Does private equity really outperform public equity? This is a question raised recently following an article in the Financial Times highlighting apparent short and long-term relative underperformance of private market investments.
Specifically, it focused on the State Street Private Equity Index, which tracks performance from private equity, private debt and venture capital funds. It points out the private markets index has been outpaced by the S&P 500 over one, three, five and 10-year time periods for the first time since the year 2000.
Should this finding be a concern given the trend in which more smaller investors acquire exposure to private markets? Should advisers consider these metrics a warning a fundamental shift has taken place and private equity is no longer likely to outperform?
Viewing the market through the prism of a single index obviously runs the risk of index bias or index idiosyncrasy skewing your analysis.
As always, the devil is in the detail. A glance at headline figures casts only a superficial insight on the risks and rewards of private market investing. For advisers, a more nuanced approach is needed.
Let us start with some basics. Return dispersion in private equity is much wider than in public markets.
There has always been a large gap between the best and worst performing private equity managers. Interestingly, there is evidence the gap is widening.
The end of the ultra-low interest rate era has changed the return profile of the private equity asset class.
In the past, fund sponsors could lean more heavily on financial engineering, such as leverage and multiple expansion (combining a number of assets into one whole to realise an overall valuation expansion), to drive returns. In today’s higher rates environment, those levers are less effective.
Value creation today increasingly relies on operational improvements at the portfolio level, which requires real expertise, insight and managerial skill.
These capabilities are difficult to execute and replicate, which means the relatively small number of private equity managers who excel in this area are doing well while others are struggling.
How exactly, then, are these managers able to provide outperformance? Top-quartile funds tend to have the ability to source assets at more attractive EBITDA multiples (Earnings Before Taxes, Depreciation and Amortisation — a common valuation metric) than the market average while unlocking greater value through deep operational knowhow.
This advantage often stems from a well-developed network, providing access to off-market opportunities and the ability to mobilise the right resources to help portfolio companies succeed.
Leading managers are also increasingly narrowing their focus to three or four core sectors where they can build singular insights that then lead to market-beating performance.
The firms we work with have built large teams internally or have networks of partners who purely focus on improving the performance of portfolio assets and driving long-term value creation.
These individuals are often experts in specific areas such as pricing, go-to-market strategies or cost optimisation.
Many are former CEOs who have run businesses in the same sector and may now in effect operate as a bridge between the private equity sponsor and the management team at the portfolio company.
Taking all this together, the more nuanced performance story is the fundamentals of the private equity industry have changed alongside macro and market changes, which means financial engineering can no longer be seen as a driver of returns.
In turn this means only the very best managers can be relied upon to deliver the outsized returns relative to public markets investors have come to expect from the private equity industry.
For investors, it is not simply a case of picking up an illiquidity premium from taking exposure to private equity, but rather picking up an expertise premium from taking exposure to top quartile managers.
Rigorous manager selection therefore is key. It is important to evaluate — or rather, as an adviser, find a specialist manager who can evaluate for you — general partners across multiple dimensions.
As well as looking at metrics such as total value to paid-In and distributed to paid-in capital, it is also important to have an investment framework in place that takes into account consistency across vintages, team stability, sector focus and demonstrated ability to create value beyond financial engineering.
Coming back to the State Street index, I would question its utility as a definitive performance metric for the private equity industry. Other industry indices, such as PitchBook’s North American Private Equity Index, show private equity has outperformed the US large-cap market over five, 10, 15 and 20-year time horizons.
Viewing the market through the prism of a single index obviously runs the risk of index bias or index idiosyncrasy skewing your analysis.
This aside, the useful takeaway from the returns story is the recognition that returns in the private equity space are highly dispersed.
Again, if we look at PitchBook data for North American private equity, between 2000 and 2024 the average top internal rate of return (IRR) quartile was 22.32 per cent, while the median IRR was 13.82 per cent.
With such dispersion an increasingly important aspect of the private markets business, the lesson is clear: private markets do provide outperformance versus public markets, but only in the elite funds segment, which means manager selection and access to top-quartile funds should be first-order priority for smaller investors looking to take exposure to private markets.
Steffen Pauls is founder and co-CEO of Moonfare.
