Over the last 20 years, a seismic shift has occurred in the capital markets with only passing acknowledgement from popular media and scant acknowledgement in the financial press. Since peaking at 8,090 listed stocks in 1996, the stock market had declined to only 4,397 public companies by 2018—a nearly 50% decline. While the number of listed companies has risen more recently to about 6,000, this still represents a 25% fall from its peak.
At the same time, the number of private equity-backed companies has grown significantly, as shown in Exhibit 1 below.
Exhibit 1: Number of U.S. Private Equity Backed Companies Has Surpassed Public Companies
This diminished opportunity set poses an existential question for institutions: does our portfolio have the ability to keep pace with spending plus inflation while relying exclusively on traditional asset classes? This change in market composition is also why some investors are exploring strategies for how to increase their exposure to smaller, fast-growing companies.
Understanding the core components driving overall portfolio expectations, from both a historic and forward-looking perspective, is an important first step in developing a thoughtful response to this question.
When reviewing historical market returns, it’s tempting for board members to ask, “Why not just buy the S&P 500?” After a surprisingly resilient 2020, the S&P 500’s trailing 10-year average annualized return was 13.9% as of year-end. Bonds were less sanguine, with the Bloomberg Barclays U.S. Aggregate Bond Index generating a 3.8% return over the same period. Building on these historic returns, a straightforward portfolio of 60% equities and 40% bonds (“60/40 portfolio”) would have produced a fulsome 9.8% annualized return over the prior decade. Modelling a typical “hurdle rate” comprised of a 5% annual spend plus the historic CPI, the 60/40 portfolio would have handily surpassed its investment objectives over the previous decade.
Exhibit 2: Traditional 60/40 Portfolio Has Outpaced Hurdle Rate Over the Previous 10 Years
This backward-looking analysis, however, doesn’t consider the impact of the starting point, which implies materially different expectations given the divergence between capital markets assumptions and historic returns. To make a reasonable forecast of future returns, empirical baseline assumptions are needed to guide investors in developing their long-term strategic asset allocations. On an annual basis, BNY Mellon Investor Solutions develops capital market return assumptions (CMAs) for approximately 50 asset classes around the world, based on a 10-year investment time horizon. Using the same sample 60/40 example, but now building in forward-looking CMAs, the picture is considerably less robust: the same naive 60/40 portfolio is expected to generate a return of only 4.58% over the next 10 years. Based on our forecasted CMAs, the likelihood of the traditional 60/40 portfolio meeting anything close to the implied forward hurdle rate of 7.4% is slim. With public markets shrinking and alpha more difficult to source, asset owners must ask whether beta alone will be enough to meet their hurdle rate expectations over the next decade, as illustrated in Exhibit 3 below.
Exhibit 3: Top Capital Gains Tax Rates and Economic Growth1
As asset owners think about their future liabilities and forecasted returns, it becomes increasingly challenging for the portfolio to keep up with spending plus inflation while relying exclusively on traditional asset classes.
Post COVID-19, the answer to the question of how to keep up with spending plus inflation now comes with a greater sense of urgency for numerous nonprofit organizations. Many nonprofits are rethinking spending, and several have publicly announced that they are either accelerating spending or increasing the level (percentage) of their draw in response to both COVID-19 challenges (academia) and social justice priorities (grant makers).
For academia, the longer-term headwinds of demographics and online learning have been exacerbated by the impact of COVID-19. Falling grants and slowing tuition hikes have compounded cash flow headaches and increased the pressures on the endowment draw. For grant-makers, the tragedies and ensuing protests that played out across much of America in 2020 have given renewed impetus to funding community-based solutions to systemic inequities. Illustrating this trend, in 2020 a BNY Mellon grant-making client approved increasing its annual spending level over a three-year period from 2020 to 2022. This action enabled the foundation to target more funding to agencies focused on COVID-19 relief and equity issues.
Using the simple 60/40 example, the most obvious and accessible first step for asset owners is to look past the narrow confines of U.S. large-cap companies (S&P 500). Diversifying portfolio allocation to include U.S. mid, small, and international companies may improve the overall return profile; however, these moves are not forecasted to be enough to overcome the yawning gap illustrated above. This is where the shift in the capital markets composition described in Exhibit 1—from public to private—can be leveraged to benefit a portfolio.
Benefits of Private Investments
The structural changes within the equity markets are driving the need for investors to reevaluate how they get exposure to smaller, fast-growing companies. What are the drivers? Companies are staying private for longer primarily to avoid the onerous scrutiny of being public, and as the flow data supports, to take advantage of the abundance of private capital willing to fund them. As a result of start-ups staying private longer, much of the value creation is now during the private stages of a company’s life, rather than when they become public companies. Investing with the top-tier fund managers in venture capital (VC) is therefore imperative to gaining access to these fast-growing businesses. This access, however, is often difficult to come by unless you have been investing with these managers for an extended time and have developed a long-term relationship. The ability to access top-tier capacity-constrained managers is a significant hurdle for those new to the asset class.
The central rationale driving the need for exposure to private companies, as illustrated in Exhibit 4, is that top-quartile private equity (PE) and VC funds have historically outperformed other asset classes, including public equities.
Exhibit 4: Asset Class Returns by Quartile2
As well, the broader data tracking performance and exposure to private equity supports the premise that a greater exposure to PE/VC drives higher returns. The 2020 NACUBO Endowment Survey demonstrates the impact of PE/VC allocations on colleges and universities’ long-term performance. Endowments with greater than $1 billion saw a 10-year annualized return of 7.9%, while those with up to $25 million saw a 10-year annualized return of 7.5%. The performance discrepancy is underscored by the allocation to PE/VC: endowments greater than $1 billion have 26% in PE/VC, while those with $25 million or less have 3% (note: the SEC qualified investor threshold for entities is $25 million).
This premise is also supported by data from a recent peer review conducted by BNY Mellon of its institutional custody clients; it found that larger endowments and foundations (E&Fs) maintained relatively high allocations to alternatives over the last five years and that exposure to high-performing private equity and hedge fund sub-asset classes increased significantly. The study also discovered that E&Fs with more than $1B in assets outperformed their smaller counterparts over three-, and five-year periods as of year-end 2019, (9.61% vs. 8.33% and 7.38% vs. 6.02%, respectively).
BNY Mellon’s institutional clients with exposure to VC/PE outperformed those without an allocation, as shown in Exhibit 5.
Exhibit 5: 15-year Comparison of a U.S. Equity Portfolio With and Without VC/PE3
And as noted above, while the public market has shrunk the private market over the last decade has grown steadily. Through the end of 2019, the venture industry deployed $136.5 billion in U.S.-based companies, surpassing the $130 billion mark for the second consecutive year, according to the PitchBook-NVCA Venture Monitor6. This is in sharp contrast to 2010, when U.S.-based venture investments totaled only $22 billion. The dramatic growth in private equity has prompted valid questions about inflated valuations and too much money chasing too few opportunities. The points made regarding flows into PE are good ones, and asset owners should be cautioned that median performance may not justify the illiquidity inherent to private vehicles.
Investment committees should consider the following steps when thinking about building an allocation to PE/VC:
Understand Risk Tolerance
Taking a holistic view, organizations should examine their risk tolerance from an enterprise perspective rather than through a narrow portfolio lens. This critical concept was recently detailed in BNY Mellon Wealth Management’s paper Importance of Understanding Your Nonprofit’s Risk Tolerance. While the key metrics to consider when evaluating enterprise risk may vary by peer segment, the following are particularly relevant across all organization:
- Spending rate & flexibility
- Operational dependence & reserves
- Access to credit
- Debt burden
Set Clear Objectives
After analyzing enterprise risk and determining that an allocation to PE/VC is appropriate, one of the most important steps for investment committees is to define a clear objective for the program. As the median returns in Exhibit 2 demonstrate, a move into private investing is not appropriate for every organization. Organizations without the internal or external resources to perform the rigorous due diligence required by private investments are likely to be disappointed by their experience in the asset class.
Build the Blueprint
The next critical element in building a sound PE/VC allocation is diversification across style, geography and time. Unlike public markets, PE/VC investments are not readily accessible. Instead, they are accessed in a specific “vintage year,” which refers to the year that the fund begins to deploy capital. Private investment timing varies, so it’s important for investors to align vintage year diversification with the timing of fund offering periods. Vintage year diversification counsels’ multiple investments throughout an economic cycle, as the underlying investments are affected by the variable macro factors that occur at different points in the economic cycle. This contrasts with a flawed approach of only committing to one or two vintage years (invariably, fallow years) and then missing out on the ensuing vintages that reward a disciplined, long-term commitment. This methodical investment process means that the target allocation for PE/VC isn’t met for an extended period, typically 5-7 years.
As a result, the traditional approach to building a PE/VC position is a slow, multi-year buildout, although the maturing secondary market has opened other avenues for constructing an allocation to private investments. Opportunities in the secondary market now give investors the ability to introduce PE/VC to their portfolio in a compressed time frame. Secondaries speed up the allocation process as a consequence of these funds already being significantly drawn down, having typically been investing for about 5 years. This provides backward-looking vintage exposure, meaning investors generally see much earlier distribution. The result of the earlier distributions is a shorter duration of the investment, with no or minimal J-curve lag. For investors with existing positions, the secondary market also enables them to access completion managers or exploit tactical opportunities. Whether pursuing a traditional multi-year build out or an accelerated one on the secondary market (or a combination), investors must be cognizant of the extensive sourcing protocols.
Invest in Due Diligence
While developing a thoughtful, diversified approach to a PE/VC allocation is a key initial step, manager due diligence and selection is just as critical. As shown in Exhibit 4, there is a wide disparity of returns across PE/VC—significantly greater than the dispersion in public markets. The ability to access capacity-constrained managers and the resources to perform a thorough selection process has a much greater impact on private returns relative to the public markets: top-ranked PE funds outperformed bottom-ranked funds by an average IRR of 20%. However, for asset owners able to align with both emerging and established managers with proven investment teams, it’s possible to exploit visible competitive advantages in less crowded target markets.
Set the Pace
A disciplined PE/VC allocation values the importance of careful capital commitment pacing in developing the appropriate commitment strategy for an institution. That strategy should be agreed upon well in advance of any commitment, customized for the organization’s specific objectives, and informed by a thorough understanding of their risk parameters. As well, a PE/VC strategy benefits materially by a self-sustaining allocation: distributions essentially fund the capital calls, and investors forego the “cash drag” from uncalled capital.
As nonprofits face mounting pressure to keep pace with growing spending needs, the reliance on public equities may prove insufficient. An allocation to private markets could offer important long-term benefits. The decision to invest in PE/VC, however, should be driven by each nonprofit’s unique set of circumstances. Organizations must ask themselves: What are we solving for? What is our hurdle rate? What is our enterprise risk? Do we have the resources and expertise to prudently move into private investments? It’s only after answering all these questions that nonprofits should take a closer look at private markets.