PEI Keynote Interview: The Science of Portfolio Construction

Private Equity International (PEI): How has the denominator effect impacted investors?

Bryan Jenkins (BJ): The situation is very different today than a year ago because listed assets rebounded strongly in H1 2023. Global equities are close to where they were at the market peak in 2021. But investors are still experiencing a numerator effect as unrealised valuations increased faster than expected through 2021 and have held up better than expected since.

How big an issue this presents depends on the maturity of the private equity programme and how well the LP resisted the temptation to ramp up commitments between 2016 and 2021, when it seemed as though every GP was coming back to market every 18 months.

If a younger programme based its pacing on historical data, they would have expected around 80 cents of NAV for every dollar committed. They will have been surprised when in that 2016-21 period they were getting closer to $1.20 for every dollar committed, or around $2 for every dollar if they were heavily allocated to venture capital. Any LP with significant concentration in those vintage years is likely to be a bit over their skis in terms of exposure right now.

PEI: How are LPs tackling that overexposure?

BJ: There are three broad categories. Some LPs have put their pencils down for the better part of 12 months. These are typically LPs with less flexibility in moving exposures around, or those that are newer to the asset class and haven’t experienced these NAV fluctuations before. Then there are LPs for whom the response has been to keep calm and carry on. They believe the current situation will be fleeting. They may have more flexibility around resetting allocation targets and are of the opinion that consistency is the best strategy.

The third group of investors are active managers, taking advantage of the secondaries market to shed non-core relationships to re-up with high-conviction GPs. Regardless of the approach, this has been a good time for LPs to reflect on their pacing and instil discipline in their exposure management.

PEI: How are investors thinking about allocations to the different size brackets?

BJ: This is a topic that forces itself to the front of the line every few years. This time it is because the market share that large-cap funds are taking has swelled significantly, from a 15-20 percent share of fundraising on average over the past decade to nearly 45 percent over the last few years.

Our view is that there is little evidence of diseconomies of scale on average performance. Average performance across the small buyout, mid-market and large-cap segments is similar. However, at the smaller end there is a wider dispersion of returns, which means more funds have very strong returns, but there is also a higher loss ratio. Those funds are inevitably more concentrated so that makes sense. The opposite is true of the large-cap market where there is a much tighter distribution of outcomes and where funds tend to be more diversified.

It is in the mid-market where we think the distribution of returns is most attractive. There is a lower risk of loss than at the small end of the market, but you can still capture some of that upside if you are a skilled allocator.

PEI: What role is private credit playing in portfolios today?

BJ: It’s playing a much bigger role than five or six years ago. Historically, private credit was something of an afterthought. It got lumped into private equity portfolios, which meant that to justify the allocation you had to expect to get private equity-like returns. Private credit franchises were therefore marketing distressed debt and mezzanine funds with the promise they would reach that private equity return hurdle. Whether there is a cohort of distressed debt funds that reached that bar is another matter.

Over the past seven to 10 years, however, we have seen the emergence of funds that provide debt capital higher up in the capital structure, thereby targeting lower returns than private equity but with an arguably more risk efficient profile. That type of investment has become more attractive as interest rates have risen. It is also another lever that investors can pull to customise their portfolio, particularly around the liquidity component.

The challenge continues to be deciding where this allocation should come from. Investors need to consider a dedicated allocation to private credit with a separate benchmark. Private credit is unlikely to produce equity style returns but it is a compelling alternative to traditional fixed income and can be expected to generate a premium to broadly syndicated leveraged loans or high yield.

PEI: How are LPs approaching allocations from a geographical perspective?

BJ: Some LPs have a desire to invest in their home region given the positive externalities that can bring. They may also believe they can benefit from information asymmetries when it comes to local managers. Geopolitical dynamics are another factor at play – nobody wants to be pulled in front of their congress or parliament and have their investment decisions publicly scrutinised.

Generally, the US tends to account for 65-75 percent of private markets allocations, Europe accounts for 15- 25 percent and the balance goes to Asia and other emerging markets. One thing to note, however, is that Europe has become more interesting over the past six months. While there is still some risk, economic conditions have not proved as dire as many were predicting.

Meanwhile, listed equities are trading at 20-30 percent cheaper in Europe versus the US and European LBOs are trading at similar discounts. In addition, there is historical performance data that suggests the spread of returns in European private equity relative to European listed equities is larger than is the case in the US, meaning that Europe offers better relative value, even if absolute performance in the US has tended to be a little bit higher.

PEI: How do you see private markets performing over the next few years and how is that likely to impact investor appetite?

BJ: In the short term, I think we will see a wider spread in performance among funds and deals. There may also be a brief, fleeting period where listed assets outperform unlisted assets. Volatility works in both directions – while private equity may perform better in times of stress, during that period of rebound, listed assets may briefly outperform. That is not without precedent: if you look at rolling one-year returns, public markets outperform private equity 25-30 percent of the time. That could impact short-term allocation decisions.

In the long term, I am very optimistic about appetite for the asset class. Most data and research on how private markets perform suggests that – in the long-run – private equity performance is consistently strong. Some LPs may need to recalibrate their absolute return expectations from the unrealistic bar set during 2021, where return spreads over listed assets topped 1,000 basis points and a 25 percent net IRR would have been bottom quartile. That was never sustainable. But I do believe the asset class will deliver at least a few hundred basis points over listed assets. That can be meaningful when compounded over long periods.