How Private Equity Became a Beta Play

All the numbers point to private equity and venture capital being at a peak. But it’s not for the reasons many think, according to McKinsey.

Illustration by II

Illustration by II

Institutions once invested in private equity for the potential to earn higher returns than other asset classes, and the persistence of the outperformance, among other things. But pensions, sovereign wealth funds, endowments, and other institutions are now allocating increasing amounts to private markets because they don’t have a choice, according to a McKinsey & Co. report expected to be released Friday.

Institutional investors “used allocate to PE for three reasons: outperformance versus public markets, predictability as there was strong persistency of top quartile managers, and the belief that PE was fairly uncorrelated,” said Bryce Klempner, a partner at McKinsey and one of the authors of the report.

“Uncorrelation was a myth to begin with,” he went on. “The extent of outperformance and persistency have declined but have not disappeared. Both are still valid reasons for investors to look to PE. However, there’s another reason to be in the asset class now, which is exposure.” The number of private equity-owned companies has doubled since 10 years ago, Klempner pointed out, and the number of publicly traded companies is half that of 20 years ago. “Institutions need to be in private equity if they want exposure to growth companies, regardless of whether they can pick the top managers.”

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Private equity still has the potential to outperform, but it’s not as easy for investors to choose the top managers, as their persistence has declined, according to McKinsey’s report.

“Although persistency of outperformance by PE firms has declined over time, making it harder to consistently predict winners, new academic research suggests that greater persistency may be found at the level of individual deal partners,” the report’s authors wrote. “In buyouts, the deal decision-maker is about four times as predictive as the PE firm in explaining differences in performance.” However, the McKinsey report stressed that it is difficult for institutions to make funding decisions based on individuals.

“Most LPs think they are above average at picking the winners,” Klempner said. “But only half of them can beat the median.” As a result, many investors’ performance expectations may be too high.

Klempner explained that investor demand for broad-based exposure to private equity is what has driven fundraising and other metrics to records.

Assets in private markets increased by $700 billion in 2019, and $4 trillion over the past decade, according to McKinsey. The number of private equity firms grew in tandem, more than doubling during the time period. Meanwhile, the number of private equity-backed companies in the U.S. increased by 60 percent, according to the consulting firm.

Fundraising has also been strong. McKinsey reported that by the end of 2019, the industry had raised $919 billion, a little less than what was gathered in 2018. Despite that, 2019 was the second best year for fundraising ever, according to the report. The consulting firm expects 2020 to be another healthy year for fundraising, as large private equity firms have said they are targeting an aggregate intake of about $350 billion.

Dry powder, or cash on hand to invest, also hit records last year. Uninvested capital reached $2.3 trillion in the first half of 2019, up from $2.1 trillion the year before.

Kempner sees both fundraising and dry powder as in line with the growth of the industry overall.

“Dry powder is not just a keg of powder getting bigger,” Kempner said. “It’s inventory. When you’re a small business, you need less inventory than when you’re larger. So it’s much more about how many years of capital do you want to have on hand. If it were zero, the industry wouldn’t have any money for a rainy day. And that’s when you can buy low.”

According to the report, dry powder is at a “record in absolute terms, though the roughly two ‘turns’ of annual deal volume that this represents is within the range of historical norms.”

While institutional investors are allocating more to private equity and venture capital, McKinsey said that, compared to targets, investors are under-allocated by more than $500 billion in private equity alone.

The sizes of private market funds are growing along with the amount of assets. When it comes to buyout funds, half of the total amount of money raised in 2019 was pulled in by funds of $5 billion or more. The market share of smaller funds, those below $1 billion, is at a fifteen-year low as well.

“Yet paradoxically there is little evidence of any consolidation at the top of the industry,” the report found. “And even as the number of active PE firms continues to grow (it’s now nearly 7,000), more managers are calling it quits than ever. Most of those raised just one fund, suggesting that attrition is mainly a result of one-and-done managers.”