With fundraising by private equity funds hovering near all-time highs for the past several years, many institutional investors have been asking whether there is a bubble in private equity as an asset class.
University of Chicago Booth School of Business Professor Steven N. Kaplan, one of the world’s foremost experts in researching the performance of private equity and venture capital, addressed this question in his keynote address at the Chartered Alternative Investment Analyst (CAIA) Association’s annual awards ceremony on November 9.
“Where are we in the cycle? Not a great place,” Kaplan said, citing the fact that private equity returns tend to be lower in years with high levels of capital commitments, as well as the rising leverage levels and valuations for buy-outs. “Are we in a bubble? I would say, no, because … a bubble basically means that expected returns are negative, and I don’t think that expected returns are negative.”
See the slides from Prof. Kaplan’s presentation: “Past, Present, and Future of Private Equity: Is there a Bubble Brewing?”
Private Equity’s Waning Outperformance
In 2005, Kaplan along with Massachusetts Institute of Technology Professor Antoinette Schoar developed the Kaplan Schoar Public Market Equivalent (PME), which measures the performance of private equity funds relative to the S&P 500. A score greater than 1.0 means that private equity funds of a given vintage have outperformed the S&P 500. Kaplan said that for funds raised between 1996 and 2005, the PME was greater than 1.2 in most years, which means that private equity funds of those vintages generally have outperformed public equity by four or five percentage points a year.
But since 2006, the gap between private equity and public equity performance has narrowed significantly, with PMEs generally ranging between 1.0 and 1.1. Kaplan, however, was quick to point out that although private equity’s relative outperformance has decreased over the past 11 years, there have been only two years when private equity underperformed public equity.
“Bottom line: this is not a time when I would raise my commitments to private equity,” Kaplan said. “But would I get out of private equity altogether? Probably not because it’s not obvious that (private equity will fare) worse than public equity; it’s just a tough environment for investing.”
In addition to discussing his research into the performance of private equity, Kaplan also shared his findings related to the persistence of performance among managers. Surprisingly, this research found that managers whose previous fund ranked in the second quartile of performance actually outperformed, in terms of subsequent funds, managers whose previous fund was in the top quartile.
“The bad news is that you can’t just pick out top-quartile funds,” Kaplan said. “The good news is that you actually have to think and figure out who is going to do well.”
Venture Capital Shows Greater Persistence and Less Oversupply
Kaplan said that persistence trends are much stronger when it comes to venture capital funds. A venture manager’s second-previous (i.e., the fund before the most recent one) is very predictive of a new fund’s future performance. “Venture is easier in the sense that you can identify who is good,” Kaplan said. “It’s harder in the sense that you probably can’t invest in them because everyone else wants to.”
Unlike with private equity fundraising, commitments to venture funds over the last five years have been slightly below historical averages. “If you are looking for where to invest, I would say that VC has less of an oversupply of capital than private equity.”
Over the past two years, Yale University’s endowment fund, led by Chief Investment Officer David Swensen, has lowered its allocation to private equity from 16% to 14% while increasing its allocation to venture capital from 14% to 17% over that span, Kaplan said. With more than $25 billion at the end of 2016, Yale’s endowment is the second-largest among U.S. universities, behind Harvard. “For what it’s worth, David Swensen and I agree. Whether we are right or not, who knows? At least we agree.”
What This Means for Your Financial Communications and Marketing
Given all of the talk among the institutional investor community about private equity entering into bubble territory, it’s natural that your clients are beginning to wonder whether to adjust their allocations to the asset class. If you are a private equity manager, rather than hiding from these potential concerns, you should address them head-on in your quarterly investor letters, pitch books, and other marketing communications.
You can point out that while Kaplan’s research shows that private equity returns are cyclical, Kaplan emphasized that even in periods of robust fundraising, like we are experiencing now, private equity has still outperformed public equity in most years. Also, you can highlight that Kaplan’s research shows how picking funds based only on past performance isn’t a smart approach when it comes to private equity. Rather, investors needs to dig deep to understand a fund’s investment thesis for specific sectors or assets. This is where writing white papers, blogs, and other thought-leadership pieces is so useful because this type of content gives you a forum to articulate your investment thesis.
If you are marketing venture capital funds, Kaplan’s research should be a tailwind for your fundraising efforts. In your pitch books or letters to potential investors, you may want to point out that venture capital seems to be at an attractive place in the market cycle—particularly relative to private equity and public equity—and that Yale University has increased its allocation to venture capital over the last two years.
Whether you work in private equity, venture capital, or another alternative asset class, I’m happy to help you brainstorm ideas about how you can address trends related to fundraising, performance, and persistence in your marketing communications. Don’t hesitate to reach out if you would like to discuss these opportunities.
About the Author
Scott Wentworth is the founder and head financial writer at Wentworth Financial Communications. Scott and the team of writers and editors at WFC help professionals across the financial services industry build their brands by creating investment-grade white papers, bylined articles, newsletters, blogs, social media posts, and other forms of content marketing.