Private Equity’s Trillion-Dollar Question

After a record 2017, private equity funds have $1 trillion to deploy.The Financial Times reported this week that the buyout industry is raising more money than it can spend. As new risks surface, we think public equity portfolios with the right strategic mindset can deliver similar benefits to investors.

Fundraising is booming in private equity—but will this affect the industry’s return potential? In 2017, 921 funds globally received $453 billion in investor commitments, according to Preqin, an alternative-investments research group (Display). It’s easy to understand why. Private equity offers the prospect of higher returns than public equity portfolios. And returns from private equity are widely considered to be uncorrelated to stocks.

New Challenges for Private Equity

Turning new funds into investment returns could be more challenging in the coming years, in our view. Deploying private equity funds takes time, and with a trillion dollars now sitting on the sidelines, Preqin expects heightened competition for deals amid “very high” entry prices for assets. Leverage has reached alarming heights, with the FT reporting that the extent of debt used by US buyout firms to fund takeovers is “just shy’’ of the levels seen before the global financial crisis in 2007.

Investors also pay an opportunity cost for every month that their funds are not invested, especially as equity markets continue to rise. Meanwhile, the abundance of cash and a limited number of target companies could prompt private equity funds to buy publicly listed companies, which would benefit equity investors.

What about the benefits of uncorrelated returns? We think this perception is something of an illusion. Many people think private equity is uncorrelated with public equity, but nobody really knows, because private equity funds are not marked to market daily like stock funds.

In fact, we think private equity funds may be much more correlated to public equities than is widely believed. Private equity relies on cash flow and earnings growth for returns, which are directly tied to macroeconomic growth—just like stocks. So unlike bonds, which are uncorrelated to return sources derived from global growth, private equity can be expected to deliver performance patterns similar to equities, in our view.