The evolving role of private equity in diversified portfolios

As private equity sees another round of increased investor interest, it is worth considering its role in today’s diversified portfolio. Investors have historically regarded private company exposure as a high-returning and diversifying asset class of its own – one which has outperformed public markets over the past decades while reducing volatility – an enhancement to the traditional 60/40 portfolio.

This has certainly been true in the past,¹ but what about the future?

Figure 1: Historical analysis of adding private equity in a portfolio between 2004 and 1Q 2024

Private equity’s outpacing of public markets is a complicated story, most evident by asking “what is a public company?”

Historically, it has been a business of considerable scale, with a professional management team, experienced shareholders, and which is held to exacting standards of accounting and public disclosure. How does this hold up in 2024?

Private equity-backed companies are larger than ever, as more companies elect to remain private beyond the point where they would previously have gone public. Of companies with revenue over USD 100 million, Bain & Company notes that only 15% are publicly held.² In many ways private equity has taken the place that publicly traded small-cap equity used to occupy, but there are material differences.

Figure 2: Number of US private equity-backed companies versus domestic listed firms on NYSE and Nasdaq

Private equity firms, as compared to the typical small-cap investor, are highly specialized and operationally focused. More importantly, they have control in the form of majority ownership which enables absolute discretion over the operating decisions of a portfolio company. This includes the selection of the management team; when private equity investors lose money, they do not ask what the management team did wrong – they ask what the private equity firm did wrong.

The average private equity owner is significantly more sophisticated than the average small-cap management team when it comes to financial engineering (usually generating a gain, but sometimes a painful loss).

Two more closely related aspects of private companies complicate the picture.

Public companies are required to report quarterly earnings, greatly increasing shareholder visibility into company performance, which cuts two ways. This is one of the greatest transparencies available to investors, which means quarterly earnings can become the primary focus of even a sophisticated and experienced management team. Most people agree that many important decisions should not be measured in quarters, a fact often sidelined when investing in public companies. Freedom from managing to quarterly earnings is a fundamental differentiating factor as compared to public companies.

There is another, less glamorous possibility for the seemingly more stable and more attractive return profile of private companies.

If strict quarterly reporting standards result in a myopic focus on short-term performance, their absence can sometimes be to investors’ detriment and allow sponsors to hide behind opaque internal practices. Valuation methodologies for privately held companies can vary considerably between managers, and auditors allow significant discretion. The most proximate valuation metric is (ironically) public-company-comparables, the valuations at which listed companies tend to trade.

One particularly timely example in which investors may have a false sense of security is when smoothing effects obscure volatile performance. To take an obvious case, when a private equity portfolio contains a publicly traded position, the fund in almost every case has to take the public mark for its valuation. But a stock which loses and then regains value from one quarter-end to the next appears perfectly stable, where the same investor may perceive it as risky if they saw the daily performance.

Many factors behind valuing private companies can contribute to this return smoothing. The peer set can change (or be changed). The valuation multiple may be an average of several quarters, making it slower to reflect a new market reality. These effects can cause an investor to believe that its portfolio has a certain value even when that value could be predicted to be lost in the future – something which is not possible in public markets.

And some academic studies have tried to correct for such effects, finding that while there is some smoothing, private equity returns are still distinct from public markets.³

The fact that exposure can be tailored within a private equity allocation allows investors to configure their portfolio in such a way that reduces this effect further. While a mega-cap private equity fund likely mirrors public markets more closely, lower middle-market funds invest in small companies which have very different profiles than today’s large-cap dominated equity markets.

Venture capital (often also a part of the private equity allocation) is more distinct still. If public equity is the best way to bet on today’s winners, lower middle-market private equity and venture capital are the avenue by which to back their challengers.

Another important distinction is the lack of passive-investment options the way public markets have index funds.

This feature means manager selection, differing value creation abilities, and fund strategy are unique opportunities and risks to the private equity portfolio.

Figure 3: Difference between top and bottom quartile managers (%)

The attractions of private equity have caused more investors to add exposure to their portfolios. Long dominated by the world’s most sophisticated investors, such longtime backers continue to increase allocations.

Figure 4: Change in private equity allocation, 2019 vs. 2023

But the asset class is also becoming more mainstream; with retail investor access to alternatives proliferating, institutional investors of all stripes have indicated they plan to increase their allocations, including to private equity.⁴

One reason for that may be the manager selection benefits already mentioned. At top quartile, the return potential of private equity (buyout and venture capital) is attractive. Combined with the active management component of private equity portfolios, and overlaid with the active management of portfolio companies, this outperformance and return profile can seem tangible and repeatable in the eyes of investors.

While private equity may not offer a public equity-based portfolio the same fundamental level of diversification that you would expect from fixed income or real assets, investors are recognizing the distinct value and return profile it brings to a portfolio. Little wonder investors are full speed ahead on private equity.

¹ “A portfolio of 40% global equities, 40% US bonds and 20% alternatives would have returned an annualized 6.9% with 8.3% reported volatility. By comparison, a traditional 60% global equities and 40% bonds mix would have generated 6.1% return with 10.6% reported volatility.” UBS CIO GWM, Quarterly private markets update, September 2024.
² Bain Global Private Equity Report 2023.
³ The Private Equity Conundrum: Reconciling Private and Public Equity Risk/return Profiles, State Street Global Advisors, August 2019
⁴ Bain Global Private Equity Report 2024, Nuveen Institutional Investor Survey 2024, UBS Global Family Office Report 2024