The rise and rise of private equity

The Economist has a summary of the bumper year for PE firms,

In the first 11 months of 2021, private-equity firms sealed over 13,000 deals globally, worth a combined $1.8trn—more than in any previous full year. Private buyers have bought or are eyeing up Sydney airport, Italy’s phone company, the French football league and Saudi Arabia’s pipelines. Private-capital firms—which include pe shops as well as funds that target credit, infrastructure and property—have raised $1.1trn from end-investors this year, not far off the highest-ever annual tally (see chart 1). The boom is pushing up pay to even more extraordinary levels. On December 10th KKR, a buy-out firm, announced long-term share awards that could net its two new co-chief executives more than $1bn each.

The assets under management of PE firms has grown spectacularly

Private assets were once so obscure they were called “alternatives”. The label seems absurd today. Private-capital firms manage a record $10trn of assets, the equivalent of 10% of total assets globally. This includes several types of activity. PE—which consists of taking over companies using debt, juicing up profits and reselling them at a premium—promises racy returns. Infrastructure and, to some extent, property help diversify portfolios. Private credit lends to smallish firms with a relatively high default risk, earning attractive yields.

In an environment of low yields, PE has emerged as a mainstream asset category,

In order to meet their future liabilities, institutional investors such as pension funds must achieve annual returns of 6-7%. With interest rates at rock-bottom levels they piled into private assets where, it is argued, returns are more attractive. Using data from Preqin, The Economist calculates that the world’s biggest 25 investors by assets under management—including pension funds, insurers and sovereign funds that together manage $22trn—now hold 9% of their assets in private markets, twice the share in 2011 (see chart 3). Australia’s Future Fund, a sovereign-wealth pot of $142bn, allocates 35% of its portfolio to them; cdpq, a pension fund in Quebec, nearly 55%.

This has been aided by a process of capital recycling through IPOs,

With capital markets open for initial public offerings, a virtuous circle of activity is taking place: private-capital firms can sell more of their existing assets (to another buyer or by listing them) and return the proceeds to their ultimate investors, who in turn are keen to participate in fresh fund raising for private markets. For Blackstone, for example, the biggest firm of all, asset sales, cash returned and funds raised so far this year have all been roughly double the level of 2020. Greater deal “velocity” means asset managers are deploying capital faster and raising funds more often. 

The mainstreaming of PE has been accompanied by some large investors in PE funds (the Limited Partners) setting up their own PE divisions to manage their money, and some PE funds themselves getting into the businesses they are investing in.

Lured by high returns, some investors are keen to be more directly involved in running private assets, rather than being passive customers of the big private-capital managers. apg, a Dutch pension manager that oversees $703bn, aims to own at least 10-15% of every fund it backs, so as to negotiate veto rights over strategic matters, says Patrick Kanters, its private-markets boss. Many big limited partners also “co-invest” alongside funds directly in portfolio companies, which allows them more discretion over the size of their exposure, and lowers overall fees. Some bypass managers entirely. Co- and direct investments are set to reach $265bn this year, the highest-ever amount by far. Large investors in “real” assets, which include property and infrastructure, have become full-fledged developers, enabling them to create their own pipeline of deals—whether for student housing or hospitals—and pocket a fat margin.

The increase in funds and competition is engendering several distortions and perverse incentives,

Valuations are creeping up. In a survey of 71 global institutions carried out by Probitas this autumn, 65% ranked unhealthy competition for deals as the biggest risk, up from 55% last year. Frenetic activity means less due diligence. Limited partners (as the ultimate investors in funds are known) have little time to forge relationships with new managers and diversify their bets. Some are recruiting more staff, triggering what Maxime Aucoin of CDPQ calls a “war for talent”. Meanwhile managers are feeling rushed, too. “Decisions are being made on bigger dollars in fewer days,” notes Steve Moseley of APFCc. The amount of “dry power”, the total committed to funds but not yet spent, stands at a record $3.3trn. The pressure to deploy capital means fund managers have less incentive to evaluate potential targets strictly, or to turn down deals.

Interestingly, the article makes only a passing mention of the returns on PE, and that too a selective one. This is representative of the mainstream narrative on PE.  

I have blogged here, here, here, and here about the returns of private equity investing. This paper by Ludovic Phalippou is a must read. 

Update 1 (14.01.2022)

Arthur Korteweg has a paper in the Annual Review of Financial Economics which finds that VC returns this century have been lower than those made on similarly risky assets in public markets.

The weight of evidence suggests that, relative to a similarly risky investment in the stock market, the average venture capital (VC) fund earned positive risk-adjusted returns before the turn of the millennium, but net-of-fee returns have been zero or even negative since. Average leveraged buyout (BO) investments have generally earned positive risk-adjusted returns both before and after fees, compared with a levered stock portfolio. Based on an expanded set of risk factors from the literature, VC resembles a small-growth investment, while BO loads mostly on value.