Morningstar - Q2 2022 - 34

Spotlight: Public/Private Markets
Does Your Portfolio Need Private Equity?
Despite the potential for higher
returns, the investment case is mixed.
Amy C. Arnott
PORTFOLIO
Private equity has been a hot topic lately. Many
institutional investors expect lower returns
from traditional stocks and bonds over the next
10 to 20 years and are looking further afield
to help fill the gap. There's some evidence that
private equity can provide higher returns,
but for most individual investors, the negatives
probably outweigh the positives.
Hunting Ground for Returns
Private equity-a broad category that includes
buyout funds, venture capital, and growth
equity assets that don't trade on an exchange and
aren't SEC-registered-is a popular hunting
ground in the search for higher returns.
For example, the California Public Employees'
Retirement System recently raised its private
equity allocation target to 13% of assets
from 8%. Many other state and local pension
funds have made similar increases.
Another reason behind the growing interest:
Companies are remaining private longer.
The number of publicly traded companies in the
U.S. has significantly declined over the past
couple of decades. Meanwhile, as my colleague
Dan Lefkovitz mentioned in the previous article,
the private market is home to about 1,000
unicorns-companies valued at $1 billion or more.
In addition, the U.S. Department of Labor issued
a June 2020 information letter indicating that
defined-contribution plans can offer private equity
1 Steve Kaplan is a member of Morningstar's board of directors.
34
Morningstar Q2 2022
as an investment option as long as it's part of
a broadly diversified and professionally managed
portfolio, such as a target-date, target-risk, or
balanced fund. (It later clarified that private equity
may not be suitable for smaller plans that lack
the resources needed to evaluate private equity.)
Meanwhile, the lines are blurring between venture
funds and private equity specialists on the
one hand and traditional asset-management firms
on the other. Sequoia Capital, one of the largest
and most successful venture capital firms,
recently announced that it plans to restructure its
operations to launch an open-end fund and
become a Registered Investment Advisor. On the
other end of the spectrum, Vanguard recently
expanded its partnership with HarbourVest to give
some of its clients the option of investing in private
equity, as long as they meet the requirements for
being both a qualified and an accredited investor.
Are Returns Really Higher?
As shown in EXHIBIT 1 , institutional investors
have high expectations for private equity returns.
Based on the Horizon Actuarial 2021 Survey of
Capital Market Assumptions, return expectations
for private equity over the next 10 years (averaging
8.8% annualized) are higher than for any other
major asset class. Whether returns will meet those
expectations is an open question.
For one thing, measuring returns for private equity
is not straightforward. Private equity funds
typically report returns using an internal-rate-ofreturn
calculation that incorporates the beginning
and ending values of the fund as well as
interim cash flows. One drawback to this method
is that it assumes investors can reinvest
any interim cash flows at the same rate of return,
which is usually not the case. In contrast to
total-return calculations that are compliant with
global investment performance standards, internal
rate of return does not have a single standard
calculation method and can also be subject to
manipulation by " gaming " the timing of cash flows.
In addition, reported IRR figures are subject to
reporting lags due to the manual process
of determining valuations on private companies,
making it difficult to compare private-market
assets and other parts of a portfolio in a timely
fashion. Since late 2008, the Financial Accounting
Standards Board has required private equity
firms to value their assets at fair market
value each quarter. However, this still takes time,
with reports usually coming out more than a
month after quarter-end. On the venture capital
side, IRR measures can also be heavily influenced
by valuation levels at the time of exit.
Many venture-funded firms were able to exit
at steep valuations during 2020 and 2021,
contributing to eye-catching recent returns for
venture capital funds.
To address some of the shortcomings of IRR,
academic researchers Steve Kaplan1
and
Antoinette Schoar developed an alternative
measure known as public-market equivalent
returns in 2005. The PME uses the total
return of the S&P 500 as a discount rate for all
cash inflows and outflows and measures the
fund's net lifetime return relative to that
of the S&P 500. For example, a PME of 1.2
would indicate that the fund outperformed the
benchmark by 20% on a cash basis (not
annualized), while a PME of 0.95 would indicate
that it underperformed by 5%. Some
researchers have also adapted the PME measure
to incorporate other market benchmarks.
With those limitations as a caveat, there's
some evidence of above-average performance
for private equity (EXHIBIT 2 ). PitchBook, a
Morningstar company that tracks private markets,
estimates that PME returns for private equity
https://www.morningstar.com/authors/2350/amy-c-arnott
Morningstar - Q2 2022

Table of Contents for the Digital Edition of Morningstar - Q2 2022
