INVESTMENT ACTIONS

The evolution of private equity

Sep 23, 2020

We study the returns and outperformance of private equity over the last four decades. Through various periods of financial duress, we analyze how private equity behaved in market downturns and discuss various stylized facts and return drivers. In addition, we provide insight into long term correlations between private equity and a set of observable variables. We wrap-up by discussing trends we see when entering the next decade.

Strategic evolution

The first private equity funds were created in the 1950s. However, there were few such formal structures and they were mostly marketed to individual investors rather than to institutional investors. A series of regulatory changes in the US and Europe enabled institutional investors to effectively outsource the management of fund investments to specialized firms and eliminate the need for in-house expertise. These favorable regulatory events together with the evolution of the limited partnership resulted in a spectacular growth of the private equity industry.

Comparison to other assets

A hypothetical investment of USD 100 invested in five different financial instruments on 1 January 1980 and assuming reinvestment of all proceeds provides a clear return comparison across asset classes. Private equity clearly shows the highest returns with an ending value of USD 27,024, equating to an annual time-weighted return of 15.0% - an outperformance of 5.5% and 4.3% over the MSCI World and S&P 500 indices, respectively.

Significant outperformance of private equity at the asset class level

Time-weighted returns across 5 asset classes

Time-weighted returns across 5 asset classes

Source: Value of USD 100 invested into five financial instruments on 1 January 1980. Private equity: Burgiss; Fixed income: Barclays US Aggregated Bond index; Hedge funds: HFRI FOF index; both MSCI World and S&P500 represent total return indices. Private Equity data sourced from Burgiss covers vintages 1980-2019, 5,643 funds, and USD 3,992 billion in market capitalization. Private equity strategies include all equity strategies. All dollar figures are USD. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future returns.

However, as opposed to public equity investments where the investor is immediately fully invested, private equity managers call committed capital from their investors over time as they find investment opportunities and distribute principal and gains as investments are exited. For this reason, the timing and size of cash flows is more important than in traditional asset classes. Private equity practitioners do not typically report time-weighted returns but analyze and report performance in a money-weighted performance metric, the internal rate of return (IRR). The money-weighted mechanic of the IRR better reflects the timing and size of the underlying cash flows. In addition, TVPI and other multiples are used to reflect cash-on-cash returns.

Historical performance

Consistent outperformance over public markets over the past four decades

Pooled, absolute and relative performance

Pooled, absolute and relative performance

Source: Global private equity fund pooled, absolute and relative performance against the MSCI World index for 40 vintage years and 4 pooled aggregates – all in USD as of 31 December 2019. Private Equity data sourced from Burgiss covers vintages 1980-2019, 5,643 funds, and USD 3,992 billion in market capitalization. Private equity strategies include all equity strategies. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future returns.

The above figure demonstrates strong performance for each of the four decades in isolation for various aggregates on both an absolute (IRR) and relative (direct alpha) basis. In aggregate and since inception, the direct alpha over these 40 vintage years (1980-2019) is 5.7%. This pooled outperformance is also substantial, when looking at different time windows and ranges from 3.6% for 5 years to 4.4% for 15 years. The 10-year pooled outperformance is the lowest, resulting from the longest public equity rally in history fueled by monetary policies. The equivalent outperformance on an absolute basis for TVPI ranges from 9% for 5 years to 16% for 15 years. On a look-through basis, the direct alpha or pooled outperformance over the MSCI World index is positive in 37 of 40 vintages.

Key Takeaways

  • Private equity outperformance over the MSCI World index is consistently positive and reports a lower decline than public markets during periods of high market volatility.
  • Whether public or private, equity investments are exposed to the same factors and hence private equity returns show a high correlation with public returns.
  • In the next decade, we see the private equity industry evolving with the democratization of access, the impact of technology, focus on ESG/impact investing, and the integration of equities.
Russ Steenberg
Global Head of BlackRock Private Equity Partners (PEP)
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Jeroen Cornel
Director, BlackRock PEP
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Kyle McDermott
Analyst, BlackRock PEP
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