Understanding PE’s Current Value Proposition

Private equity has long served as the darling asset class. As commitments to the sector have increased and valuations remain frothy, some investors are contemplating whether such strategies still deliver a fair value proposition.

Understanding the illiquidity premium or value private equity investments offer in the current environment was a popular topic among speakers at NEPC’s annual conference, held in Boston on May 9 and 10.

“Private equity has become way more mainstream and way more efficient,” said Jeffrey Roberts, director of private equity research at NEPC, at a panel discussion. In many cases, managers are raising capital and hitting their hard caps, above their expected targets. “Fundraising is little bit out of control,” Roberts said.

Further, increased competition continues to intensify for both investors accessing popular funds and for managers accessing deal flows. As more money pours into the sector, concerns regarding the erosion of the illiquidity premium have percolated.

Some market practitioners and academic studies indicated that the illiquidity premium for investing in private equity should be about 3% over a public market benchmark, according to Sean Gill, partner and director of private markets research at NEPC.

Recent criticism of private equity also includes inadequate benchmarks to compare performance. For some, public market indexes may not accurately reflect the size and sector of the private investments.  Others also argue that investors were better off simply investing in the S&P 500 in the past few years, given its outperformance.

While illiquidity premium does exist over most time periods, it is not consistent, according to NEPC’s analysis. The determination of that premium also depends on the proposed benchmark. For example, for the past 10 years ending on March 31, the US Private Equity Index as measured by Cambridge Associates returned 10.7% and outperformed the S&P 500 and MSCI ACWI ex US by 2.3% and 8.8%, respectively.

In the past few years, however, public markets have offered better value. For example, since 2015, the rolling seven-year average performance of the S&P 500 outperformed median private equity returns.

Gill also indicated that despite the amount of private equity capital raised, it has been fairly consistent relative to US gross domestic product and stock market capitalization over the past 10 years.

“The theory tells us, the data tells us that there is some non-zero premium for illiquidity over time,” said Gill. “Magnitude tends to change, whichever benchmark you utilize to compare against may color your outlook, but overall consensus —  those from the academic community and practitioner community — is that private equity is accretive to the portfolios.”

Going forward, structural changes to the economy, such as rising interest rates, may affect the premium. “How much [rising interest rates] will impact that premium remains to be seen,” Gill said.