The LP of the future will still be expecting outperformance from its private equity portfolio to justify the associated fees and expenses. But rather than sticking an absolute number on those expectations, it is likely to judge performance in relation to other investment options.
“It’s shifting away from an absolute to a relative standard,” says TorreyCove’s David Fann. “The expectation that you’re going to achieve 20 percent rates of returns is shifting to a perspective of generating to 200-400 basis points over a public equity index or some other benchmark.”
The asset class’s eroding performance is already evident. In the American Investment Council’s 2016 Pension Fund Analysis, private equity investments by US public pensions outperformed all other asset classes, yielding a median 10-year annualised return of 11.4 percent. This compares favourably with public equity’s 7.6 percent, real estate’s 6.3 percent and fixed income’s 5.2 percent.
This year, the numbers are less impressive. In the 2018 report, private equity yielded a median 10-year annualised return of 8.6 percent, against 6.1 percent for public equity, 4.7 percent for real estate and 5.3 percent for fixed income.
The best performing pension fund – Massachusetts Pension Reserves Investment Trust – earned a 10-year annualised return of 13.37 percent; the top-performing fund in 2016, the Teacher Retirement System of Texas, posted 15.40 percent that year.
“It’s a secular trend. There’s just more competition for private assets,” says Fann.
“Returns are much higher in an environment where there are 200 firms operating internationally, returns were typically 30-40 percent 20 years ago. Today, getting high-teens rates of returns would be impressive. You’re operating in an environment where there might be thousands of firms that are trying to transact. Almost everything is being sold in an auction today.”
Private equity is still performing well relative to other asset classes. Almost 70 percent of LPs and GPs surveyed by Palico for its latest Key Trends report expect private equity to outperform other forms of investment despite historically high prices, and 62 percent believe investors lose less money in private equity than in the stock market. Increasingly challenging investment conditions will put the onus on future LPs to select funds, co-investments and direct investments carefully to target top performers. “With the amount of capital coming in, on average if you look at funds’ base cases, it has come down,” says Hayfin’s Mirja Lehmler-Brown. “However, there remain pockets of the market capable of delivering strong returns in line with historic expectations.”
Of course, private equity doesn’t exist in a vacuum; how both the public markets and the financing markets behave have a significant effect, which could turn negative when the next downturn hits. “If there is a correction in the overall capital markets, that could pose challenges for those that have bought assets in the last five years,” Fann says. “There could be downwards pressure on rates of returns in all markets, including private equity.”