With All Private Markets Outperforming, It’s Hard to Tell if Managers Are Skilled — or Lucky

Since 2000, annual leveraged buyout returns outpaced global equities by more than 10 percent on average.

Brendon Thorne/Bloomberg

Brendon Thorne/Bloomberg

Private markets have been winning investments across the board. While investors are unlikely to complain about their returns, they now face a tougher-than-ever job of determining whether a manager’s positive performance record was the result of luck or skill.

According to Hamilton Lane’s recent 2022 market overview report, private assets have outperformed those in the public markets for decades and last year was no different. The alternative firm’s data showed that pooled buyout returns beat the MSCI World PME — Public Market Equivalent — in each of the past 20 vintage years (through 2020) and by more than 1,000 basis points on average. Private credit has outperformed leveraged loans every year during that 20-year span by 625 basis points. Performance of both private asset classes was measured by the Internal Rate of Return.

Hamilton Lane expects the outperformance to continue over the next three to five years. In fact, Andrew Schardt, head of global investment strategy and the co-head of direct credit investments at Hamilton Lane, said the firm is anticipating that private markets will trounce public companies by 300 to 500 basis points every year for the next five years.

The performance statistics come as the Securities and Exchange Commission seeks to get better disclosure from private equity and other alternatives managers. With few requirements for general partners to provide standard information about their funds and underlying investments, it’s often difficult for investors to compare their funds’ returns, fees, and risk measures to other offerings available in the market. Without true transparency it’s hard to prove definitely that private equity works.

Given its performance run, it’s not surprising that private markets firms have raked in cash for years. Fundraising for products valued at under $1 billion has been consistent since 2014. But, fundraising for funds valued between $1 billion and $5 billion has risen significantly.

While private markets firms pulled in a record amount of money in 2021, Schardt noted that the annual fundraising numbers remain a small fraction of the global market cap of stocks. In 2021, private market funds raised commitments from investors that represented about 2 percent of the market cap of the MSCI World index. Schardt said the growth simply is emblematic of a healthy, growing asset class.

But it’s also a reflection of the growing number of companies that are choosing to stay private longer and, as a result, the shrinking public markets.

“[The performance] goes back to two fundamental pieces of the private markets,” Schardt told Institutional Investor. “First, it’s the landscape. There’s just way more opportunities in terms of investing and finding private companies relative to just a few thousand opportunities in the public realm.”

The second fundamental, Schardt said, is the way that value is created in private markets. Schardt said most private assets are controlled by active managers, while a growing share of public stocks are now held by index and other passive funds.

Schardt argues that active managers keep their investments for longer periods and create profits by upgrading the company’s underlying business model.

“The choices of those private market managers that control those companies are emblematic of strategy, operational improvement, alignment of employees, and reflective of a longer hold period in active management,” Schardt said.

This contrasts heavily with the nature of the public markets, in which managers generally make decisions on a shorter term basis: “People think of things day-to-day, quarter-to-quarter, month-to-month, earnings report-to-earnings report,” Schardt said.

The fact that private market managers are less concerned with shorter-term prospects allows for more consistent value creation over a longer-term time horizon, Schardt argued.

But, while the private markets are fertile ground for limited partners, hedge funds, and others looking to generate strong returns over the next decade, Schardt said these same LPs will eventually have to make some “harder decisions” when it comes to manager selection. Because of strong private market performance across the board, it’s increasingly difficult for investors to distinguish which managers made decisions that led to good outcomes and which failed to improve their businesses. Separating the skillful from the lucky is crucial for investors in less flush times. At the same time, with so much growth, there are more managers than ever who have gotten into alternatives.

“There’s still room to grow for the asset class as a whole, but that also means that investors have more choices today than ever before,” Schardt said.

Moving forward, Schardt said he thinks private markets will start rewarding deal picking and thematic investing, and managers that can ride that wave will have the greatest success with investors.

The strong performance has made private markets a much bigger part of many investors’ portfolios, sidelining public stocks — a phenomenon many call the “denominator effect.” Many investors now appear to be over-allocated to private markets, particularly amid the recent volatility in markets, Schardt said.

“If you’re trying to stick to a targeted allocation for private market exposure, that denominator effect makes it challenging,” Schardt said.