Private equity is unlike most other asset classes—fund vehicles are often closed-end and returns cannot definitively be determined until well into a fund’s life. Numerous factors affect performance and the ultimate results can vary widely. In this article we highlight two of the factors which affect performance and underscore the importance of strategy diversification when constructing a private equity portfolio:
- Some strategies exhibit their own cyclicality distinct from overall global economic conditions and market cycles
- There is a very wide dispersion in terms of risk and return expectations across strategies.
Well-constructed private equity portfolios typically are diversified across multiple areas, including vintage year, geography, strategy, manager, and industry. Strategy diversification often is thought of in terms of the risk/reward payoff; for instance, venture capital has higher return potential but also higher risk, so is often included as a higher alpha generator. In addition, different strategies follow different cycles. There are certain private equity strategies that are generally accepted as having greater cyclicality than others, and this should be a consideration when constructing portfolios.
This raises a couple of key questions: should an investor try to time vintage year commitments and focus on different strategies at different times, and how much focus should be placed on diversification across strategies in private equity portfolios?
The Burgiss* database contains an array of performance metrics which can be broken down using a multitude of factors. For this analysis, we have taken the pooled internal rates of return (IRR) for different private equity strategies and:
- Ranked them within each vintage year between 1997 and 2013. Note, our ranking is based on absolute performance relative to each other not relative to a benchmark.
- Examined the following strategies: distressed (“Dist.”), mezzanine (“Mez.”), natural resources (“NR”), secondaries (“Sec.”), venture capital (“VC”), expansion capital (“EC”), small buyout (“Sm. BO”), mid buyout (“Md. BO”), large buyout (“Lg. BO”), and mega buyout (“Me. BO”).
- Defined the sub-strategies of the buyout space according to fund size (small < $500MM; medium $500MM - $1B; large $1B - $5B; mega > $5B).
The heat map above shows the results of our analysis.
Historically, natural resources has been a segment that has exhibited more pronounced performance cycles relative to other private equity strategies. As can be seen on the heat map, capital committed to natural resources between 1997 and 2002 has outperformed other strategies, but has markedly underperformed since 2009. This is not explained entirely via one factor, but a significant proportion of the performance within this strategy is correlated with movements in oil prices (as they are a broad indicator of natural resources generally).
We also expect to see distressed investments exhibit cyclicality, as they should outperform other strategies when the overall market/economy underperforms. Capital committed to funds focused on distressed investments before or during times of market turmoil can be seen to outperform, for example when the tech bubble burst in the early 2000s and around the financial crisis in 2007. Note, the specific vintage year of outperformance may not exactly match the dates of a market downturn as the investment period of funds can reach out for up to five years after the fund was raised.
As is typical in capital markets we expect the most risky strategies to strongly outperform in some vintage years and strongly underperform in others, while strategies with average risk typically fall within the middle of the performance range more often than not. The heat map shows evidence for this risk/return trade-off. Venture capital, one of the riskier private equity strategies, is a good example where it is typically either the top or bottom performer in any single year and just a few instances where it is an average performing strategy.
As we see evidence for risky strategies either dramatically outperforming or underperforming the average, we would expect the “safest” strategies to consistently perform below the average private equity strategies. These “safer” strategies should be producing consistent but lower returns across vintage years. Mezzanine is a debt-focused investment strategy, and compared to the other private equity strategies which are largely equity-focused produces consistent but lower returns through time.
There are numerous factors that contribute to the performance of any single strategy within a vintage year and predicting the magnitude of the effect of these factors can be extremely difficult. Rather than try to analyze each factor in turn, we can look at the results of the analysis (the heat map) and draw conclusions about portfolio construction that are independent of the causes of the patterns we observe.
There is a wide dispersion of return rankings across strategies. Timing the outperformance of certain strategies is hard; a lot of market-timing decisions come down to luck, though ought to be slightly easier in times of market dislocation or extreme conditions. In addition to dispersion across strategies, there is a wide dispersion in performance of individual managers within each strategy. It should be noted that there is some evidence for the persistence of performance for managers in private equity (although it may be reducing), certainly compared to the public markets.
Investors frequently face trade-offs when constructing portfolios, as there can be a conflict between diversifying to manage risk and concentrating to reflect views. At Aon, our top three priorities in structuring private equity portfolios are:
- Gain access to the best managers and funds; the difference between top-and bottom-performing managers is generally larger than the difference in performance between strategies.
- Diversify across strategies in a prudent way such that risk is reduced, but that the portfolio does not simply generate average market returns.
- Tactically shift the weightings to each strategy at different times, depending on the prevailing economic conditions. Include strategies that are driven by different cycles.