Private Equity for Institutional Investors

by Karl Mergenthaler, CFA, and Chad Moten
J.P. Morgan Investment Analytics and Consulting
karl.c.mergenthaler@jpmorgan.com, chad.e.moten@jpmchase.com

Pension plans and other institutional investors are pouring money into private equity at an astounding rate. At this time, the private equity industry accounts for approximately $1.5 trillion in invested capital, and private equity firms raised $300 billion in fresh capital in 2007. Undoubtedly, there will be both winners and losers in this high-stakes, modern-day gold rush.

In our view, private equity involves a complicated risk and return proposition. Private equity investors may be attracted to the potential for impressive returns that are not highly correlated with traditional equity and fixed income investments. Skeptics point to the multiple risks due to the illiquid and opaque nature of the funds.

The J.P. Morgan Investment Analytics and Consulting group analyzed more than 5,500 private equity funds for vintage years from 1990 through 2005, including both U.S. and global funds and representing every major style. Our analysis indicates that there is a wide range of performance between top quartile and median funds among every major style. Moreover, the relative performance of private equity funds versus the public equity markets has been mixed.

In our view, institutional investors face several hurdles to investment success in private equity. Institutional investors have to identify the funds, management teams, and deal structures that are likely to result in positive results. Moreover, once attractive funds and strong managers are identified, it is often difficult to gain access to the most attractive funds. Finally, private equity partnerships typically involve annual fees of approximately 2% and carried interest of 20% of profits.

Nonetheless, investors seem willing to take their chances in this challenging asset class. According to a recent survey conducted by J.P. Morgan and Greenwich Associates, approximately 62% of current investors in private equity expect to increase their allocations in the near term. In our view, plan sponsors should only consider allocations to private equity if they believe they are able to identify, and gain access to, managers that are likely to be in the top quartile.

The Investment Case

In many ways, private equity holds the potential for huge gains. Clearly, high rates of return are possible, particularly among top-quartile funds. For example, top-quartile venture capital funds that were raised between 1993-1997 generated average internal rates of return of 52%. Likewise, buyout funds that were raised between 2001-2005 generated average internal rates of return of 40% for the top quartile. In good times, private equity can generate outstanding investment results. In Exhibit 1, we summarize recent results for private equity.

However, the risks are daunting. First, investment in private equity is illiquid, and the money is often tied up for ten years or more. Second, the funds are often highly concentrated and involve significant company-specific risks. Third, private equity funds are not transparent, and there is frequently a lack of reliable, publicly-available information. Fourth, and perhaps most importantly, there is a wide dispersion between the top performing funds and the rest of the pack.

The amount of capital raised in private equity funds has skyrocketed over the past five years. As shown in Exhibit 2, the total amount of capital raised in private equity funds increased to approximately $300 billion in 2007.

Exhibit 2: Fundraising
Source: J.P. Morgan Investment Analytics & Consulting estimates, Dow Jones Private Equity Analyst.

With the huge amount of capital raised, private equity funds are searching for new markets to deploy the cash. For example, emerging markets funds raised approximately $59 billion in 2007. In our opinion, the large inflow of capital into private equity funds begs one question: Will future results be as attractive as they have been historically?

Historical Returns – The Evidence is Mixed

Our analysis suggests that investment success in private equity is not a “lay-up.” First, there is a wide dispersion of returns for similar funds, and top quartile funds tend to perform much better than the median. Also, the relative performance of private equity and the public markets is mixed. Most importantly, our analysis suggests that the ultimate returns of private equity funds that are raised in years with high levels of fundraising are likely to be poor.

Clearly, there is a wide dispersion between top performing funds and the median. Our analysis focuses on venture capital and buyout funds, which together account for more than 80% of assets invested in private equity. In Exhibits 3 and 4, we illustrate the top quartile and median returns for venture capital and buyout funds with vintage years between 1990 and 2005.

Exhibit 3: Venture Capital
Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Intelligence.

Exhibit 4: Buyout Funds
Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Intelligence.

As indicated in Exhibit 3, top quartile venture capital funds out-performed median funds by 1,750 basis points for vintage years between 1990 and 2005. Also, top quartile buyout funds (see Exhibit 4) out-performed the median by 1,230 basis points during this time period.

The performance of private equity funds versus the public equity markets has been mixed. We compared the internal rate of return for private equity funds versus the annualized time-weighted rate of return for the Russell 2000 over comparable time periods. Although comparing results between public and private equity is problematic due to the different performance measurement methodologies, we believe the comparison is directionally correct and provides some useful information.

Exhibit 5: Venture Capital
Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Intelligence, Dow Jones Private Equity Analyst, Bloomberg.

Exhibit 6: Buyout Funds
Source: J.P. Morgan Investment Analytics & Consulting estimates, Private Equity Intelligence, Dow Jones Private Equity Analyst, Bloomberg.

As indicated in Exhibit 5, venture capital funds that were raised in the mid-1990’s posted returns in excess of the Russell 2000. In our opinion, it is likely that many ventures that were funded in the mid-1990’s were harvested in the late-1990’s technology bubble. It is interesting to note that funds raised in 1998-2002 (i.e., the strong fundraising years) produced internal rates of return that were materially lower than the public markets. In fact, based on our analysis, the median venture capital fund has under-performed the Russell 2000 for most of the past decade.

Buyout funds raised over the past decade have out-performed the Russell 2000 over the time period from 1995-2005 (see Exhibit 6). In recent years, fundraising for buyout funds sky-rocketed. Meanwhile, the differential between median buyout funds and the Russell 2000 has been declining in the most recent years.

Diversification

In order to assess the diversification benefits of private equity, we analyzed the 20-year track record of the Cambridge Venture Capital and Private Equity indices relative to several traditional and alternative asset classes. The results of our correlation analysis are summarized in Exhibit 7.

The correlation of private equity to other asset classes is low, which does indicate that there may be some diversification benefit to participating in this asset class. However, we would note that many of the correlations for other alternative assets, such as Timber and Funds of Hedge Funds, are lower than those experienced by private equity. Also, we believe the correlations may be understated due to the infrequency of reporting for private equity and use of estimates in calculating private equity returns. Therefore, diversification should not be the sole reason to invest in private equity.

Conclusions

In our view, an allocation to private equity may make sense in the context of a large institutional portfolio. However, investors in private equity should be aware of the wide dispersion in results among funds with similar strategies. In our view, the high levels of fundraising in recent years may hinder the ability of private equity firms to generate stellar results going forward.

We believe investors in private equity should take a long-term view. It may make sense to spread out capital allocations over many years to dampen the impact of fundraising cycles. We believe plan sponsors must analyze the details of any individual private equity fund, and consider how that fund is likely to perform in various market conditions. Furthermore, plan sponsors should only consider allocations to private equity if they believe they are able to identify, and gain access to, managers that are likely to be in the top quartile. In all, we believe it is worth the effort to analyze private equity funds and consider allocating a percentage of portfolio assets to this asset class.

For a copy of our complete white paper, “Private Equity for Institutional Investors”, please contact Karl Mergenthaler at karl.c.mergenthaler@jpmorgan.com.