Private-equity performance has been misunderstood in some essential ways. It now seems that the private-equity industry decisively outperforms public equities with respect to risk-adjusted returns, which may prompt return-starved institutional investors to allocate even more capital to the asset class. But this good news comes with an asterisk: top private-equity firms now seem less able to produce consistently successful funds. That’s because success has become more democratic as the general level of investing skill has increased.The new priority for success is differentiated capabilities. Limited partners (those who invest in the funds raised and managed by general partners) expect funds that exploit a general partner’s distinctive strengths will do well, while more generalist approaches may be falling from favor. Institutional investors will need to get better at identifying and assessing these skills, and private-equity firms will need to look inward to better understand and capitalize on the factors that truly drive their performance.

A new understanding of an elusive industry

Private equity has grown from the equivalent of 1.5 percent of global stock-market capitalization in 2000 to about 3.9 percent in 2012. Along the way it has boomed and busted alongside public markets, while inexorably taking additional share. At the same time, many have observed that private equity—though ostensibly an “alternative” asset class—has in two ways drifted toward the mainstream. Several researchers concluded in the mid-2000s that, on average, buyout funds underperformed the S&P 500 on a risk-adjusted basis; only about a quarter of firms consistently beat the index. Other research has found that private-equity returns have become highly correlated with public markets.

As the perception of private equity’s differentiation has waned, the fees that the industry charges investors, already under pressure, have come to seem especially exorbitant to some. And as firms have come under fire for some of their practices, they have not always done a good job of explaining their role to the public.

These are serious challenges but, if returns are only average, none of the rest matters very much. Private-equity returns are, however, notoriously difficult to calculate. By and large, the industry does not publish its results; the data that are available can be inconsistent and hard to reconcile, as both private-equity firms and their limited partners use diverse approaches for their calculations. Making things more difficult, a database on which researchers have relied turns out to have had serious methodological issues.

Encouragingly, new research based on more recent and more stable data suggests that private-equity returns have been much better than previously supposed, though top firms’ performance is now somewhat less consistent. The conventional wisdom on returns stems from analyses of funds raised in 1995 and earlier. In January 2011, McKinsey developed an analysis for the World Economic Forum in which we found that funds created since 1995 appear to have meaningfully outperformed the S&P 500 index, even on a leverage-adjusted basis (Exhibit 1). Two academic teams have since reached similar conclusions.1 Both find that over the long term, private-equity returns have outstripped the public market index by at least 300 basis points.

Read more: http://www.mckinsey.com/insights/financial_services/Private_equity_Changing_perceptions_and_new_realities?cid=other-eml-alt-mip-mck-oth-1404

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