Five things we learned from KKR’s latest macro report

Henry McVey explores why public market indices are not a good measure for private equity volatility and why venture should be approached with caution.

In his latest macro insight, KKR’s head of global macro and asset allocation Henry McVey takes on the topics of negative interest rates, the validity of risk-adjusted returns in private markets and, of course, the economic outlook for 2020.

Here are five private equity-related insights we gleaned from Wisdom in Curiosity:

The search for a PE performance measure

Traditional risk-based metrics used in the public markets are not perfect tools for valuing performance in private markets and can understate volatility, because private markets returns have lots of nuances, Frances Lim, managing director, global macro and asset allocation, told Private Equity International.

Investors generally measure volatility by measuring standard deviation across index pooled returns only to find that the volatility measured is too low relative to reality. Intuition would tell investors that leverage and small-cap companies in private equity funds would account for higher volatility, but the data doesn’t reflect that since it uses fair value, not market value, for these calculations, Lim said. Quantitative analysts have a technique called de-smoothing, which scales up the volatility of funds. De-smoothed volatility can better measure true volatility by removing “auto-correlation” or the memory of old pricing from the funds, Lim said.

Now could be the time for distressed  

KKR might increase its distressed/special situations allocation when it updates its target allocations heading into 2020, driven by global factors such as near recessionary conditions in markets such as Germany and India and the structural slowdown in China. Market indicators point to a manufacturing recession, but there may not be a full-blown recession, at least in the US economy, which is “stuck somewhere between a 2001-like formal recession and a 2011-12 slowdown,” the paper said.

Private equity had the most attractive risk/reward in the market across all asset classes, and corporate carve-outs remain compelling. Globally, large corporate multinationals are divesting non-core subsidiaries, and while these transactions are more complex, carve-outs can unlock lots of value. The same trend is also building up across energy, real assets and infrastructure, particularly in the optical fibre sector.

Private markets asset classes are not equal

Higher risk doesn’t always translate to higher returns. Lim examined public and private benchmark data over 20 years and found that private equity – with higher risk – generated 12.1 percent historical annualised returns over 20 years, compared with returns of 11.5 percent for public equities. However, venture capital, despite higher risk, returned only 3.1 percent in the same period.

Performance is sticky

All returns are not created equal, according to Lim. KKR’s data showed that if the predecessor fund was in the first quartile, there was a 75 percent probability the successor fund would be in the first or second quartile. In venture capital funds, this persistence, as the paper called it, dropped to 50 percent. Negative persistence was just as strong: the probability a successor fund of a fourth quartile fund would remain fourth or third quartile was also 75 percent.

Venture, not worth venturing into except with strong managers

Venture capital generates high returns only if you commit to the strongest venture capital managers, otherwise the Sharpe ratio – used to calculate the risk-adjusted return – can disappoint investors, the paper said.

KKR’s data show venture capital outperformed in the early 1990s when small capitalisation stocks outperformed large capitalisation stocks. Even then, the outperformance was dominated by just a handful of funds.

The venture capital industry is larger and more diverse now, but “many players have not consistently translated thoughtful ideas into substantial returns for their LPs”, the report said. More investors are experiencing smaller illiquidity premiums and lower returns, especially in the smaller end of the private market.

KKR is also cautious on early-stage growth investing and its potential to create liquidity. Public markets want more cashflow conversion than the private market community is anticipating and this “mismatch of expectations” will lead to more funding issues in the unicorn universe than the consensus currently thinks, the paper said.