When you look at the classic risk-return charts presented by general consultants, private equity is the proud resident of that top right quadrant – often so far out there it appears lonely.
Why does this matter or why should we care? Well, it is this perception of private equity that determines its positioning inside investors’ portfolios. Today, for the average U.S. institutional investor, private equity represents approximately 6% of total assets. Europeans are lagging slightly at 4.5%. Both parties, it is worth noting, are growing — increasing their allocations.
Driving this growth is a search for returns, not a conclusion that the asset class’s risk profile is changing. But perhaps that perception of risk should be changing, or at least should be reexamined.
If we look back 15-20 years to when most major U.S. plans began to enter the asset class in earnest, there were three key attributes that “defined” the asset class.
- Illiquidity – There was no secondary market to speak of ten or fifteen years ago. Liquidity was simply not an option.
- Venture Capital – For many, venture capital was private equity and firms like Forstmann Little and KKR were exceptions to the rule. Investors were much more familiar with the venture capital firms that had already been operating for 10+ years. Even the few buyout funds that were operating were extremely small and were buying small, largely growth oriented businesses.
- Financing – For those doing buyout deals, capital structures were designed with as little equity as possible and as much debt as possible – 10% equity was not uncommon.
Today, I would contend that the asset class is in a very different place, and yet neither LPs nor general consultants seem to be reexamining our place on the risk-return curve.
So, while we are still far from being a truly liquid asset class, a growing and increasingly sophisticated secondary market has greatly aided both LPs and GPs, providing increasing levels of liquidity.
The much more interesting components, however, have to do with the types of businesses that are being acquired by private equity firms and how they are being financed.
Today, venture capital represents a small portion of the total asset class, and many would argue that its place is shrinking and will continue to do so. Private equity today is a buyout world, and increasingly, it is a “bigger” buyout world.
Further, the businesses that are being acquired today by leading buyout firms are large, stable, well-managed, leading franchises. They are not being acquired with 10% equity and 90% debt. They are, in fact, being acquired, on average, with equity levels in excess of 30%. More importantly, take a look at the terms on the debt structures of today. Anyone see any onerous covenants? In fact, anyone see any covenants at all?
I’m not suggesting that private equity is a risk free asset class (far from it), but if one component of risk is the frequency of capital loss, then consider this: Name for me the last buyout fund that failed to return principal. In Hamilton Lane’s database of over 750 fund managers, there are fewer than five buyout funds poised to return less than full cost.
What I am suggesting is that the private equity asset class is maturing – at a rapid pace – and yet, the allocation models and perception of risk for both consultants and limited partners remains stagnant. We are no longer an asset class defined by venture. Nor are we an asset class driven by the purchase of small, growth-oriented businesses. And lastly, we are not an asset class driven by financial engineering.
Our market is changing and it is time for us to change with it.