Two powerful forces have shaped the global equity landscape in recent years – passive investing and private equity (PE). A broad range of investors have turned to index-tracking funds for low-cost exposure to the broader market. Meanwhile, a somewhat smaller but growing group have gravitated towards PE, attracted to its potentially higher returns and diversification benefits.
The growth of passive and private investment has been such that, together, the assets under management of the ‘two Ps’ have quadrupled over the past decade to some USD 12 trillion, overtaking the traditional active equity market (at USD 11 trillion).
In our view, passive and private investing might take different paths over the next five years.
When it comes to passive funds, their best days may now be behind them. Investors and regulators are becoming increasingly aware of – and concerned by – the risks that come with the expansion of index trackers. Research shows passive investing poses threats to market stability and sustainable investing.
The prospects for PE look brighter, though whether it can continue to grow its share of the pie is contingent on it becoming more widely accessible and less opaque.
- Investors have gravitated towards PE, attracted to its potentially higher returns and diversification benefits
Historically, PE has been considered too much of a risk for all but the most experienced, professional investors. But that is no longer the case. One reason is the sheer size of the market. Because private equity-owned companies are proliferating while the number of listed firms is falling, the arguments for opening up PE to individual investors have become too loud to ignore. This speaks to the democratisation of finance.
That is not to say passive investment will go into reverse, just that the pace of expansion may slow as investors and regulators discover that passive strategies, while cheap and easy to access, are far from risk free.
Re-pricing risks and benefits
While passive’s low fees might look attractive in an era of post-pandemic belt tightening, that comes at a price: index trackers follow the entire market, rather than picking the best bits at any one time. That is a problem because the mispricing that has occurred during recent bouts of volatility has created fertile ground for stock pickers. The gap between winning and losing stocks will only widen as companies that embrace innovation and technology thrive and the strength of balance sheets becomes ever more important.
More generally, the rise of passive investing threatens efficient market pricing. The stock market relies on active investors to determine an equilibrium value. Yet under index-tracking, the shares of companies with large weightings attract more capital irrespective of their financial performance. So, if the system is dominated by passive investing, the price of a security ceases to function as a gauge of a firm’s underlying prospects, leading to capital misallocation. Potentially making matters worse is the concentration of the passive market. There are growing concerns that as index-tracker funds continue to accumulate assets, the lion’s share of that money will flow to the three large asset managers that control the passive industry. Already, the big three passive fund houses collectively own more than 20 per cent of US large-cap stocks; they also hold 80 per cent of all indexed money. Should those proportions continue to rise, the resulting concentration of shareholdings – known as common ownership – could reduce competition and threaten the efficient functioning of markets. There is a growing body of research attesting to these negative effects. A 2018 study (1), for instance, found that when big institutional investors were large shareholders in firms producing both brand-name and generic drugs, the generic manufacturers were less likely to produce non-branded versions. This increased prices for consumers. Similar trends have been documented in other industries where common ownership is high, such as airlines and the banking sector. This is causing alarm among regulators in Europe and the US – the Federal Trade Commission and the US Securities and Exchange Commission have both said they are monitoring developments closely.
Passive investing does not necessarily aid the development of responsible capitalism, either. Passive funds, by their nature, do not choose the companies they invest in. That reduces the potential for investors to engage with the companies and to encourage them to embrace responsible and sustainable business models aligned to environmental, social and governance (ESG) principles. Passive portfolios tend to invest in so many companies as to make direct engagement with them impractical, and the small share of each holding within the portfolio reduces the incentive on an individual company basis.
Private equity, of course, is also far from risk free, but we would argue that many of its issues may be better understood and reflected in pricing.
First, there is the problem of transparency. PE has a patchy track record on ESG, for instance, and the requirements for transparency and disclosure for privately held firms are far less stringent even if a few are now trying to change that.
Then, there is debt. PE also has high leverage (just under 80 per cent of buyout deals in 2019 were carried out at over six times EBITDA relative to roughly 60 per cent at the prior peak by this measure in 2007) (2). PE investments are also primarily in small and mid-sized firms, whose business models are less well established. These factors could weigh on PE returns in a period of pandemic-induced economic weakness. Furthermore, PE-owned businesses are excluded from some government bailout schemes, while those that are available tend to come with complex conditions that may relegate them to a last resort.
In the longer term, though, the PE sector can help to finance businesses in a period when public markets may be less open. We may see more public companies taken private, as well as PE funds gaining minority stakes in listed companies, with an eye to increasing these later.
Dry powder
Crucially, PE has plenty of dry powder, some USD1.46 trillion according to latest available data (3). That can be used to shore up balance sheets and, later, to make new investments, supplemented by additional money that major investors have signalled they would like to allocate to PE. (The reported gap between actual and intentioned allocations stands at over 2 per cent of private sector pension funds’ total assets) (4).
A potential game changer will be the drive to democratise finance. Historically, PE has been the preserve of institutions and the ultra-wealthy – a disparity that regulators are now looking to fix by opening up the market to individual investors. The US has led the way, laying the foundations for ordinary savers to invest in PE funds through employer-sponsored 401(k) retirement accounts, which analysts forecast could bring in USD400 billion of fresh cash (5). The US Labor Department, meanwhile, sanctions the use of PE in professionally managed multi-asset-class investment vehicles, such as target-date, target-risk, or balanced funds. Other countries, including the UK, are considering similar moves.
Potential attractions for current and future PE investors include diversification benefits and a broader opportunity set – not because PE companies are somehow inherently better, but because they tend to have different characteristics to listed equities.
For a start, they are younger. The median age of a company going public in the US has risen from an average of seven years in the 1980s to 11 years between 2010 and 2018. The private market also includes a large number of small but rapidly growing companies with significant intangible assets. Typically such firms do not want to disclose their early stage research publicly and therefore favour a closed group of shareholders. What is more, in the US at least, the pool of private investments is deepening. Private companies are proliferating while listed ones are in decline. Since 2000, the number of listed companies has fallen to 4,000 from 7,000.
PE also offers the possibility of benefiting from operational improvements in the way businesses are run. When executed well, this can lead to impressive returns.
However, choosing the right PE investments is far from straightforward. The fees are relatively high and investment structures are complex. Moreover the sector lacks transparency, so opening it up to less experienced individual investors (such as 401(K) holders) presents challenges for regulators. Indeed, the US Security and Exchange Commission has recently rebuked PE and hedge fund managers for charging excessive fees and appearing to favour some clients over others (6). There are calls for reform of the fee structure to make the industry more sustainable, and a few firms have already started to move in that direction (7).
- Due diligence is much more important in PE than in public markets
Due diligence is much more important in PE than in public markets. According to our research, in 2018 the difference in performance between the 5th and 95th best-performing funds was 60 per cent in the US PE universe, versus just 8.5 per cent for US small/mid-cap equity funds. Studies also suggest the high persistence of manager returns, which was a feature of private equity – has declined, meaning yesterday’s winners are now less likely to top the tables tomorrow.
Due diligence is paramount: there are some signs in the US that, in aggregate, the returns gap between listed and private equity is starting to narrow. Indeed, over the next five years, we forecast global private equity returns of 10.3 per cent per annum in dollar terms, which represents a premium of just 2.8 percentage points over public equities, almost half its long-term historical average. That’s partly because of the sheer weight of capital chasing potential opportunities. Of course, the high dispersion means that some will do much better while others fare much worse. And, at a time when bond yields are very low, even a lower-than-average excess return may be attractive to many.
PE has the potential to continue to capture an ever-growing share of the equity market – as long as it succeeds in opening up to a wider range of investors and proves its potential to add value. Passive equity has already shown what can be achieved with a democratic approach and will continue to do well, but, having grown faster and for longer and attracting greater scrutiny from regulators, it may now be nearer its natural plateau as a proportion of equity AUM.
Column written by Supriya Menon, Senior Multi-Asset Strategist at Pictet Asset Management.
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Notes:
[1] ‘Common Ownership and Market Entry: Evidence from the pharmaceutical industry, Newham, M., Seldeslachts, J.,Banal Estanol, A., 2018 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3194394
[2] Bain Private Equity Report 2020
[3] Preqin, as of June 2019
[4] McKinsey Global Institute, “A new decade for private markets”
[5] Evercore
[6] SEC, June 2020
[7] “An inconvenient fact: private equity returns & the billionaire factory”, L. Phalippou, 2020
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