Is private equity performance really immune from market volatility?

 

Pension schemes have been moving into alternative assets such as private equity on the premise that they provide diversified returns. In theory these investments should provide good returns when the public markets suffer falls like they have in recent weeks.

However this does not mean that private equity is completely immune from market volatility, particularly when the current market jitters are being driven by concerns over global growth. Indeed, some academics have previously argued that returns provided by private equity firms understate the economic co-movement between private equity and market returns, creating a so-called ‘diversification illusion'.

Performance falls

Returns from global private equity investments turned negative in the third quarter last year, marking an abrupt end to a 12-quarter streak of positive returns, according to State Street.

Its GX private equity index shows that overall returns fell to -1.37% in Q3, the biggest decline since Q3 2011, against a backdrop of volatility in the public markets. Prior to that the index had seen uninterrupted positive returns across 12 quarters, which was the longest winning streak in the index's 20-year history. All three major private equity strategies - buyout, venture capital and private debt - posted negative quarterly returns in Q3 at -1.63%, -0.51% and -1.27%, respectively.

State Street Global Exchange senior vice president Will Kinlaw says: "With growing uncertainty about the global economy and a big spike in public capital market volatility over the past six months, it's no surprise that the private equity market is taking a pause."

There have only been 10 quarters in the index's history where declines were larger, including: Q3 1998 at the time of the Russian debt default, Q4 2000 as the dot-com bubble imploded, Q3 2008 through Q1 2009 during the global financial crisis, and Q3 2011 when the index dropped by 5.1% amid fears of a Eurozone crisis.

So does this mean that private equity is still a good investment for pension schemes, particularly when the asset class has recently come under fire for high fees?

Market volatility exposure

Towers Watson head of private equity Mark Calnan says it is not necessarily the case that volatility in markets will affect pension schemes' private equity portfolios, and warns against relying too much on quarterly or annual data.

"There are so many issues with the way you characterise the private equity data that it's very difficult to draw any meaningful conclusions from short-term performance statistics," he says.

His firm's data shows that if there is market volatility then there will be some correlation between the private equity and equity markets. "Very traditional, highly leveraged, often larger mega-cap strategies are the ones that we think are most highly correlated with leveraged equity markets," he says.

JLT Employee Benefits investment consultant Guy Hopgood agrees that private equity can be affected by volatility in the public markets, but will inherently have less volatility as it is dealt with less often than equities.

However, as there is some lag as to the impact on private equity performance, he would not be surprised if the index reports negative returns for the fourth quarter of 2015 as well.

One argument against relying on short-term data is that private equity is a long-term investment.

Good time to invest?

"The question should be 'is now a good time to invest in private equity?', rather than looking at what the private equity industry indices are going to look like over a 12-month period," says Calnan.

"It is less about 'will private equity do better over the next 12 months than the last 12 months'; it's more about 'will new capital being invested into private equity deliver a 300bps or more outperformance and give some diversification benefits versus the other assets we own?'."

It is also uncertain what the returns will be until the investments are sold as the true valuation of a company is not known until the investor comes close to selling it.

A lot of the time private equity fund performance comes at the latter stages of the investment period. "We've seen more recently that funds that seemed to be performing fairly averagely actually ended up performing very well once they got rid of all their assets," says Hopgood.

Also, if schemes commit to a private equity fund today, it typically has a three- to four-year investment period, which means their capital may not actually be invested until 2018, 2019 or even 2020. "So schemes should bear in mind they are actually buying at future prices rather than today's prices," says Hopgood. He therefore argues that now is a good time to get into the asset class, and that "we're moving into a cycle now where opportunities lie".

Regional data

It is important to look at performance on a regional level rather than purely looking at the global index. Hopgood says most UK schemes would be in developed markets private equity, perhaps 50%-60% in US and the remainder in Europe. Therefore they are probably less exposed to where most of the falls have been in emerging markets private equity.

State Street's index shows that private equity funds outside the US and Europe, primarily made up of emerging market funds, had a volatile third quarter, with performance dropping from 4.47% in Q2 to -3.13% in Q3 2015. However European-focused funds recorded a return of 0.29% in Q3, benefiting from a tailwind in the euro to US dollar exchange rate, the firm says. Private equity funds in the US posted -1.43% and -1.25% quarterly returns, respectively.

One argument for shifting from long-only public equities into private equity is that the persistence of manager skill is higher in private markets than public markets. "As the public markets are more efficient, it is harder to build consistent track record of performance," according to JPMorgan Asset Management pension solutions managing director Rupert Brindley.

Calnan agrees, adding that now is a good time to invest in manager skill. "Private equity managers have proven across cycles, particularly when times are volatile, that they can generate returns as a result of a range of value creation levers they have at their disposal that traditional long-only equity managers do not have," he explains.

"They are more proactive in timing entry and exits of companies when they have fresh capital, and are able to put new investments on hold for a year if appropriate.

"For these reasons, given the market outlook, we do think that it is time for those schemes with an appetite for illiquidity to consider making the shift from long-only equities into private equity."

Further reading

Tax relief green paper: A chance to sort pensions once and for all?

• Law and Regulation
• 08 July 2015

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• Topics
• Investment
• Private Equity
• private equity
• Illiquid assets
• Volatility
• State Street
• Towers Watson
• JLT
• JP Morgan Asset Management