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Private Equity Returns Still Outperform Public Markets

Private Equity Returns Still Outperform Public Markets

The best funds will continue to outperform by a wide margin by doing two things differently.

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Private Equity Returns Still Outperform Public Markets
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This article originally appeared on Forbes.com.

Private equity buyout funds globally delivered returns that beat public equity markets by a sizable margin in 2016. In the US, funds delivered a 6% end-to-end pooled internal rate of return (IRR) for the 12 months ending June 2016, compared with 4% for the S&P 500 using an apples-to-apples metric developed by investment advisory firm Cambridge Associates. The gap was even larger in Europe and Asia-Pacific. And private equity continues to outperform over longer time horizons as well.

As we explain in Bain & Company’s newly released Global Private Equity Report 2017, one strand of the returns story bears watching: The spread between buyout returns and public markets—and within buyouts, the spread among fund performance quartiles—has narrowed in recent years. To understand why, let’s look at a few underlying trends.

Buyout returns have slowly trended downward. The PE industry has matured and become more competitive, with many more participants and massive amounts of capital competing for a limited set of deals. Outsized returns that general partners (GPs) could earn on once-common undervalued assets are harder to find today.

Therefore, the gap has tapered between the average performance of buyout funds and public equity markets. Over time, one would expect average PE returns to settle at the level of public market returns plus an illiquidity premium. The best funds, though, will continue to outperform by a wide margin.

The spread of returns within buyouts also has converged recently. Here, the narrowing gap among fund quartiles likely is a short-term phenomenon rather than a long-term trend. Funds invested huge amounts of capital at high prices in 2006 and 2007. The financial crisis then dealt a major blow to asset valuations, and funds extended their holding periods. While many of the boom-time deals ended up fine, few ended up great. As a result, the spread of returns narrowed for these deals compared with investments made earlier in the decade, particularly when measured by IRR given the longer holding periods.

An additional factor contributing to the recent narrowing spread in returns is the relatively benign, consistent macroeconomic environment since 2010, which naturally limits the range of deal outcomes. Big winners and losers tend to emerge in periods of turbulence. Only when we see the next positive or negative jolt to the economy will return scenarios be amplified.

So what accounts for top-quartile performance? Looking over the past three decades, top-quartile funds did two things differently.

First, they were able to contain the rates of capital impairment to much lower levels than other funds. Top-quartile funds had 20% of their deals experience capital impairment and an additional 6% of deals fully written off, about half the levels of bottom-quartile funds, according to Cambridge Associates. Second, top-quartile funds made more winning deals than other funds. Top-quartile funds reaped more than five times the total value paid in on 13% of their deals, compared with just 2% of deals for bottom-quartile funds. Performance tends to persist in private equity, as the best firms can often repeat their success from one fund to the next.

Breaking into the top quartile requires raising one’s game in several dimensions. Avoiding flops calls for excellent due diligence. Building star investments involves applying the insights from due diligence to a post-acquisition agenda, selectively taking on more risk and adding value over the holding period. To satisfy their investors’ expectations, GPs will have to continue to generate outsized returns.

Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company’s Private Equity practice.

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