PE Efficiency Outperforms PMEs

Median Operational Performance of North America Buyout vs. S&P 500 Index 

This week’s chart is for those still struggling to recover from their 2022 hangover and singing the “valuations are inaccurate” song. Throughout 2022 and early 2023, it was broadly decided that private equity couldn’t be flat, let alone up, when public markets were down. It had to be a valuation gimmick that would correct at some point. That hasn’t happened, especially since public markets have seemingly moved up, but some investors hold steadfast to their belief that day of valuation reckoning is near. But private equity has historically outperformed in severe public market downturns. Our focus is on answering the question why private equity has historically excelled. The outperformance in 2022, along with the continued performance in 2023, is a simple matter of stronger revenue and EBITDA than the profiles of public companies typically found in comparison benchmarks such as the S&P 500 Index.  

Does this mean private equity investors are smarter than their public counterparts? Not necessarily, but the industry’s governance does prove to be better, and the choice of companies is different and has historically contributed to better performance. Buyout has generally avoided some areas that are more represented in broad public market indices, notably materials and consumers. Instead, it has generally been overweight in sectors that have shown greater growth and resilience during economic cycles, such as information technology and industrials. More importantly, the size of companies varies drastically, with an average company size of $32.5B in the S&P 500 Index vs. $328M in the buyout universe.* The amount of control you can exert over such companies is likely enormous vs. larger ones.

Buyout’s operational outperformance is closely tied to better sector and company selection and a greater ability to create paths for operational growth. We believe this is, in the end, the core of the reason private markets have historically outperformed.

Catch up on Chart of the Week.

*Source: Hamilton Lane Data, Bloomberg (December 2023)

Definitions 

Corporate Finance/Buyout: Any PM fund that generally takes control position by buying a company. 

S&P 500 Index: The S&P 500 Index tracks 500 largest companies based on market capitalization of companies listed on NYSE or NASDAQ.

PME (Public Market Equivalent): Calculated by taking the fund cash flows and investing them in a relevant index. The fund cash flows are pooled such that capital calls are simulated as index share purchases and distributions as index share sales. Contributions are scaled by a factor such that the ending portfolio balance is equal to the private equity net asset value (equal ending exposures for both portfolios). This seeks to prevent shorting of the public market equivalent portfolio. Distributions are not scaled by this factor. The IRR is calculated based on these adjusted cash flows.