Private Equity

Welcome to our first edition of a new audio series PEP Talks with Russ. My name is Amy Park and I'm a Product strategist for BlackRock Private Equity Partners, also known as PEP. We're excited to kick off a series of short candid conversations with our founder and Global Head of Private Equity Partners, Russ Steenberg. Russ' experience dates back to the early 1980s, where he was co head of at&t pension fund's private equity portfolio. In the mid 1990s Russ founded his own middle market buyout shop before joining Merrill Lynch Investment Managers, where he built the private equity solutions business that we have today at BlackRock and oversees $34 billion in LP commitments.

Each episode will be focused on a single topic or question. We look forward to leveraging Russ' experience and sharing his perspectives on a variety of PE related topics. For today's episode, alongside Russ, we have my colleague, Dr. Jeroen Cornell, private equity product strategist, focused on quantitative solutions and author of our most recent white paper titled “The evolution of private equity.” He'll be chatting with Russ to reflect on the progression of PE portfolio construction over the past four decades, its impact on performance, and how many investments are too many. Let's listen in.

Hi Russ. Thank you for your time with us today. In our recent white paper on the evolution of private equity, we demonstrate in detail how the industry as a whole has clearly outperformed public equities across several economic cycles in the last four decades. Yet, it is harder for us to track the evolution of portfolio construction, especially how institutional investors have changed their mix of strategies and transaction types over time. Could you please share your thoughts, and experience on that.

Well, first of all thank you, Amy, for the very kind introduction and, Jeroen, it's nice to see you to talk about private equity. From a research point of view as well as a practice point of view, related to your question, you know, we know from public market research and academic research on portfolio construction and the impact on its total return in a portfolio that it's probably 90 to 92% with the remainder being the residual effect of the individual assets or selections that are in the portfolio. We know, and some of the academic research is starting to show, that in the private equity world, it probably is not that high, but it is significant. So, as we always do in the industry, we talk about returns of individual assets and the importance of selection to the overall portfolio. It is absolutely crucial to alpha, no doubt.

However, portfolio construction also adds a significant amount of alpha. And depending upon the risk return that an individual organization through their private equity portfolio is looking for in the marketplace. Now this certainly has evolved over time. When we started private equity at the at&t pension fund in 1983-84, you selected individual groups and the general sense was based upon the experience with public market investing, that you probably didn't want to have a whole lot of groups you wanted to have fewer groups. And back then your choices were far less abundant than they are today. So when you talk about the classic things for private equity portfolio construction of stage, by size- mega large upper mid and small growth venture capital, all the stages within venture capital. It was simple back then it was venture capital in non venture capital. And when you talk about geography, back then it was also pretty simple. It was fundamentally in the United States, with a little bit starting in Europe, towards the late 80s. That has all changed because now you have private equity, all around the world so geography is important.

The stages have gotten far more sophisticated and a lot more specific, in the definitions. You now have sector focuses that are coming into all of this. All of this in the sector, too, having different risk reward profiles attached to it. So how you combine these things today in the private equity world has a much greater impact on the performance, given the evolution of the private equity world, than it certainly good in the mid 80s or late 80s, or in the early 90s, when private pension funds like at&t, General Motors, GE in IBM were essentially in the United States the pension funds that were more actively involved as limited partners investing in private equity. That, too, has significantly changed is the LP base has grown across the world. And indeed, private equity is not an alternative investment anymore it's a mainline investment. It is included in almost every asset class that exists within institutional portfolios, and certainly now, even within individuals portfolios.

Absolutely I couldn't agree more, Russ.

Now, another part of the asset allocation, that has changed back in the mid 80s you picked partnerships. Starting at at&t in the late 80s, we actually started to add co investments, which really no one else was doing at the time, which was investing side by side with the general partners we had in our portfolios. That has all changed too. Now it's not only primaries, with all the different diversification criteria to the primaries that we were talking about, but it's also co investing across all of those diversification criteria. And now with the advent of the development of the secondary market, which started really in the late 80s and early 90s and pretty much a one-off way to now being very sophisticated relative to pools of private equity partnerships, as well as what's known as GP-led secondaries, which is something that's developing very very fast so again, this impacts private equity and impacts the way you think about your construction of your portfolios. All in all, typical of private equity, it's changing and evolving every day. And that's what makes it so exciting.

Now one more point correlation coefficients, and everyone has struggled with this one in a big, big way and I'm not sure the academics really have added a whole lot to the discussion except they're now starting to do some research on this. And again, it depends, I think, about the size of your portfolio investments relative to individual assets. You know, the bigger they are, the safer they are, most likely the lower return, you're going to get off the asset, and probably a higher correlation to public markets. And so I think at the end of the day, very size dependent. The discussion from anecdotal evidence and information in the case that the more co investments you add to a portfolio, and maybe even the more GP led secondaries you add to the portfolio, you can lower your coefficient or your beta to the public markets. We will have to see how that turns out in practice, and we'll have to see, Jeroen, how the academics are able to see if they can give us some help on this particular one. One more point, I was wrong, I need to make another one. And that is the number of assets that you need in the portfolio. We knew from academic work, and I think it's Markowitz his work that in a public portfolio you needed 18 to 25 stocks to diversify away the market. In fact, we also know anecdotally from experience that in private equity is as far as partnerships go, you probably only need somewhere between, surprise, surprise, 18 to 25 in portfolio. Now, why would that be? Well, if you look through these partnerships. They typically are investing in a place between 15 and 30 companies depending upon what stage and what size of the market that they're hunting in. As a result, you can have a portfolio with 18 to 25 funds in it that can have any place from 500 to 1000 different companies, all around the world. Plenty of diversification. So trading away more diversification for less return because more diversification is only going to drive your alpha to the mean is probably not a good trade off. A few thoughts on asset allocation and portfolio construction.

Absolutely. Thank you very much, Russ.

Thanks for tuning into PEP Talks with Russ. You can download a copy of the evolution of private equity white paper on the BlackRock website. Our next episode will be focused on the impact of technology, specifically the increasing use of big data in the private markets. Until then, be well.