ pooled net IRR data (as of December 31, 2015) for the trailing one-, three-, five- and ten-year periods for U.S. large and mega-buyout funds showed returns of 10.5, 16.8, 15.1 and 11.4 percent, respectively. Large and mega buyout funds are those larger than $1 billion and $5 billion, respectively. By contrast, the S&P 500 (including dividend reinvestment) produced 1.4, 15.1, 12.5 and 7.3 percent annualized returns over the same time frame. Data intelligence firm Preqin also noted that private equity now manages $2.4 trillion in assets, with 689 funds closed in 2015, raising $288 billion.

Increasingly, UHNW families have been seeking direct investments in privately held companies. And while some have the operational history and in-house expertise to source direct private-equity investments, this is not the case for most multifamily offices (MFOs) and registered investment advisors (RIAs).

Building a full portfolio of direct investments, however, requires substantial due diligence and operational expertise, especially now. Pitchbook’s Q1 2016 U.S. Middle Market Report showed that in 2015 there were 2,023 private-equity middle-market deals, with an aggregate value of $374 billion. In a May 2016 BloombergGadfly column, “Private Equity is Seeing Diminishing Returns,” Nir Kaissar postulated that, given the increasing size of private equity, industry returns could be expected to decline. Data sources CohnReznick, Preqin and Pitchbook have all noted that deals have gotten more competitive and valuations have increased. The potential for high returns on capital brings more investors and dollars, which tends to compress returns. Despite this backdrop, the longer-term outlook for middle-market private equity seems positive.

Even if returns are subject to compression, U.S. middle-market buyout (inclusive of small-market buyout) returned 9.9, 14.0, 13.5 and 12.7 percent over the previously mentioned period, providing excess returns over public markets.

"Disciplined and patient investors may be rewarded over time by allocating to a diversified portfolio of private equity investments and funds."

Additionally, as reported in CohnReznick’s Momentum 2016 Middle Market Private Equity Outlook, “Far beyond financial engineering and balance sheet optimization, it is increasingly imperative for middle market PE firms to explore and implement digital strategies that can dramatically improve business.” 

Given the available alternatives, patient investors may be rewarded over time if they allocate to a diversified portfolio of private equity investments and funds.


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