Private equity has a reputation for surviving, and even thriving, in most economic crises, thanks in part to its illiquid nature and focus on long-term horizons. However, while this quality can insulate investors from economic volatility, at times it can also insulate them from reality.
It has been a bad year for public markets. At the time of writing, the S&P 500 is down by just over 18% year-to-date, while Europe Stoxx 600 is down by just over 12%. Yet it is harder to say how PE has fared. Fundraising and dealmaking have cooled off, but in both cases, this still only really reflects a return to activity pre-2021: US PE deal value hit $1.2 trillion that year—64% higher than the previous record—while fundraising topped $301 billion, just shy of 2019’s record, according to PitchBook data.
News of portfolio markdowns has been sporadic thus far. For example, Blackstone saw its corporate PE portfolio fall 6.7% in Q2. More recently, there were also reports that in Q3, Massachusetts Pension Reserves Investment Management noted a 5.7% drop in the value of its PE portfolio.
Even so, the fear rippling through the public markets has not carried over to PE investors.
Instead, the industry is cautiously optimistic—even confident—about its ability to ride out the economic and financial storm, with investors’ portfolios sufficiently diversified to absorb any unfolding economic shock.
A part of this optimism could be chalked up to genuine resilience, but there is also something to be said about the way fund managers report their portfolio performance and how this could contribute to a relatively rose-tinted view.
As the macroeconomic picture gets bleaker, more markdowns could materialize, and some investors may find that the glass is not half full.
Investments in public markets are more volatile, but investors have a clear and current understanding of what their holdings are worth. The same can’t always be said of private equity funds, where the GP has leeway on what to report, custom benchmarks can cloud the picture and opacity is accepted.
Private equity typically outperforms public markets, but the difference has been particularly stark of late. In the first three months of the year, private capital funds generated IRR of 2.5%, according to PitchBook’s Global fund Performance Report. Over the same period, Morningstar’s US Market Index fell 16.8% with all diversified stock funds posting a loss. The apparent outperformance is causing some to once again question whether PE returns are being overstated.
In previous years, PitchBook analysts have described the practice of “return smoothing.” This happens when fair value accounting is used to estimate the actual value of portfolio assets. The practice often results in firms underestimating fluctuations in the value of assets, resulting in artificially smoothed returns.
To be clear, return smoothing does not always imply a deliberately unfair net asset value manipulation. It is a practice that is intended to mitigate both positive and negative short-term impacts for a long-term asset class.
Yet others have described this practice in more disparaging terms—the most notable being Clifford Asness, the founder of US hedge fund AQR Capital Management, who, in 2019, referred to it as volatility laundering.
He also argued that it is a perk of PE, rather than a flaw, that GPs smooth returns to cater to LPs—a view recently supported by a paper titled “Catering and Return Manipulation in Private Equity” from the University of Florida. Academics Blake Jackson, David Ling and Andy Naranj explain that this smoothing is desirable to an investment manager at a pension fund, for example, wanting to report top-line returns to their trustees.
It is still a process that relies on subjective input from managers, and in times of growing volatility, the temptation to play down risks is stronger, potentially resulting in greater losses down the road.
Featured image by Chloe Ladwig/PitchBook News
