In the last couple of years, you would have been hard-pressed to find a market participant who did not say that they were expecting the market cycle to turn soon – though perhaps nobody anticipated the nature of the events that have played out during the first quarter of 2020. In this note we look at how private markets’ performance has varied across prior cycles, including the significant changes in performance dispersion across different periods. We will return to some of these themes in more detail in future notes.

Whilst not the focus of this note, on most measures private equity has delivered consistently strong performance across vintage years both relative to public markets and on an absolute basis. In the current market environment, what is of more interest is the variation of vintage performance in relation to the two most recent major global economic cycles; the “Dot Com” bubble of the early 2000s, and the global financial crisis of 2008 (the “GFC”).

The chart below shows the performance of private equity funds on a global basis by vintage year. Of course, given the drawdown nature of private markets funds, a private equity fund would typically be making acquisitions across the 3-5 year period following its close – i.e. a 2005 vintage fund would have typically deployed capital over the period 2005 – 2008.

Truffle notes the following key trends from this data set;

  • The longest period of sustained lower returns has occurred across 2004 – 2007 vintage funds. These funds deployed all, or a significant proportion of, their capital in the run up to the 2008 GFC; buying businesses at high valuations and often with high levels of leverage. It is, therefore, reasonable to expect that recent vintage funds will face an uphill struggle to deliver the same level of performance as vintages from earlier in the current cycle.
  • 2008 vintage funds experienced returns around the centre of the range over the analysed period (2008 vintage median performance of 12% is in line with the vintage average over the period, and top quartile performance of 17% is slightly below the average of 19%). Whilst this is arguably impressive performance given the economic backdrop at the time, a recent report from EY found that private equity funds were hesitant to deploy capital in the aftermath of the GFC, commenting that “In hindsight, the industry missed a significant opportunity to acquire high-quality assets at deep discounts”. If fund managers view this as a “lesson learned” from 2008, then it is possible that 2020 vintage funds could stand to perform even better than their 2008 counterparts.

Source: Pitchbook. Performance represents the median and upper quartile global private equity performance by vintage, as of Q3 2019. Reflects net IRR to LPs.

Truffle has also looked at how the dispersion of private equity returns has varied by vintage year, overlaying the Dot Com and GFC periods. Truffle notes that the vintages since 2000 break down into three groups;

  1. 2000 – 2004 vintages, with very high levels of performance dispersion (average 16%);
  2. 2005 – 2018 vintages, with low performance dispersion (average just 9%); and
  3. 2009 – 2016 vintages, which have seen a return of moderately higher levels of dispersion (average 13%, or 12% if you exclude 2016), though, 2016 aside, not matching the pre-GFC period.

Whilst these trends would have been driven by a range of factors, Truffle expects the following to have been key contributors;

  • Pre-2008 private equity investing was arguably more focused on financial engineering than operational value-add. Given the prevailing context of high valuations and readily available financing in the 2005 – 2008 period, managers of these fund vintages were increasingly doing the same thing; buying companies at high valuations and applying significant leverage. It is no surprise that in this context return dispersion compressed for these vintages.
  • Since 2008, the private equity industry has evolved its approach bringing value creation strategies to the fore. This is not to say leverage is no longer a factor. With leverage levels over the past few years hovering around the pre-GFC peak, it is still very much present. However it is not the only factor, with the asset selection and value-add capabilities of funds becoming increasingly relevant, and driving differing return outcomes.

In aggregate, it would appear that the adage “a rising tide lifts all boats” does not apply equally to private equity – indeed, the reverse would be closer to the mark. We await with interest the impact of the current correction on the performance dispersion of recent vintages.

Source: Pitchbook. Performance represents the median and upper quartile global private equity performance by vintage, as of Q3 2019. Reflects net IRR to LPs.

Conclusions

If history were to repeat itself then you might expect that recent year vintage funds would experience lower returns, as the impact of the current economic disruption effects portfolio company cash flow directly and the wider market environment restricts exit activity.

In contrast, 2020 vintage funds and those raised in the coming year or two, are likely to be investing into a significantly lower priced environment and consequently may prove to be very strong vintages. It is worth noting though that the level of dry powder in the market today is approximately 2x that at the time of the GFC – so, if transaction volumes remain suppressed for a significant period, it is possible that there will be a large volume of capital chasing a small number of deals.

Finally, history suggests that over the next vintage year or two, dispersion in manager returns may increase. The implies that manager selection will be as important as ever in determining the overall performance of a private markets portfolio. We will return to this theme in a future brief, looking at some of the key due diligence themes at this point in a market cycle.