Portfolio Construction Series - Part Three
To PE or not to PE? Is that the question.
by Colin Campbell - Managing Director
What is PE?
Private Equity (PE) funds are created in the unlisted space to pool capital from investors to acquire, add value to (by improving operations, changing management etc), manage, and ultimately sell businesses to create sustainable investor value. The lifecycle of a PE fund typically spans 10 years, including initial fundraising, subsequent investment, active management, exits, and ultimately wind-down. They are usually offered as closed end funds and hence illiquid.
Why PE?
If the question, posed to an adviser, as to whether a client should add some (PE) in their portfolio, the answer is usually “Yes”. PE now represents over 10% pf total market equity capitalisation and nearly double that in 2010.[i] As a result, the PE asset class has been a major beneficiary of flows as directed by Wealth Advisers and now forms a core component of advisor asset allocation frameworks.
Why the growth?
Private Firms make up the bulk of the corporate universe (globally 95% of investable companies are private, of which 65% are mid-market), so the potential for PE to access good investments is high.
The listed equity market is shrinking in the number of listed stocks most especially in the small caps space. Why? Greater regulation of listed companies, costs, increased scrutiny and PE firms taking over listed companies are the main drivers. Also, the rise in PE as a major source of equity capital has given private firms a justification to stay unlisted. Rather than undertaking an IPO, firms increasingly have a strong option in staying private.[ii]
As the listed equity market is shrinking, it is also increasing in its concentration (i.e. Mag 7 in the US and CBA in Aust). PE provides investors a form of diversification inside the equity asset class.
Belief that PE managers are superior to traditional business owners in terms of extracting shareholder value thereby rewarding investors. This has been generally true historically.
Whilst usually the domain of Sovereign Wealth Funds, Pension funds and intergenerational family offices, wealth management clients have been attracted by the extra potential return in PE and more recently, user-friendly investment structures.
Clients are also more comfortable with the trade off in lower liquidity to access the promise of higher returns than listed equivalents. What is known as “accessing the illiquidity premium”.
PE funds have smoother and more stable returns vs. their listed counterparts.
Why the criticism?
PE is not without its detractors and detractions! These have become more prevalent of late. Some argument include;
Returns are not as strong as reported or promised. We will do some more analysis of this below, but a common complaint is that some PE managers are a little (ok - a lot) loose in stated returns and methodology of calculations.
There is also a wide variation of returns generated by managers and the different vintages (further below).
Fees. PE funds are expensive with average fee structures of 2% management fee with a 20% participation in returns above a set hurdle rate (i.e. 8%).
The traditional PE fund usually has a term of 7 years from commitment to end, with a mandated extension of 2 more years (and potentially another 1 or 2). So, it is a long-term commitment, albeit the bulk of funds are usually returned earlier. See the discussion on the PE J curve below.
PE Funds have a call structure. This requires a commitment up front often with fees payable on the full commitment from day 1 whilst the investor must manage the liquidity on drawdown “calls”. Potentially this creates a cash drag as uncalled funds are usually held in lower yielding liquid assets. Again, part of the J curve dynamic.
A major component of the PE return formula is using leverage and current higher interest rates have dampened the effectiveness of gearing up a company’s balance sheet. Interest expense eats into margins and valuations.
Leverage is overused and if listed comparables have the same gearing, their returns would be a lot closer.
Leveraged debt is now often being provided by the same investment house as for equity. These PE firms may intentionally sacrifice some equity return for an optimal position across both debt and equity. For the PE investor this may be a major conflict and sub-optimal.
Exits for PE deals are narrowing with a lower level of IPOs forcing PE funds to accept lower returns and seeking trade sales, play “pass the parcel” in selling the assets to other PE funds or create Continuation vehicles to take on residual assets, thereby extending the holding life of the asset inside the PE’s domain/control.
Lower portfolio volatility in valuations, whilst providing a smoother return picture, does not defray the underlying economic position versus a comparable listed entity. This smoother return is disproportionately rewarded by investors. Importantly, volatility in price, is not necessarily greater risk.
Returns -it’s simple, isn’t it? - Part 1
In our analysis on returns there are 2 components that should be considered
1. Large variations in returns reported by managers.
Referencing research from Blackstone and Morningstar, top quartile private equity managers in the US delivered returns of 29.6 per cent over the past five years. Meanwhile, bottom quartile private equity managers saw returns of 14.6 per cent – demonstrating a performance dispersion of 15 percentage points. In comparison, the gap between top quartile and bottom quartile managers in public asset classes was less than 2 per cent.[iii]
So, manager selection is critical.
Source: MLC
The “J curve” in PE
As described by Russell Investments, in private markets, the J-curve is the term commonly used to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life, particularly with primary (newly formed) fund investments. This occurs because capital commitments take several years to be called, yet fees are charged (on committed capital) prior to the realization of returns, i.e. such as distributions or the sale of portfolio company investments. And while the J-curve reverses over time as investments are made, the fund’s net asset value grows and investments are realised, investors are nonetheless exposed to negative returns in those early years
Source Russell Investments[iv]
Minimising the J-curve impact - Secondaries
The secondary market involves the buying and selling of pre-existing PE investor commitments to private markets funds. Secondary funds, in turn, can buy either from the investment managers (known in the industry as general partners or GPs) or those investing into their funds (limited partners or LPs). As secondary interests are comprised of existing portfolio company investments, they are more mature in their lifecycle when compared to primary fund investments. So, you avoid the first part of the J Curve.
Their solution was to turn to co-investments by inviting especially trusted clients/Limited Partners (LPs) to invest with them directly into individual companies, rather than indirectly into companies via traditional PE funds.2
The chance to invest directly in hand-picked deals and companies, differs from traditional private equity (PE) funds where investors commit capital without knowing which companies will be acquired.
For LPs, co-investments represent a more targeted allocation of their capital enabling them to have direct access to privately held companies on which they can gain deeper insights than when investing through funds.
Additionally, co-investments enable LPs to gain a better understanding of a GP’s sourcing capability and operational skill, thereby providing valuable intelligence for the future relationship between the parties.
Diversification is a feature of strong co-investment programs with investee companies spanning multiple GPs, countries, industries and vintages.
Other potential benefits of secondaries include reducing blind pool risk and the potential to purchase assets at discounts to net asset value. Under GAAP rules, Secondary funds can buy assets at market and by bringing back to book value, generate an instant revaluation.
When investors commit to primary funds, they don’t know in advance what investments the GP will make. In contrast, secondary funds invest in existing commitments and can conduct due diligence on these assets prior to investing. With this greater transparency into the underlying assets comes greater visibility into potential future performance, including near-term exits, pending asset write-ups and positive inflection points. These all contribute to improving near-term performance outcomes for investors.
As for returns, the secondaries market are funds are often open-ended funds, so investors can subscribe and redeem on agreed terms and there is no cash drag up front on funds waiting to be deployed. Conversely, managing the tail of investment under the traditional PE fund is obviated i.e. the back end of the J curve, also enhancing cash deployment and return optimisation.
PE and vintages
In PE vintage refers to the year that the fund was raised and capital was committed. While effective manager selection is important, investors considering private equity may also seek to take into consideration the nuances of fund timing in relation to the market environment. The historical relationship between public market valuations and private equity fund vintages proves that entry point for deployment did have a meaningful impact on vintage performance. Not surprisingly, deploying capital in cheaper valuation environments tended to lead to higher performing vintages than in more expensive investment environments.
People talk about ‘vintages’ as a reference point for comparing funds of certain eras. This enables them to compare the returns of funds from, say, 2010 over a 10-year profile to those from 2014. Also, vintages are particularly useful when talking about macroeconomic and structural shifts that may have happened in the fund’s lifecycle.
Will 2025 be a cheap or an expensive vintage?
As this is not necessarily evident up front, vintage diversification is recommended. Also, the attraction of secondaries is that this can be achieved via a single fund vs managing several discrete tranches.
Returns -it’s simple, isn’t it? - Part 2
Nothing like an acronym to confuse investors, however, it is important to acknowledge that numbers generated by funds using them need to be analysed. One term widely used in PE is MOIC.
So, a $100,000 investment which returns $250,000 has a MOIC of 2.5X. This is also known as the “cash on cash” return. While this is an important number, the time period involved is critical – was the return over 3 years or 5 years?
To answer this question and address the passage of time we also use the Internal rate of return (IRR) measure.
IRR (Internal Rate of Return): the annualised discount rate that makes the net present value of cash flows equal to zero. Highly sensitive to cashflow timing and size. Somewhat vulnerable to manipulation (e.g. GP may measure from the time that capital is called, even if credit facilities were used to deploy before that date. They may also exclude manager fees). Research has shown that these funds generally overstate stated returns during fundraising periods and drop back down afterwards. These funds generally do not survive.[vi]
Private equity investors must, therefore, pay close attention to both the MOIC and IRR, as the two are complementary rather than mutually exclusive.
Portfolio Allocations – Some thoughts
Listed equity markets and PE fish in the same pond i.e. equity exposure to business – so basically the same asset class with the same macroeconomic forces, therefore
PE sub class should be seen as a subset of Growth (Equity) allocation. How much will be determined by the client’s need for liquidity and timeframe.
Although both fish in the same pond, a decline in market “interconnectedness” can drive valuation divergence, both expansion and contraction (i.e. small no. of listed small caps, no available IPO exits etc).
Being illiquid, we believe that PE returns should be around 2 to 3% over the equity market on a continuously invested view for Secondaries. Higher rates can be achieved, but this will usually be in traditional structures and through the selection of superior managers and accessing the illiquidity premium.
As the dispersion of returns achieved by managers is much wider than in listed markets, manager selection is critical.
Where liquidity is somewhat important, we use Secondaries Funds which have more liquidity features.
Finally
There are more private equity (PE) firms in the U.S. than McDonald's restaurants. While the exact number of PE firms fluctuates, estimates range from 14,000 to 18,000. The number of McDonald's restaurants in the U.S. is significantly lower, with estimates around 13,500[vii].
Pick Wisely – or better still, contact your adviser!
[i] Bfinance March 2025 “Private Markets and the Asset Allocation Imperative”.
[ii] Institutional Investor “Sparse IPOs have paved the way for years of growth in Private Markets’ Oct 7, 2024
[iii] Money Management “Manager Selection a “critical risk” in private markets. 23 April 2025
[iv] Russell Investments The J-curve in Private Equity – and potentially how to beat it June 17, 2024
[v] https://www.wallstreetprep.com/knowledge/moic-multiple-on-invested-capital/
[vi] Do Private Equity Funds Manipulate Reported Returns? Gregory W. Brown, Oleg R. Gredil, Steven N. Kaplan
[vii] Alisa Wood, Partner KKR presentation Melbourne 26 Feb 2025
Disclaimer: This information is provided by Carnbrea & Co Limited ABN 33 004 739 655, Australian Financial Services Licence No. 233763. Any advice included in this document is general in nature and does not take into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it is appropriate to you. If a product we recommend has a Product Disclosure Statement (PDS) or a Prospectus, you should read it before making a decision. Past performance is not a reliable indicator of future performance. Derivatives are leveraged products which means gains and losses are magnified and you may lose substantially more than your initial investment. We do not endorse any information from research providers that we provide to you, unless we specifically say so.