The outperformance of private equity should be nuanced, says investment expert Jan Longeval. “But it offers an important advantage that is rarely highlighted.”
The European Commission is heavily promoting private assets through new regulations. Since the beginning of this year, we have Eltif 2.0. With these European Long-Term Investment Funds, the Commission aims to stimulate investment in private assets. The driving force behind this is to encourage financing for the energy transition. The European Commission states that around 2 trillion euro in infrastructure investment is required, and most infrastructure projects are not publicly listed.
Copernican shift
“For asset managers today, alongside sustainable funds, private assets top the commercial agenda,” says Longeval. “A Copernican shift is underway. Traditional active management is under threat from the rise of passive management, placing pressure on growth and profitability in that market segment. However, margins in private assets remain very attractive. Private asset funds account for around 20 percent of assets under management but generate about half of the income. There is nothing inherently wrong with this. One cannot fault the sector for seeking more profitable assets.”
The sector now seeks to make private assets accessible to the general public. They can use Eltifs for distribution across Europe and are developing local funds that pool the contributions of smaller investors. Longeval notes, “The entry thresholds for the best private asset funds are often very high, so this pooling is a smart move. By bringing private assets to smaller investors, the sector enters a new dimension. Private assets have, until now, been reserved for institutional investors and ultra-high-net-worth individuals, as they are a somewhat more sophisticated product. It’s therefore useful to recall certain key points.”
Reported returns
Longeval advises caution regarding the reported returns of private assets. “The commercial narrative typically suggests that returns on private assets are exceptionally high, higher than those found in publicly listed assets. I’m not saying this is entirely wrong, but it should be nuanced. With private assets, the focus is usually on the Internal Rate of Return, or IRR, also known as the money-weighted return. This measures the yield of each euro invested in private assets, taking into account the timing of cash flows. When investing in a private asset fund, you must commit capital, but it’s usually called upon gradually and often not in full.”
For example, you might invest in a private asset fund and get your money back after eight years, Longeval explains. “But it may take two or three years for the capital to be called. Suppose 30 percent of your capital is called initially, the remaining 70 percent usually sits on your end in low-risk investments, such as cash or short-term bonds. This is money not yet entrusted to the private asset manager, incurring an opportunity cost. That cash now yields around 3 percent, and if you include that in the return calculation for the entire period, the IRRs of funds that call capital slowly tend to decrease. So, when presented with returns on private assets, verify that the returns are not skewed.”
Buyouts
“A second important nuance concerns buyouts, the largest segment within private equity. Historically, the returns of buyout funds have outperformed their publicly listed counterparts, the small caps. A significant portion of this outperformance is due to the higher leverage at the level of the companies in which they invest. Comparing the leverage of companies in buyout funds with that of companies in the publicly listed small- and mid-cap universe reveals a notable difference. Currently, this ‘excess leverage’ of U.S. buyout funds is about 25 percent higher than that of publicly listed companies.”
“Remarkably, this gap has narrowed over the past decade. Companies in buyout funds rely less on leverage than before, while publicly listed small- and mid-cap companies are now using it more. So, the leverage difference between companies in both worlds is converging.”
“You could also adjust for beta. In private assets, there’s sometimes a perception that returns are almost magical, as if they’re derived solely from the superior qualities of private assets and their managers. However, a significant portion of private asset returns reflects market risk. I’m not suggesting that these nuances negate all outperformance, but it’s less spectacular than is often portrayed.”
Volatility
“The fundamental difference between private equity and publicly listed small- and mid-caps is, of course, volatility. A buyout fund’s performance is typically calculated only once a quarter, so the visible volatility of these buyout funds appears much lower than that of their publicly listed counterparts. But this is merely an optical illusion; if you revalued your private asset portfolio continuously, like a publicly listed portfolio, the picture would not be so different.”
Nobel laureate Daniel Kahneman showed that the average investor is extremely risk-averse: the psychological impact of losing one euro is approximately 2.5 times that of gaining one. Longeval notes, “Many investors, especially retail investors, are highly fearful of the volatility of publicly listed shares and, as a result, hold too few equities in their portfolios. Private assets, with their perceived lower volatility, can bridge this psychological gap and help investors take on sufficient equity risk. In this way, private equity assists investors in achieving an optimal portfolio composition. In my opinion, this important advantage is too rarely highlighted.”
“Additionally, investors—especially retail investors in pooled vehicles—should be mindful of costs. The private asset funds in which pooled vehicles invest already carry relatively high costs, typically a fixed fee plus a performance fee.”
Investment Officer speaks monthly with investment expert Jan Longeval about his views on economic and financial developments.