In 2023, US private equity (PE) performed better than venture capital (VC), but returns for both asset classes trailed those of the public markets, which rebounded strongly from a tough 2022. For calendar year 2023, the Cambridge Associates LLC US Private Equity Index® returned 9.3% and the Cambridge Associates LLC US Venture Capital Index® returned -3.4%. Information technology (IT) continued to be the largest sector in PE and VC and produced divergent results across buyouts and growth equity (the components of the PE benchmark) and venture capital. Tech buyouts, which are generally mature companies, performed the best and growth equity–backed technology companies earned better returns than those in the VC index. Figure 1 depicts performance for the private asset classes compared to the public markets. ¹

Calendar Year 2023 Highlights

• Despite posting lower short-term results (six months and one year) than the public markets as of December 31, 2023, the US PE index outperformed relevant public indexes in every period longer than three years. The US VC benchmark’s performance relative to public indexes has been more mixed, in part due to its lackluster returns since 2021.
• After spiking during the COVID-19 pandemic era, exposures to public companies in the PE/VC indexes have fallen. At the end of 2023, public companies accounted for a modestly higher percentage of the market value of the VC index’s market value than of the PE one (roughly 8% and 7%, respectively). At the same time, non-US companies represented about 20% of PE and 13% of VC.

US Private Equity Performance Insights

In 2023, a macro environment marked by stubbornly high interest rates, geopolitical tensions, and a concentrated but strong rebound in the public market proved to be challenging for PE fundraising, investment activity, and exits. PE portfolio company valuations, which tend to move directionally with the those of public companies, neither fell dramatically in 2022 nor rose massively in 2023 and in both years, were more resilient in buyouts than in growth equity. Limited partner (LP) cash flows were down again in 2023 as market uncertainty and a large bid-ask spread constrained buying and selling, leading to fewer capital calls and distributions. As of the end of 2023, four vintages (2018–21) accounted for nearly 60% of the PE index’s value, which is not surprising, given the abundant fundraising in that era. All four vintages earned at least 9.6% for the year.

According to Dealogic, in 2023, seven US PE-backed companies went public, and they were valued at $19 billion; the number of initial public offerings (IPOs) was up from 2022 (two), but the overall value was down about $3 billion. Among the seven, two were IT-related businesses, two were consumer companies, and there was one each in energy, financials, and healthcare. The number of PE-backed merger & acquisition (M&A) transactions trailed the total completed in 2022 (1,060 versus 1,150), marking the second consecutive drop in M&A exits. Only 17% (or 180 deals) had publicly disclosed valuations and based on the data available, the average transaction size among those deals was $1.2 billion, about $90 million less than the average in 2022. During 2023, there was not much variation in the number of deals by quarter, but the total and average deal values were by far the lowest in the fourth quarter.

Vintage Years

As of December 2023, eight vintage years (2015–22) were meaningfully sized—representing at least 5% of the benchmark’s value—and, combined, accounted for 86% of the index’s value. Calendar-year returns among the key vintages ranged from 1.8% for 2015 to 13.5% for 2022; the 2015 and 2022 vintages represented 6% of the index’s value at year’s end, placing them at the small end of the largest vintages. The two largest vintages, 2019 and 2021, returned 9.6% and 11.7%, respectively (Figure 2).

Part of the divergence of returns across the vintage years was related to the performance of the fund strategies within the PE universe—buyouts and growth equity—which do not share the same return profiles. In 2023, for instance, the benchmark for US buyout funds earned 10.4%, while the US growth equity index posted a 6.1% return. Similarly, for all large vintages except for 2015 and 2016, buyouts meaningfully outperformed growth equity. Additionally, the younger vintages (2018–22) generally earned higher returns than more mature ones (2015–17).

Write-ups in industrials and to a lesser extent IT boosted returns for the top-performing vintage (2022), while in the lowest-returning vintage (2015), write-ups in consumer discretionary and IT were somewhat offset by write-downs in financials and other sectors. Values across the key sectors were written up in the largest vintages, 2019 and 2021, with financials and healthcare earning the highest returns in the 2019 cohort, and financials, healthcare, and IT leading the way for the 2021 funds.

LP Cash Flows

In 2023, limited partner (LP) cash flows were on par with activity last seen in 2020, with $137 billion in capital calls and $125 billion in distributions. Both totals represented declines from 2022, a 27% drop in calls and a 12% drop in distributions. Following ten years (2012–21) of distributions equaling or surpassing contributions, over the past two years, calls outpaced distributions by a ratio of 1.2x. However, during the second half of 2023, fund managers returned more capital to LPs than they called, perhaps a hopeful sign for distributions but also an indication of a less active investment environment.

Five vintage years (2019–23) represented 89% ($123 billion) of the capital calls, with each drawing down at least $10 billion during the year; the 2021 and 2022 vintages were the most active, combining to call almost $85 billion. Seven vintages (2013–19) accounted for most of the distributions, and within that group, the 2016–17 and 2019 vintages led the way as each returned about $17 billion to LPs.

Sectors

Figure 3 shows the Global Industry Classification Standard (GICS®) sector breakdown by market value of the PE index and a public market counterpart, the Russell 2000® Index. The comparison provides context when comparing the performance of the two indexes. The PE index continued to have a significant overweight to IT and meaningful underweights to financials, energy, and real estate (the latter two are reflected in the “other” category).

As of December 2023, there were six key sectors by size and IT was by far the largest (36% of the index’s market value). Three of the six large sectors earned double-digit returns for the year (IT, financials, and industrials) and among all six, calendar year returns were best for IT and lowest for communication services.

US Venture Capital Performance Insights

For the second consecutive year, the CA US venture capital index produced a negative return in 2023 (-3.4%), as the industry continued its reset with respect to valuations, fundraising, investing, and exits. Performance for IT companies was a significant drag on the benchmark’s return, a stark difference from the public market indexes, whose rebounds in 2023 were buoyed by a small number of tech-related companies.

According to the National Venture Capital Association and Pitchbook, by number, US VC managers completed about 18% fewer deals in 2023 than they did in 2022 (14,491 from 17,709), a smaller decline than when measured by value ($166 billion from $242 billion in 2022). Exits have declined more dramatically, especially by number. Compared to 2022, total reported exits (1,073) fell 24% in 2023, driven by a slower environment for M&A and buyouts, rather than in IPOs, which were marginally higher in 2023 than in 2022. Values for M&A exits declined commensurately with the drop by number and despite the small increase by number, the value of IPO exits was also lower in 2023 than in 2022. Notably, for the second consecutive year, the value of exits via M&A was higher than those of public listings in 2023, while the number of M&A exits (755) was the lowest of any of the last ten years.

Vintage Years

As of December 2023, nine vintage years (2014–22) were meaningfully sized and combined, accounted for 81% of the index’s value. With one exception (13.9% for vintage year 2022), returns across the key vintages were largely negative, ranging from -9.6% (2014) to -0.8% (2021) (Figure 4). With a 0.5% return in the fourth quarter, the VC index ended its seven-quarter streak of negative returns, its longest since the tech wreck that started at the end of 2000.

For the lone key vintage (2022) that earned a positive return during the year, all sectors except for IT performed well. In the lowest-performing vintage, 2014, all key sectors suffered write-downs. For the 2021 cohort, financials was the biggest drag on returns.

LP Cash Flows

Amid the challenging investment and exit environment, US VC LP cash flows declined in 2023, with capital calls ($30.3 billion) mirroring those of 2020 and distributions ($19.4 billion) hitting the lowest total since 2016. After ten straight calendar years (2012–21) of distributions outpacing calls, the reverse was true the past two years, with calls outnumbering distributions by a ratio of 1.3x.

Four vintages (2020–23) accounted for 89% (roughly $27 billion) of the total capital called during the year. While each vintage called more than $3.4 billion, the 2021 and 2022 groups were the most active, combining for almost $19 billion in total. Distributions were more widespread than contributions, with seven vintages (2012–18) returning at least $1.2 billion to LPs for a combined $13 billion. The 2012 vintage distributed more than $3 billion, the most of any group.

Sectors

Figure 5 shows the GICS® sector breakdown of the VC index by market value and a public market counterpart, the Nasdaq Composite Index. The breakdown provides context when comparing the performance of the two indexes. The chart highlights the VC index’s meaningfully higher exposures to healthcare, financials, and industrials. The indexes are both heavily tilted toward IT, and Nasdaq weightings in communication services and consumer discretionary have remained much higher than those of the VC index.

Collectively, the five meaningfully sized sectors made up 91% of the VC index. Communication services posted the lowest return and industrials the best.

View more investment insights.

Caryn Slotsky, Managing Director
Wyatt Yasinski, Associate Investment Director
Drew Carneal, Associate Investment Director

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.

The post US PE/VC Benchmark Commentary: Calendar Year 2023 appeared first on Cambridge Associates.

The Advantages of Private Fund Investments

Benchmarked Return Potential

Private markets can add considerable value to family portfolios. Yet, when it comes to evaluating the performance potential of direct versus fund investments, the landscape differs significantly. The figure shows how private investment funds—as measured by Cambridge Associates (CA) benchmarks—have outperformed their public market equivalents over the past 20 years. It is worth noting that these benchmark returns are net of all fees, demonstrating the strong return potential of PI funds despite higher associated costs.

Although CA uses proprietary asset class benchmarks for private investments, standardized public benchmarks for direct investments do not exist. The bespoke nature and complexity of directs often requires investors and their investment managers to instead rely more heavily on their own qualitative assessments and judgments related to the intrinsic value of the asset.

Greater Geographic Reach

Families who focus only on a local market or region may miss a large part of the investment universe. Investors relying solely on a domestic portfolio risk becoming too concentrated while also forgoing opportunities to invest in leading companies domiciled in foreign markets. The broader the investment options, the higher the bar is raised. What’s more, investment talent is everywhere. We believe PI fund managers that specialize in specific markets, rather than having a global focus, are often better positioned to outperform. For example, a family with an operating business in Europe may seek to further globalize their investment exposure by seeking US-focused fund opportunities. Often, a fund-specific strategy is designed to complement a direct portfolio, augmenting the “in-house” resources of the family office.

Expanded Sector Allocations

Similarly, it can be difficult to source direct investment opportunities outside of the specific sector where a family has built their wealth and networks. And if deals are sourced, it can be challenging to develop the know-how required to be an effective investment partner. Expertise in one sector may not translate to expertise in another. For example, it would be difficult for a family with a background in software to leverage their knowledge and capabilities in an industrial strategy requiring large capital investment and manufacturing knowledge—or vice versa. Yet, both sectors should be considered as part of a family’s diverse investment opportunity set. PI fund investments can serve as a conduit to expand a family’s investable universe beyond sectors familiar to them. Relationships with general partners (GPs) can also provide access to professionals and CEOs outside of the family’s typical investment network, which can have a strategic benefit to other businesses in the portfolio.

Opportunities Across Various Stages

Unlike directs, PI funds offer families the opportunity to balance allocations across the PI spectrum to help manage asset class–specific risk. For example, the risks and returns of an early-stage venture opportunity are different from those in a mega-cap buyout strategy. While it is possible to invest across different asset classes and life cycle stages with direct investments, it typically requires managing a larger number of individual investments compared to fund investing. PI funds invest in companies at various stages of their life cycle, frequently specializing within a certain range of business development. Fund investing is also more capital efficient for diversification, especially for families with a smaller PI budget. Having multiple fund investments that target different deal stages can help reduce the impact of any one investment performing poorly. It also has the potential to provide differentiated sources of return and cash flow profiles.

Opportunities Across Different Deal Sizes and Co-investments

Often, large- or mega-cap direct deals—which can range from $10 billion to more than $200 billion—can be challenging for families to secure with participation dependent on the size and scale of the investors involved. Most direct deals tend to be focused on small- and mid-market segments. Through PI funds, families who may otherwise be left out can allocate to a diverse range of market caps, including small-, mid-, and large-cap investments. This can help improve the stability of portfolio returns and enhance their protection against downside risk. Additionally, PI funds offer professional management, diversification, and access to exclusive investment opportunities that might not be available through direct deals alone.

Co-investments provided by a GP to its limited partners (LPs) offer another pathway for families to engage with investment opportunities that might otherwise be inaccessible. They allow families to invest alongside a fund in specific deals, often with no or substantially reduced management fees or carried interest compared to what would typically apply to fund investments. This may enhance the potential returns on those investments. For families of wealth, co-investments represent a compelling way to gain more direct exposure to high-quality opportunities, while leveraging the expertise and due diligence capabilities of the fund managers. This approach can not only broaden the investment horizon but further align the interests of the investor and the fund manager, helping foster partnerships that could lead to other strategic investment opportunities. Investors should keep in mind that the most attractive co-investment opportunities offered by PI fund managers often parallel a manager’s specific experience and expertise, providing direct exposure in areas outside a family’s traditional skill set and business networks.

Different Generational Factors

Many direct investors got their start as entrepreneurs and grew into experienced business owners. They often leverage the skills honed from growing and running their personal businesses into being active, effective direct investors. However, this can make business and wealth succession planning challenging if the inheriting generation of family members does not share the same interest or abilities as the controlling generation. By contrast, fund investments are more institutional and transactional by nature, and do not require family members to preside over them in the same way. They can be easier to leave to beneficiaries and are suited to long-term investors focused on building a family legacy. PI fund opportunities can also provide a means for working with innovative investment ideas—from artificial intelligence to life sciences and music royalties. This can be a way of further engaging families with members across multiple generations and areas of interest.

Key Operational Differences

Direct investing and private fund investing can both be complex—but in different ways. It can be easy for families to underestimate the work involved with holding a directs portfolio. Direct investments sometimes require investors to sit on a board, provide operating advice, or may require extensive “in-house” capabilities to be dedicated to making an operation successful. Generally speaking, the more challenging the market environment and/or business conditions, the greater the time commitment. While fund investments require investment operational support, such as negotiating and executing LP agreements and managing capital calls and distributions, the operational burden they put on investors tends to be more consistent and—more often than not—significantly lighter.

Potential Challenges of Private Fund Investments

Skill Set Requirements

Whereas direct investments are typically more “hands-on,” a different kind of expertise is usually required to be successful in PI funds. The development and execution of fund strategies demands strategic insight, comprehensive due diligence on fund managers and underlying assets, careful risk management through diversification and hedging, and a deep understanding of fund structures and performance metrics. In many cases, industry knowledge and negotiation experience can give families an edge. To remain aligned with their broader investment goals, families should look for experienced investment managers in building a private fund portfolio.

Important Risk Variables

Blind pool risk is a principal factor pertaining to private funds. Families considering fund investments should remember that they do not have control over how the fund allocates capital. As a result, it is important to recognize that fund investments also often come with a high degree of illiquidity risk.

Fee Considerations

Private fund investors pay higher fees relative to other strategies. Historical returns should be considered when determining how they fit into a family’s broader portfolio, keeping in mind that top-tier PI fund performance may result in additional fees over the long term.

The Family Advantage

In our experience, families of wealth are often viewed as preferred strategic LPs by fund managers. While many PI fund managers can be hard to access, families have certain competitive advantages such as bringing a variety of operating backgrounds that are viewed favorably by fund managers. In addition, some managers appreciate that families can have less complex or formalized governance structures relative to institutional investors, helping with faster decision making through more immediate access to the decision maker(s). Many GPs also appreciate and identify with families who have an entrepreneurial background, allowing them to speak the same language of business ownership and development.

New Horizons

Incorporating a private fund portfolio alongside direct investments presents family investors with a strategic opportunity to augment their private market allocations, enhancing the potential for higher returns and greater diversification. However, skilled implementation is key, given the significant variance in returns within the private funds industry, coupled with its inherent illiquidity and other associated risks. To navigate these complexities, families should align their PI funds approach with their long-term financial objectives and desired level of risk tolerance. This alignment, combined with rigorous due diligence in manager selection, can greatly influence the outcome of their investments. Furthermore, disciplined management of the PI fund program—emphasizing vintage year diversification, maintaining adequate liquidity, and robust risk management—is crucial. By adhering to these principles, families can help create a resilient and high-performing PI fund portfolio that complements their direct holdings and successfully broadens their investment horizons.

Learn more about our Private Client Practice.

Elisabeth Lind, Managing Director, Private Client Practice

Sheetal Zundel, Senior Director, Private Practice

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.

The post Unlocking New Opportunities for Family Investors Through Private Funds appeared first on Cambridge Associates.

We believe success in co-investing is driven by access to robust and high-quality deal flow, and the current market climate creates additional incentives for GPs to expand their co-investment offerings. Private fundraising ² activity slowed in 2022 and 2023, with respective declines of ~21% and ~35% from its peak in 2021. Though 2024 fundraising data show early signs of recovery, private markets have also underperformed public markets in the short term. The continuing distribution drought has led to skepticism among some LPs about the benefits of private investments, which in our experience has created a dynamic whereby GPs have to work very hard to secure fund commitments.

Co-investments play an increasingly important role in today’s fragile environment for two reasons. First, providing co-investment opportunities allows GPs to build goodwill and showcase their expertise to current and prospective LPs. Second, GPs can use co-investments to make their current fund capital go further. Due to the added incentives for GPs, LPs should benefit from improved access to high-quality opportunities, resulting in a more robust funnel. However, the co-investment evaluation process is critical; LPs must remain wary of adverse selection.

Co-investments offer LPs an important tool to control pacing and express market views. While this is true in any investment environment, it is particularly valuable when private market activity slows. In 2023, global private equity capital deployment was down ~46% from its peak in 2021, and in 2024 it is tracking to a ~43% decline from the historic high. ³ Despite this slowdown, GPs are increasingly incentivized to offer co-investments as discussed above. LPs can leverage this co-investment deal flow sourced across GP relationships to manage investment pacing. Further, compared to blind-pool funds, co-investments allow LPs to control specific exposures—and associated risks—in a portfolio. This enables LPs to focus on opportunities that are attractive in the current environment, which can help be identified through the due diligence process. Acknowledging that market volatility has led to allocation constraints for some investors, co-investing can still be a useful tool. Those with direct co-investment programs can adjust annual budgets to respond to market swings, while LPs using co-investment funds can continue to benefit from them by scaling back other commitments.

Co-investments are underwritten based on the current market environment, and today’s landscape should foster more conservative assumptions. Private equity firms synthesize macro and microeconomic data from public and private markets to inform their assumptions that drive financial forecasts and return projections. Typically, GPs provide detailed information about their underwriting to co-investors that can then validate these assumptions as part of their own due diligence process. These factors include, but are not limited to, company valuations, market growth rates, industry dynamics, and the availability and cost of debt. Recently, valuations have fallen from 2021 highs, growth forecasts are more conservative, and higher debt costs have focused sponsors on appropriate capital structures. The confluence of these factors should provide LPs with confidence that the current opportunity set is based on prudent underwriting assumptions. We believe deals struck in this vintage could produce attractive returns in the long run.

While co-investments offer high potential to add value, they are complex to source and execute. Co-investors should have a sound strategy and understanding of where they can be most competitive in finding the greatest value. We believe success is driven by a robust pipeline of opportunities and by having the appropriate resources to be able to transact quickly and efficiently. Today’s market has shifted the incentives of GPs to provide quality co-investment opportunities to LPs, for whom the ability to control capital deployment is increasingly valuable. In response to higher interest rates and a challenging fundraising market, underwriting standards have risen. Co-investors can evaluate these underwriting assumptions and build conviction in today’s opportunity set. Co-investing is a critical component of the private investment ecosystem and one that is particularly attractive today for those that are well positioned and prepared.

Rob Long, Senior Investment Director, Private Equity

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.

The post Are Co-investments Attractive in Today’s Environment? appeared first on Cambridge Associates.

At present, short-term private equity returns do not compare favorably to those of public benchmarks. For the nine months ended September 30, 2023, global private equity and global venture capital underperformed the MSCI ACWI on a public market equivalent basis to the tune of 500 basis points (bps) and 1,400 bps, respectively. And, based on the strong public equity market performance through year-end 2023, as we wait for fourth quarter private investment numbers to finalize, we expect this pattern to continue.

Private investment managers incorporate public market comparables to varying degrees into their investment valuation methodologies, so it is not unusual to see private company valuations move somewhat in tandem with those of the public markets. However, this relationship often severs during extreme periods when the public markets move like an express train in either direction (up or down) due to rapidly processed information. Private markets move more like a local train, processing information (and incorporating it into valuations) on a quarterly basis. In 2023, fueled by a rally in the “Magnificent Seven” tech stocks and boosted by enthusiasm around artificial intelligence, the public markets quickly revalued upward, hitting new highs on a regular basis.

By contrast, the private markets continued to incrementally revalue downward from their arguably inflated 2021 highs and remained decoupled from the public markets. Global private equity valuations declined, then leveled out in 2023, but have not improved further. Global venture capital valuations continued their downward trend in 2023, lagging even further behind, as valuation “resets” in venture often happen during subsequent financing exercises, whenever they occur. With the percentage of flat or down rounds nearly doubling in 2023 from levels in the prior two years, many venture-backed companies have tried to delay that “reset” moment for as long as possible by conserving cash. One way to conserve cash is to reduce headcount. In fact, in 2023 there were 18x as many tech layoffs globally than in 2021, a clear indication many companies tried to hit the snooze alarm on raising another round.

It doesn’t help matters that the underperformance relative to publics has occurred during a private markets “distribution drought.” Distributions to limited partners (LPs) have fallen to their second lowest point for global private equity and their lowest point for global venture capital in more than 20 years, based on our distribution yield analysis. ⁴ Many investors are experiencing the dearth of returned capital from their private investment programs at the same time as program returns are underperforming relative to public markets, raising questions about the value of private investments in a program at all.

The longer the distribution drought continues, the greater the pressure on general partners (GPs) to return capital to LPs, preferably at acceptable levels of return. While that pressure is building, it is worth noting it takes an average of nine and ten years, respectively, for global private equity and global venture capital funds to distribute 1.0x the capital that has been paid in (DPI), which is essentially the same thing as returning cost back to investors. This underscores the time it takes for the private markets to deliver on expectations. The drought will end, but it won’t happen overnight. GPs can’t legally hold on to their investments forever, and delaying exits too long will impact internal rates of return and hinder their ability to raise subsequent funds. One hopeful development in 2024 is the cost and availability of leverage are becoming more favorable, combined with revalued investments, could potentially result in more transaction activity in 2024 and, therefore, more distributions.

Experienced LPs understand private investing is a long-term strategy with performance tracked in years, not days or even months. Zooming out from the one-year return and refocusing on timeframes where private market returns are better expressed, global private equity and venture returns delivered nearly double the equivalent public market performance over three-, five-, and ten-year periods. That said, short-term public market eclipses do occur, so this moment will happen again; over the last 33 years, one-year public market returns have bested global private equity returns nine times and global venture capital returns 14 times. These eclipses can obscure the contributions private investments make to a program. They are only temporary.

Andrea Auerbach, Head of Global Private Investments

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.
4. Cambridge Associates defines distribution yield as distributions to LPs divided into beginning net asset value.

The post Have Public Market Returns Permanently Eclipsed Private Market Returns? appeared first on Cambridge Associates.

As one of the earliest proponents of private investing, Cambridge Associates has been partnering with sophisticated institutional and family investors to shape the global private investment landscape for 50 years.

Read the full profile here. 

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.
4. Cambridge Associates defines distribution yield as distributions to LPs divided into beginning net asset value.

The post Buyouts Names Andrea Auerbach to Women in PE Class of 2024 appeared first on Cambridge Associates.

Listen to the episode. 

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.
4. Cambridge Associates defines distribution yield as distributions to LPs divided into beginning net asset value.

The post Podcast: How Endowments and Foundations Can Maximize Market Volatility appeared first on Cambridge Associates.

The conversation explores private equity’s low 2023 transaction volume and why distribution rates back to LPs are at their lowest point in nearly 25 years. Andrea explains that while we’ve “gone from fourth to first gear in the private equity markets because of interest rates, it’s created a moment for private credit to shine.”

Listen to the full episode.

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.
4. Cambridge Associates defines distribution yield as distributions to LPs divided into beginning net asset value.

The post Bloomberg Intelligence: State of Private Markets appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ⁵ and ARPA ⁶ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ⁷ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ⁸

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. Cambridge Associates’ mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions.
2. Private fundraising refers to buyout and growth equity funds.
3. The 2024 fundraising activity is annualized based on data as of March 31, 2024.
4. Cambridge Associates defines distribution yield as distributions to LPs divided into beginning net asset value.
5. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
6. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
7. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
8. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

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