For decades, investors with traditional portfolios have relied on a steady bull market in stocks and bonds to meet their financial goals. And for the most part, they have been rewarded. The average return from a 60/40 portfolio over the last 10 years has been 7.1%.1
But that’s not likely to be the case going forward. Volatility has dominated public markets this year and is unlikely to ease up until there are signs the Federal Reserve is winning its battle against inflation, without pushing the U.S. into recession.
U.S. public equity returns are expected to be modest at best, with our Capital Market Assumptions forecasting annualized average returns of less than 6% for the next 10 years. For investors with traditional portfolios, it means the time has come to consider private equity.
“We believe exposure to private equity and venture capital will be a key driver of outperformance within a well-diversified investment portfolio going forward,” says Joanna Berg, senior alternative investments strategist at BNY Mellon Wealth Management. “Private equity's illiquidity offers protection against public market volatility, as well as historically better returns.”
In February, we reduced our public equity weight in client portfolios to neutral, by cutting back on exposure to small capitalization stocks. We have been advising qualified clients, including those with traditional allocations, to consider redirecting those funds into private equity.
Many investors question the years it can often take to see returns from a private equity investment, and the lack of transparency. But for those with the funds and a long-term investing horizon, adding private equity can help reduce portfolio volatility, diversify return streams with an asset class with low correlation to public markets, and potentially improve returns.
It also keeps an investor’s allocation mix aligned with structural changes in the dynamics of equity markets.
The past decade has seen a steady shift by investors and companies away from public equity markets and into private market strategies. The basic strategies include private equity (PE) funds, which typically buy majority stakes in existing companies, and venture capital (VC) funds, which provide seed and other early-stage funding to startups.
Today there are more private companies than public ones.2 Most initial public offerings (IPOs) of stocks are now initiated by private equity firms,3 and the majority of a company’s value creation occurs during the private phase of its life, rather than in the public markets.
It used to be that young companies would have to issue an IPO to raise enough funding to scale operations and grow market share. That gave public equity investors the opportunity to invest in innovative startups at the ground floor, by purchasing small-cap stocks.
However, after decades of low interest rates since the 2008 financial crisis, investors have steadily increased their allocations to private markets to achieve greater returns. Global assets under management (AUM) in private equity strategies grew 37.7% in 2021 to $6.3 trillion, and made up nearly two thirds of the total AUM across all global private markets.4
Such enormous inflows into private equity have irrevocably changed public market dynamics. Rather than having to raise funds in an IPO to scale, companies are staying private for much longer, getting all the capital they need to grow and even become dominant market players.
Uber and Airbnb, two of the largest ever tech IPOs, waited 10 and 12 years respectively before going public, at high multiples and long after they had disrupted their industries. Both were so large that they skipped the small cap sector altogether and went straight into large-cap indexes.
The number of unicorns (private companies valued at more than $1 billion) hit 1000 globally for the first time in the first quarter of this year, and rose 70% in 2021, on the back of record venture funding across industries.5
“This is one of the reasons why we recommended clients reduce exposure to small caps earlier this year and redirect that money into private equity,” says Berg. “Small cap stocks used to be the sector where startups began. But now startups can spend over 10 years in the private markets and are multi-billion-dollar large cap stocks by the time they IPO.”
Staying private for longer has numerous advantages for companies and investors in private equity strategies. PE firms are prepared to spend years nurturing portfolio companies with funding, and by applying their industry expertise and operational experience. Companies can test new products and build market share without being subjected to short-term investor sentiment driven by quarterly earnings.
While volatile public markets may hurt IPO timing and multiples, private equity portfolio managers have complete control over when they buy or sell and are not subjected to investor capitulation as public stocks are. Volatility also creates industry dislocations that managers of PE and VC funds can take advantage of.
The flexibility afforded by private equity’s inherent illiquidity and long-term investment horizon has underpinned the asset class’s ability to provide better returns than public markets.6
Investing in PE or VC typically requires commitments of as much as $5-10 million to gain entry to the best funds. Unlike a mutual fund with daily liquidity, an investor must also commit those sums for as long as 7-10 years. It can take 3-5 years before receiving a return on investment through a company sale.
Yet, as the exhibit below shows, it can be worth the wait. Private equity investments have historically added significant value to diversified portfolios over the long-term, due to their low correlation, higher returns and lower volatility.
Investors (called limited partners) who are just beginning to build a private equity allocation, can integrate private equity secondaries into their portfolios to mitigate the J-curve return effect. PE secondaries are investments in mature interests held by limited partners and are characterized by earlier cash flows that shorten the time it takes to see returns.
Finding the best-performing PE and VC managers is easier said than done, and critically important for private equity investing success. The exhibit below shows a 25% difference between the performance of the top-quartile managers and the bottom quartile.
The difficulty lies in the lack of real-time information on the performance of PE and VC funds and their portfolio companies. Another issue for individuals is that funds run by the best managers are often closed to new investors.
Many individual investors instead turn to institutions like BNY Mellon Wealth Management to gain access to the top funds. Our private equity team, for example, has experts with an average of 20 years’ experience in private markets. They have the deep industry networks and relationships necessary to gain access to the best funds.
BNY Mellon Wealth Management’s private equity team provides its core clients with a fund of funds, or multi-manager approach to private equity investing, so that investors can spread investment risk across a range of top-performing PE and VC fund managers. Our largest clients can build a private markets portfolio through a core-satellite approach, with the multi-manager fund providing the diversified core PE exposure, supplemented with highly sought-after single manager funds as satellite investment strategies.
The multi-manager approach achieves diversification across PE and VC investment strategies, the sectors they are targeting, as well as geographies. BNY Mellon Wealth Management clients are given a choice of concentrating their exposure on just PE or VC managers, or a combination of both.
Having a mix of vintage years is also an important factor, and one which can be achieved through a fund of funds.
“Because of the long-term nature of private equity commitments, economic conditions can vary during the investment horizon,” says Paul Vittone, head of private markets at BNY Mellon Wealth Management. “Since no one can predict the market, it’s prudent to invest across a complete business cycle with investments in several vintage years to diversify risk and potential returns.”
Having exposure to the best fund managers is even more critical at a time when rate hikes and higher inflation could increase the cost of leveraged buyouts and reduce valuations when private companies are taken public.
“PE fund managers and their companies will need to increase their focus on building revenue growth of portfolio companies, and effectively managing them amid rising rates and inflation. They will not be able to rely on the expansion of multiples that has buoyed the industry’s returns to limited partners in recent years,” says Vittone.
Bigger is also not always better. After 10 years of strong inflows, private equity funds now have $3.4 trillion of dry powder globally,7 much of which has poured into the biggest global PE firms. The mountain of unspent capital puts pressure on general partners of large funds to invest in ever larger deals. This concentrates private equity market competition among the biggest players.
“Having so much money to put to work means they have no choice but to compete with one another for the largest companies, which continues to put pressure on valuations,” says Vittone.
Vittone believes that leaves better opportunities for smaller PE and VC fund managers specializing in small and mid-sized deals, where big global PE firms don’t typically play, and valuations are less inflated.
“Private company valuations correlate with two variables: one is size, and one is growth rate,” Vittone explains. “When you peel back the onion on the rise in purchase price multiples for private companies, you will see that it’s the larger companies that are selling at 13-15x earnings, while smaller companies are still selling at 6-10x. We see the opportunity in funds that focus on the latter.”
BNY Mellon Wealth Management's VC fund of funds also allocates roughly 20% of its capital to non-U.S. fund managers, to capture the global nature of technology disruption driving thematic investing opportunities. Fund managers are often focused on innovation arising from secular macro trends, like digital transformation in the wake of the pandemic, aging demographics, climate change, global connectivity, and deglobalization.
Given the structural shifts in markets, private equity strategies offer the best way to gain early exposure to future disruptors in climate change mitigation technologies, precision medicine, software, automation, blockchain-based “Web3” developments, and cybersecurity.
“Clearly in the current geopolitical environment, cybersecurity is a huge trend that is offering significant investment opportunities in cloud security startups,” says Vittone. “We also see opportunities in precision medicine and real-time health data, artificial intelligence, automation and Web3 developments.”
Investing in private markets is more complex than buying stocks, and higher returns do come at the expense of liquidity. But companies are staying private for longer, now that private markets have attracted a flood of investors looking for better returns. That means the biggest investment opportunities are more often found in the private equity market rather than public stocks. These market shifts, along with expectations that public equity returns could be muted in a higher rate, higher inflation environment, makes a strategic allocation to private equity a wise choice.
Next step: For those interested in learning more about private equity, BNY Mellon Wealth Management’s private capital team have answered frequently asked questions from our clients. Learn more here.
1 BNY Mellon Wealth Management. Average return of 60% equity, 40% fixed income allocations in a portfolio, through to December 31, 2021
2 World Bank and PitchBook, September 2021
3 Jay R. Ritter, University of Florida, “lnitial Public Offerings: Updated Statistics” May 19, 2022
4 McKinsey & Company. “McKinsey Global Private Markets Review 2022.” Private Equity includes buyout, venture capital, equity growth and other PE.
5 CB Insights, February 2, 2022
6 Cambridge Associates, Bloomberg.
7 Bain & Company. “Global Private Equity Report 2022” March 2022
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