Is private equity still relevant for investors?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• Private equity can offer earlier investment opportunities, perhaps into promising sectors like AI or biotech, compared to doing so in public markets
• Adding private equity investments into a ‘traditional’ diversified portfolio could enhance risk-adjusted returns. However, managing risks is crucial
• Liquidity, or the need to ‘lock-up’ your funds over many years, is often seen as one of the key hurdles to overcome when investing in private markets. While illiquidity might be a barrier, it can also prevent investors from acting impulsively, and potentially harming long-term portfolio performance
• Higher interest rates in major economies and a weak economic growth outlook might raise concerns about investing in private equity. However, historically, it has performed well across economic and interest rate cycles. That said, shocks, like a surge in energy prices or a global pandemic, can still impact returns

In recent years, investors have increasingly turned to private equity to improve their portfolio’s risk-return profile and to access opportunities not found in public markets. This article examines the reasons why the asset class might appeal, despite the potential risks of ‘higher-for-longer’ interest rates and a weak economy in many regions. 

Potential return 

One of the main reasons for adding private equity to a portfolio is often an attempt to boost overall returns. Indeed, private equity (PE) can consistently outperform publicly traded equities, on a risk-adjusted basis, over the medium and long term (see chart). 

Our analysis examines the impact on risk-adjusted returns in an optimal portfolio of adding private equity to a traditional equity-bond asset mix. For a given risk level, the chart shows that investing just 10% in PE could lift portfolio returns by around 50-60 basis points. 

This in part reflects the additional compensation earned for holding illiquid assets, or the liquidity premium. On average, the enhanced return expected for investing in illiquid assets has usually been 2%-4%, as shown in Diving into private assets and the liquidity conundrum.

Impact of private equity on the efficient frontier

Efficient frontier shifts (the coloured lines) as a function of the incremental changes in private equity allocations

Fresh opportunities

As well as having less correlation to public market assets, and so being a good diversifier, private equity opens up opportunities that have limited availability in listed markets. Whether it’s an early-stage artificial intelligence company or a biotech start-up, PE can offer the most direct way to invest in news growth opportunities.

There is an element of timing too. In recent years, the time between a company starting up and its eventual public listing has significantly increased. Amazon went public just three years after its incorporation, while Meta Platforms (formerly Facebook) took eight years, and Instacart traded for 11 years before listing in 2023. 

This delay means public market investors risk getting into a stock after much of the value has been realised. In contrast, private equity investors have more time to create and maximise value, avoiding the risk of arriving late to opportunities.

Value creation levers

Private equity mangers historically have been able to generate strong returns by creating value in three distinct ways; operational improvements, multiple expansion and leverage.

One route to create value might be by improving the way a company operates, such as by identifying inefficiencies and streamlining processes. These enhancements can range from optimising supply chain logistics, to refining sales and marketing strategies. In doing so, private equity mangers could boost revenues and cut costs.

Private equity managers also create value through multiple expansion of portfolio companies. This can be achieved in strategies, often closely linked to better top-line growth and improved profitability. Managers can also boost multiples by timing their exit strategically. 

Often, another driver of value is leverage. By financing an acquisition partly through debt, a company’s return on equity can be enhanced. Since the cost of debt is typically cheaper than that of equity, leverage can offer an appealing way to enhance returns. In addition, the interest paid on debt can be tax deductible, which creates a tax shield that would further increase the cash available to pay down debt or distribute to investors.

Investing in a tougher macroeconomic environment 

Private equity investments have traditionally been known for their high leverage, leading to questions about whether the strong returns of the past decade will persist in a world of higher interest rates. While some PE-backed companies have felt the impact of higher rates recently, we believe there are several reasons why private equity remains well-positioned in the current macro environment.

First, leverage levels in private equity are not as high as they once were. Debt, as a percentage of enterprise value at acquisition for buyout deals, has decreased steadily over the last 10 years¹. In addition, consistently performing PE managers have also been much more active in capital markets management of late, further reducing reliance on leverage.

Second, with rate cuts by major central banks seemingly on the way this year and next, dealmaking conditions and financing could improve.

Finally, despite concerns over prospects for global economic growth, history suggests that private equity can produce decent returns in a variety of market conditions². However, not all funds perform equally, especially when the macroeconomic environment is as challenging, as it is today. As such, investors need to be able to identify and rely on a well-managed fund, led by experienced professionals with a proven track record.

Potential risks 

Although private equity investing can improve portfolio performance, it carries risks that need to be managed. One potential concern is the need to lock up funds for many years, posing possible liquidity challenges. However, having investments that cannot be traded easily, prevents you from selling them in a panic and harming long-term portfolio performance.

Additionally, while leverage can help to amplify returns, it also increases the potential downside risk. Prudent management of leverage and debt structures is crucial to mitigate this risk effectively. Moreover, the performance of private equity investments, just like most other asset classes, can be hit by shocks, perhaps a sudden surge in energy prices or a pandemic.

Worth a look?

Typically, private equity has helped to improve portfolio returns and add diversification benefits. Of course, history is no guarantee of future performance. 

It is important to recognise the accompanying risks of allocating funds to private equity, whether the economy is running hot or cold. Nonetheless, risks can be managed. For those able to commit their capital over many years and stomach the potential volatility, private equity can be a compelling addition to a diversified multi-asset portfolio.