As we exit 2022, many investors are licking their wounds from the weakest public market returns in over 40 years with stocks down -19.44% and bonds down -12.89%1. The outlook for 2023 appears ominous, with signs of slowing global growth, rising interest rates and earnings compression underway. Seeking returns and diversification, investors may be hearing the Siren’s Call2 of strong consistent historical performance provided by private markets, particularly private equity.
As illustrated below, the long-term performance of private equity vs public markets appears attractive, outperforming by 520 basis points (bps) per year from 2001-2021. In contrast, when looking at more recent performance, the returns of private equity are less impressive, outperforming by 73bps per year from 2009-2021, as the performance of public markets benefitted from the post-financial crisis low interest rate environment.
Private equity managers rely on several key market conditions for outperformance:
- Ability to acquire companies at low cost (low earnings/cash flow multiples).
- Low financing costs to restructure balance sheet and finance improvements.
- Skill to significantly enhance the operations, lower costs, improve profitability and enhance the market value of acquired companies within 3-5 years.
- Robust IPO (initial public offering) and M&A (mergers and acquisition) environment for the eventual sale of acquired companies.
For the past two decades, most of these conditions were generally favorable for private equity investors. However, the success of private equity over this period attracted more capital and spawned many more private equity firms. More firms and capital effectuated additional competition which in turn significantly raised the cost of acquired companies – thus raising the level of value creation necessary to reward investors.
As illustrated below, deal valuations have increased 40% over the past decade while global private equity assets have increased 3.5 times to $6.3 trillion.
Clearly, current market conditions – high enterprise multiples, higher financing costs and a lethargic IPO/M&A environment – are not ideal for private equity. This environment, coupled with the de minimis performance premium relative to public markets over the past decade, should give investors pause on potential allocations.
For the time being, investors, like Ulysses, may want to (metaphorically) put wax in their ears and steer clear from the potential risks of the Siren’s Call.
Important Disclosures & Definitions
1 Morningstar, as of 12/31/2022
2 In Homer’s The Odyssey, the Sirens were beautiful creatures with mystical powers who ensnared unsuspecting sailors to shipwreck their vessels and drown them with the lull of their magical songs.
Basis Point (bps): a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
Enterprise Multiple (EV/EBITDA): a ratio used to determine the value of a company by considering the company's debt. The enterprise multiple is the enterprise value (EV) (market capitalization + total debt – cash and cash equivalents) divided by EBITDA (earnings before interest, taxes, depreciation and amortization).
Net Asset Value (NAV): the per-unit dollar amount of a fund is derived by dividing the total value of all the assets, less any liabilities, by the number of fund units outstanding.
Pitchbook North Americas Private Equity Index: an index to measure aggregate performance of private equity in North America, calculated quarterly as the total percentage change in NAV for funds in the Pitchbook private equity database, net of contributions and distributions.
S&P 500 Index: Widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
One may not invest directly in an index.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.