Private-equity premium has been an intriguing topic for many investors. Where does private-equity premium come from? Can private-equity performance be reproduced by leveraging up public-equity investments? What is the outlook of private-equity performance given that cheap borrowing is not expected to return in the foreseeable future? These questions are challenging to answer due to the lack of both data transparency and tools to identify the drivers of private equity’s active performance and quantify their impact. But the answers can provide insights into the performance of the asset class and help investors understand general partners’ asset-management skills and make informed allocation and manager-selection decisions. To provide insights into private-asset performance, we examined the active performance of U.S. buyout funds over U.S. small-cap public equity by vintage years, using the newly designed MSCI Private Asset Performance Attribution methodology.
Possible drivers of US buyout funds’ outperformance
First, the sector allocation of a buyout fund and small-cap benchmark can vary. Buyout investment is heavily concentrated in specific sectors, such as information technology, health care, industrials and consumer discretionary.[1] Second, buyout funds and small caps may use different amounts of leverage to finance investments and operations. Acting as a multiplier on unleveraged returns, leverage can be an important source of active returns. Note that buyout funds’ leverage includes not only debt financing used by buyout companies, but short- and long-term financing through subscription lines of credit, net-asset-value lines and term loans, which can further impact a fund’s internal rate of return (IRR). Third, buyout and public small-cap companies in the same sector may experience a varying degree of fundamental growth and multiple expansion. Buyout general partners (GPs) pride themselves on buying undervalued companies and improving the company’s value through operational enhancement, effective sales and marketing, efficient financial management, etc. These types of active management could lead to a significant boost in a company’s revenue, profit margin and/or multiples. Last, since buyout-fund performance is measured net of fees, fees and carry can lead to additional discrepancies between buyout-fund and public-company equity returns.
To quantify the performance impact of these drivers, we constructed three hypothetical benchmark portfolios: a baseline U.S. small-cap portfolio, an allocation portfolio and a leverage portfolio.
- The baseline portfolio captures public small-cap performance measured in IRR.[2] The difference between buyout-fund IRR[3] and the baseline portfolio’s IRR is the total active performance.
- The allocation portfolio earns the returns of public small-cap companies but reweights so that it has the same sector allocation as U.S. buyout funds.[4] This portfolio differs from the baseline benchmark portfolio only by sector allocation; therefore, their IRR difference can be attributed to buyout-fund sector allocation.
- The leverage portfolio takes the sector-reweighted allocation portfolio, and adjusts its return based on buyout leverage[5]. The leverage portfolio differs from the allocation portfolio only by leverage. For that reason, their IRR difference can be attributed to buyout funds’ active leverage.
- Last, we attribute the residual IRR — the difference between a buyout fund and the leverage portfolio — to active value creation net of fees.[6]
Using the 2012 vintage year as an example, the exhibit below shows that the small-cap benchmark had an IRR of 10.94% while buyout funds had an IRR of 18.40%, leading to a total active IRR of 7.46%. Both active leverage and value creation net of fees contributed significantly to buyout’s active IRR, 2.08% and 4.91% respectively.
Performance attribution for 2012-vintage US buyout funds
One important finding in our attribution study is that the buyout funds’ active performance from allocation, leverage and value creation net of fees has changed significantly over time. In the exhibit below, we examined the performance of U.S. buyout funds from vintages 2008 to 2019. Active IRR is positive for all vintages except 2008 and has trended up. The upward trend was mainly driven by active value creation net of fees, which has increased from -5% among vintage 2008 funds to 10-15% in recent vintage years. In contrast, performance from active leverage has gradually come down from as high as 5% in vintage 2009 to -1% in recent vintage years.[7] In addition, on average, active allocation has contributed a very small amount to buyout premium.
Performance attribution of US buyout funds by vintage
As we have shifted away from a low-interest-rate regime, some investors have expressed concerns over private equity’s future performance. MSCI Private Asset Performance Attribution research shows that value creation has overtaken leverage and become the dominating driver of buyout funds’ active performance. Therefore, higher interest rates may not significantly hinder buyout performance. However, performance can differ substantially across funds. Investors may want to examine their own buyout performances to better understand their buyout funds’ resilience and value-generating potential.