Key points:
- Private equity consistently outperformed listed markets during the largest market crises of the past 25 years
- During the past 25 years, the outperformance from private markets was twice as high during crises relative to undisturbed periods
- Distributions, a key concern for LPs, became less volatile during recent crises
- Structural, fundamental and technical factors explain private equity’s outperformance
- To navigate future crises, investors should consider diversifying within private equity and beware of boom-bust cycles
- To read more, click here: Private equity’s resilience during major crises: a 25-year analysis
Over the last four years, financial markets have been subject to a series of shocks that have had far-reaching implications. From the global pandemic and subsequent shutdown of major economies to recent geopolitical tensions, the market environment has been rife with uncertainty.
Adding to the complexity, record inflation and one of the fastest rate-hiking cycles in four decades have further challenged investors and businesses. Amidst this turbulence, private equity still managed to deliver impressive absolute and relative performance. Amidst this turbulence, private equity still managed to deliver impressive absolute and relative performance.
Has private equity simply been fortunate during this recent period, or has its success extended to other crises? Using volatility as a heuristic, the past 25 years saw five major financial crises: the Dotcom Crash, the Global Financial Crisis (GFC), the Eurozone Crisis, the COVID-19 Outbreak, and the Return of Inflation. Among these crises, the GFC stands out as the most severe, with volatility peaking at nearly 80% and remaining at elevated levels for over a year. While the COVID-19 pandemic induced considerable volatility, swift government and central bank interventions resulted in a relatively brief spike in market turbulence.
Global private equity outperformed the MSCI ACWI Gross Index during each of the major disruptions with an average annualized excess return of 8%. Even in the depths of the Dotcom Crash, where private equity was challenged due to its exposure to early-stage technology companies at the heart of the bubble, it still fared better than public markets. Amidst the uncertainty surrounding COVID-19, private equity achieved annualized returns of 18%, while public markets delivered only a 2% return.
When comparing performance to the S&P 500 Total Return Index, global private equity has also consistently outperformed during all five crises, with an average outperformance of 4%.
Throughout these crises, private equity investors also experienced less volatility in performance. The maximum quarterly drawdown during the five periods averaged -18% compared to the -31% drawdown of the MSCI ACWI Gross Index.
Any comparison of public and private equity returns is influenced by valuation methodologies, as there is often a lag before private equity valuations are updated. Based on our research, private equity valuations experience a one-quarter lag to public markets. To account for this, we have extended the returns calculation window by an additional quarter. Furthermore, while valuation methodologies do contribute to these results, there are also underlying structural and fundamental factors that contribute to the observed performance differential. These factors will be further elaborated upon later.
It should also be noted that the private equity industry changed considerably from the Dotcom Crash in the early 2000s to the recent Return of Inflation in 2022 in terms of regulatory and accounting considerations, which could impact historical comparisons. The GFC served as a catalyst for introducing more rigorous fair value assessment practices, potentially resulting in private equity valuations having had less frequent mark-to-market assessments prior to that period. While the reliability of private equity outperformance during the Dotcom Crash and GFC may be affected, the greatest outperformance occurred in the crises following the GFC.
LP distributions have improved and become less volatile during recent crises
In today’s exit environment, distributions are a key focus for limited partners (LPs). However, a look back over the past 25 years offers optimism. Quarterly distributions are currently close to 10% of net asset value, which is half the long-term average. By comparison, they were just 5% during the Dotcom Crash and GFC.
Furthermore, the volatility of distributions has decreased since the GFC. This improvement may be due to funds becoming more diversified and improved risk management practices.
Additionally, new exit routes have emerged. Over the last 5-10 years, continuation funds have evolved to become a common strategy for General Partners (GPs) to hold onto high-performing assets or pools of assets beyond the life of the original fund. This provides existing investors with a liquidity option while minimizing disruption to ownership. Moreover, holding onto assets for a longer investment horizon allows for better timing of exits based on market conditions, helping to stabilize distribution rates.
Click here to read more about continuation funds: Continuation funds: What are they, and why now?
Global private equity has delivered a compound annual return of 12% over the last 25 years, outperforming the MSCI ACWI Gross, MSCI World Gross, and S&P 500 Total Return indices. The key driver behind this outperformance has been the resilience of private equity during crises. Private equity delivered an annualized excess return of 8% during the five crises and half this during undisturbed periods.
These results are driven by structural, fundamental, and technical factors specific to private equity
A typical private equity fund structure has locked-in capital, providing GPs with a stable and predictable pool of capital. GPs are not forced to sell assets in down markets and can call capital to invest at lower valuations. There is also alignment of interests through performance-based compensation at both the GP and portfolio company levels.
Furthermore, private equity firms typically target less cyclical industries such as healthcare, business services, and technology, while limiting exposure to banks and heavy industry. They favor less volatile cash-generating recurring revenue business models.
Finally, the nature of private equity returns, which partly reflect unrealized gains, contributes to less volatile reported returns. These unrealized gains are based on changes in portfolio valuations and are guided by fair-value accounting. Post-reporting period developments can influence these valuations, as firms may incorporate recent positive events into their assessments. This can lead to valuation biases, resulting in smoother reported returns.
During all disruptions except the Eurozone Crisis, private equity performance varied strongly between strategies and regions. Interestingly, all private equity strategies performed consistently well during the Eurozone Crisis, including in Europe. However, in each of the other crises, diversification was key to achieving resilient returns. Furthermore, small/mid buyouts were the best performing strategy or among the best performing strategies in four of the five crises.
Four of the five disruptions were characterized by boom-bust scenarios. Venture Capital (VC)/Growth was the best performing strategy throughout the Dotcom bubble ahead of the crash. However, after the collapse in technology valuations, it became the worst performing strategy by the end of the disruption.
Similarly, in the lead up to the GFC, buyout funds raised substantial amounts of capital, and many small/mid funds ballooned into large funds. However, when liquidity dried up, large buyout funds with highly levered portfolio companies experienced significant drawdowns and negative returns.
To read the full whitepaper, click here: Private equity’s resilience during major crises: a 25-year analysis
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