Private Equity Falling Short of Expectations?
The New York State Teachers’ Retirement System has made a bevy of new commitments to private equity, an asset class where the pension fund has recently underperformed.I read this article last week on LinkedIn and the first thing that I thought of is NYSTRS's benchmark for private equity -- S&P 500 + 500 basis points (5%) -- is simply ridiculous and unbeatable in this environment where the Fed and other central banks are pumping billions into the financial system and algorithmic traders are ramping up stocks like Tesla (TSLA) to new record parabolic highs despite fears of a global pandemic:
Documents from NYSTRS’ Wednesday investment committee meeting show that the retirement system’s private equity portfolio lagged its benchmarks for the three-, five-, and ten-year periods ending on September 30, 2019 — despite slightly beating expectations over the 12-month period.
The results mark a continuation of the underperformance reported by the pension fund at its October committee meeting, which addressed private equity returns for the period ending June 30. At that time, NYSTRS said that its 12-month return through mid-2019 was 12.1 percent, below its benchmark of 15.4 percent. The pension fund judges private equity returns against the performance of Standard & Poor’s 500 index plus five percent.
According to Wednesday’s meeting materials, NYSTRS’ private equity portfolio returned 9.9 percent over the year ending September 30, beating a benchmark of 9.3 percent. Meanwhile, the private equity portfolio’s three-year return trailed expectations, measuring at 14.7 percent, as compared to the benchmark return of 18.4 percent. Similarly, five- and ten-year returns of 13.9 percent and 14.2 percent came in below benchmark returns of 15.8 percent and 18.2 percent, respectively.
NYSTRS has a total of $21.6 billion in active commitments to private equity, according to the meeting documents.
The documents also show that the pension fund closed on eight new private equity investments between October 1 and December 31.
These included a commitment of up to $150 million to MBK Partners Fund V, a large-cap buyout fund targeting investments in media, financial services, and retail companies in Korea, Japan, and Greater China. NYSTRS also committed up to $150 million to the fifth fund raised by Valor Equity Partners, a growth investment firm that focuses on tech-related companies. Another $150 million maximum was dedicated to the retirement system’s coinvested fund with HarbourVest Partners.
In addition, NYSTRS committed up to $200 million each to a separate account with Abbott Capital Partners and Clearlake Capital Partners’ sixth vehicle, a middle-market buyout fund focused on industrials, energy, tech, and software companies.
Other new private equity investments included commitments to two funds at EIV Capital, a Houston-based private equity firm that invests in the energy industry, and a commitment of up to $100 million to the Cortec Group’s seventh fund, which focuses on middle-market leveraged buyout opportunities.
But apart from that benchmark issue and the algorithmic trading folly in these liquidity-driven markets, it also shows you that fund investing in private equity isn't what it used to be and that pension funds which rely primarily on funds (and not co-investments with GPs or purely direct investments) are in big trouble because they will fall short of their return expectations in this critically important asset class.
Indeed, there seems to be trouble in private equity land as GPs find it harder and harder to keep up with soaring stock markets.
Andrew Bary of Barron's recently reported how Blackstone's marquee corporate private-equity funds lagged far behind the S&P 500 index during 2019, an indication that the large size of the firm’s portfolio and challenging investment conditions may be weighing on results:
Blackstone’s (ticker: BX) corporate private-equity funds had gross returns of 9.3% in 2019, way behind the S&P 500’s total return of 31.5%, and down from 19.1% in 2018, when the funds handily topped the S&P’s negative 4.4% return. The 2019 returns were reported in the firm’s fourth-quarter earnings report earlier Thursday.Blackstone's private equity funds might not be performing up to historical standards but the stock is on a tear over the past year as investors keep plowing billions to the alternatives firm:
Blackstone, the industry leader, didn’t provide net returns after fees, which can run at around 2% annually plus 20% of profits industry-wide.
The firm now manages $90 billion of corporate private-equity investments in 94 portfolio companies. The private-equity industry is sitting on a massive amount of uninvested capital or “dry powder.” Competition for new deals remains intense, with transaction prices at or near record levels. All this acts as a damper on returns.
On Blackstone’s earnings conference call earlier Thursday, Jonathan Gray, the firm’s president, said that “opportunities for continued growth, even in a challenging investment environment, are significant.” Gray noted on the call that Blackstone historically has generated 15% net annual returns in private equity.
On the call, the company’s chief financial officer, Michael Chae, referred to declines in “two public positions” as a reason for a lackluster 1.5% return on the private-equity funds in the fourth quarter, when the S&P 500 returned 9%. Excluding those two holdings, the appreciation was 4.7%.
One of those losing fourth-quarter positions could be Cheniere Energy Partners (CQP), whose units fell 12% during the fourth quarter. Cheniere operates a large liquefied natural gas, or LNG, facility in Louisiana that is a major exporter of LNG. Cheniere is Blackstone’s largest public equity investment at $8 billion, followed by Gates Industrial (GTES) at around $3 billion. LNG prices are weakening globally.
Cheniere returned more than 16% last year while Gates, a maker of auto parts, returned about 4%. Blackstone had no comment on the private-equity returns, but the firm has emphasized in the past that returns should be evaluated over a multiyear period.
Blackstone scored in 2019 when the London Stock Exchange agreed to buy Refinitiv, which was owned by a Blackstone-led consortium and Thomson Reuters, for $27 billion.
Blackstone continued to deploy considerable cash in new private-equity deals last year. It was part of a consortium of investors that bought Merlin Entertainments, a U.K. theme-park operator, for about $7.5 billion in late 2019.
Blackstone’s distressed-debt returns were weak last year at negative 4.4%, while the firm’s core-plus real-estate funds returned 9.2% on a gross basis.
Blackstone, the largest manager of private-equity and other alternative assets, reported fourth-quarter distributable earnings of 72 cents, up 26% from the year-earlier period. Full-year 2019 distributable earnings were $2.31 a share, up 6% from 2018.
Blackstone remained a magnet for new investments in 2019, as the firm had $134 billion of capital inflows and ended the year with $571 billion of assets under management, up 21% year over year. The firm’s shares declined $1.54 to $61.11 Thursday, but have nearly doubled in the past year.
The big advance in the stock reflects strong continued inflows to Blackstone funds, the firm’s move to change to a corporate structure from a partnership that broadened its investor base, and an investor preference for fast-growing alternative asset managers over traditional investment managers.
The firm’s real-estate business, which has grown rapidly in recent years, now is the biggest contributor to earnings.
While private-equity returns can be lumpy, the Blackstone 2019 returns indicate that the game might be getting tougher even for the best managers.
I wouldn't touch Blackstone or Tesla shares here even if the charts remain bullish and they might run up some more in the near term.
Blackstone is the alternatives king so if you see returns coming down in its marquee private equity funds, I can bet you the same thing is going on at other large alternatives shops.
Now, admittedly, these funds got hit on two public equity positions -- Cheniere Energy Partners (CQP) and Gates Industrial (GTES) -- so the returns at Blackstone's PE funds may not be representative of what is going on in the industry.
Still, with so much competition vying for a limited pool of (overvalued) assets, you have to wonder whether it's possible for Blackstone to generate 15% net annual returns in private equity which Jonathan Gray mentioned during the conference call.
Also worth noting, Alex Lykken of PitchBook recently reported that PE firms aren't keeping portfolio companies as long as they used to:
The median holding time of private equity assets continues to decline. As of the end of 2019, it's down to 4.9 years, the first sub-five-year reading since 2011, according to PitchBook's 2019 Annual US PE Breakdown. During the time period since 2011, PE holding times saw a peak of 6.2 years back in 2014.I'm not sure if it's making LPs "happy twice over" if PE funds exit their positions early by selling it to another PE fund. That type of churning creates friction costs which LPs hate.
Much of the overall downfall is due to top-quartile hold times, which were down to 7.1 years on a median basis last year. In 2016, top-quartile hold times peaked at almost nine years. That's a fairly quick collapse in just a few years, probably a healthy one. We'll likely see an increase in top-decile holding times because of the growing proliferation of long-dated funds hitting the market.
Knowing when to sell, however, isn't always straightforward.
Portfolio companies aren't "positions" that can be pared down or modified if market conditions change. Whole companies are big and clunky compared with tradable shares, and buy-side love is in the eye of the beholder. But exits have been a bit easier to achieve in recent years amidst a broader M&A boom. That's made it easier to offload companies a bit sooner than in the past. There's also a motivation to spend more time on the fundraising trail, which, perhaps coincidentally, has been on fire since 2016.
Less coincidental is a rise in exit committees across the industry. Formalized investment committees date back to PE's earliest days, and each portfolio company tends to have a cheerleader who spearheads the firm's investment.
For a long time, investment decisions have passed through a more rigorous approval process while exit decisions are made by one or two senior directors who were responsible for that investment. Emotions get involved at the exit stage, and an increasing number of firms are formalizing those decisions and taking away individual decision-making. That trend is probably contributing to shorter holding times—likely making many LPs happy twice over.
This is why Canada's large pensions prefer co-investing along with GPs on larger transactions and/ or bidding on individual portfolio companies they like and know well when a fund winds down to keep them longer in their books.
Lastly, AQR came out last week to tell investors it's time to get sober on future returns:
Cliff Asness’s firm doesn’t want investors to get excited. AQR expects the real return of a U.S. portfolio divvied up 60 percent in stocks and 40 percent in bonds to be 2.4 percent. That’s around half its long-term average of nearly 5 percent since 1900.Not sure how AQR "models" future private equity returns but 4.3% net return for PE relative to 4% for large-cap US stocks seems low to me. Yes, the spread is closing but there's no way large cap US stocks will match PE returns going forward (AQR needs to get sober on that!).
“The year 2019 saw a reverse of 2018’s cheapening, with expected returns falling for both equities and (especially) bonds,” according to the firm’s capital market assumptions for major asset classes, published Wednesday. The firm’s research focuses on medium-term expected returns — over five to 10 years — and updates the forecast annually. All of AQR’s estimates are lower than last year because of increased asset prices in 2019.
The firm says the results aren’t surprising, particularly given low yields that have persisted for years. What investors earn on cash influences every other investment result. Central banks around the world have kept rates extraordinarily low for a decade, a policy that has altered market fundamentals.
“We should not be surprised that many long-only investments have low expected returns today. In theory, all assets are priced according to the present value of their expected cash flows. The riskless yield is the common component of all assets’ discount rates, and when it is lower than historical averages it tends to make all assets expensive,” AQR’s latest study said.
In AQR’s analysis of alternative risk premia, it argues that aggregate valuations of multiple style factors like value and momentum are near long-term averages.
“Among equity styles, defensive and momentum styles are mildly rich by some measures, while value has been looking increasingly cheap,” wrote the study’s authors. “Our research suggests there is only a weak link between the value spreads of style factors and their future returns, making it difficult to use tactical timing based on valuations to outperform a strategic multi-style portfolio.”
But the alternatives firm believes that last year some value factors became cheap enough to earn an overweight in multi-factor strategies.
Even though data is less available on illiquid assets like private equity and real estate, AQR started modeling expectations for these asset classes last year.
Using the average of two different frameworks, AQR estimates a 4.3 percent net-of-fee return for private equity. That compares to AQR’s expected 4 percent returns for U.S. large-cap equity. AQR expects 3 percent returns for un-levered real estate.
“As of January 2020, these estimates are soberingly low,” concluded AQR. “They suggest that over the next decade, many investors may struggle to meet return objectives anchored to a rosier past. Low expected cash returns are one clear culprit, dragging down expected total returns on all risky investments.”
Still, I think it goes without saying that returns are coming down across the capital structure so all risk assets including private investments, will get hit.
Just today, a high net worth investor sent me a comment by Verdad Advisors on the rise of private credit and asked me what I thought of private debt right now. I told him to stay away, too much capital there, returns are coming down and underwriting standards are deteriorating fast.
If you don't believe me, watch this Real Vision interview with Dan Rasmussen who is the founder of Verdad Advisors.
Below, has private equity changed the way it usually works? Or is it just its nimble responses to the turbulent economic climate? Joseph Baratta, Global Head of Private Equity, Blackstone speaks to Henny Sender, Chief Correspondent, Financial Times about the current market conditions, regions and sectors of interest, and strategies at play in this buoyant market (October 2019).
Second, Stephen Schwarzman, founder, CEO and Chairman of Blackstone Group, joins "Squawk Box" at the World Economic Forum in Davos to discuss sustainable investing, the role of capitalism, the "phase one" China trade deal, the 2020 election and much more.
Third, The Carlyle Group Co-CEO David Rubenstein joins CNBC's "Squawk Box" team at the World Economic Forum in Davos, Switzerland.
Lastly, Glenn Youngkin, Carlyle Group president and CEO, joins CNBC's Sara Eisen at the World Economic Forum in Davos to discuss investing in 2020. Youngkin states high prices are here to stay and I agree, if you want to allocate to private markets, you need to accept this reality.
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