Navigating the future of private capital performance

The keynote presentation by Cameron Joyce, Global Head of Research Insights at Preqin, revealed that private capital has delivered attractive returns despite some recent headwinds. He highlighted the sustained outperformance of private equity compared with public markets, using Preqin Benchmarks, and the S&P 500 and Russell 2000 indices.

Accurate performance measurement and relevant benchmarks are essential for understanding and leveraging the value of private capital. He noted the impact of return smoothing – where GPs with discretion in how they mark valuations result in smoother reported returns. Using statistical techniques to normalize these effects revealed that private capital's risk-return profile remains attractive compared with public markets, though the advantage may be less pronounced.

As the panelists, Philip Edmans, Partner at Inflexion, Jamie Fronckowiak, Director of Product Management at Affinity, Brett Richardson, Principal at Pathway Capital, and Nicholas Smith, Managing Director, Private Credit at Alternative Credit Council (AIMA), explored the factors driving this outperformance and the future outlook for private capital, it became clear that strategic alignment, active investment, and a long-term focus are key elements sustaining this trend.

Factors driving outperformance in private capital markets

Private markets have consistently outperformed their public counterparts, driven by several key factors. According to Edmans, private capital managers excel at enhancing business value through strategic and hands-on approaches.

He believes successful private capital investment begins with a shared vision between the company’s management and the investors. This alignment is further reinforced by short reporting lines between shareholders and management, eliminating the principal-agent problem common in public markets. In private capital, shareholders often sit on boards, and management teams are also shareholders, ensuring that both groups partake in the company’s successes.

Active investment is another critical factor. Whether investing in minority or majority stakes, private equity managers hold significant positions that allow them to focus on driving meaningful support and changes within the company.

The third factor is time. Private equity investors typically operate over a five-year horizon or longer, allowing them to make strategic decisions at the company level, such as in capital expenditures or new product development, without the pressure of daily market volatility. This long-term focus enables private equity managers to enhance company value sustainably.

Richardson notes that investing in companies earlier in their maturity curve allows private equity managers to professionalize operations, improve efficiencies, and capture value, especially as companies remain private for longer periods. The inherent inefficiencies of private markets enable GPs with domain expertise to leverage information asymmetry, making strong investments that public markets often miss.

On the private credit side, Edmans points out that managers offer structural advantages that public fixed-income markets often lack. Loans are negotiated directly with the borrower, allowing for tailored documentation and structures suited to the company’s needs. Additionally, private credit loans often come with covenants that provide guardrails to ensure control and influence to manage downside risk and achieve desired outcomes.

Smith adds that while initially popular among top-end SMEs, private debt solutions are now increasingly sought after by larger businesses due to the fewer coordination issues and disclosure requirements compared with public markets. Private credit is becoming more prevalent as borrowers value speed, certainty of execution, flexibility, and the ability to work with a sole or small group of lenders.

The importance and challenges of accurate performance measurement

Data presented during the webinar showed that while recent performance has shown signs of strain, private capital returns have been strong. However, accurate performance measurement in private markets comes with its own set of challenges.

Richardson stresses the need for comparing performance on an apples-to-apples basis due to the discretion involved in performance reporting. Differences in line of credit usage, valuation methodologies, and levels of conservatism must be considered.

For recent funds that are mostly unrealized, understanding their valuation approaches is essential. Comparing the multiple of invested capital at which prior companies were exited relative to two-to-four quarters prior helps gauge relative conservatism.

Ensuring comparisons against appropriate benchmarks and peers is also essential. Early-stage venture capital managers should be compared against different benchmarks than mid-market buyout firms to ensure relevance and accuracy. Accurate benchmarking allows investors to make informed decisions by providing a clear picture of performance relative to market standards.

Richardson notes that it could be different for private credit. Investors in the asset class are increasingly focused on understanding the health of their portfolios by evaluating borrowers' ability to repay loans. Methods such as interest coverage ratios and assessments of macroeconomic impacts are becoming more standardized, leading to greater consistency in performance monitoring.

However, appropriate monitoring practices vary by sector and location. Investors aim to achieve consistency across lenders and understand portfolio performance holistically. This trend toward institutionalizing monitoring practices ensures that performance metrics are reliable and comparable across different segments of the private credit market.

What does the future of private capital performance look like?

Experts believe that the future of private capital performance will likely continue the historical trend of outperformance because of its inherent structural advantages over public markets.

Edmans believes these advantages are not only enduring but may even be strengthening. In particular, he notes the ability to create value in mid-market investments through various levers, especially as these businesses are often at an earlier stage in their development, can offer more growth opportunities.

Richardson points out that the outperformance of private equity relative to public markets varies with market conditions. Over the past 20 years, private equity has significantly outperformed when the S&P 500’s trailing four-year return was below 10%, with an excess return averaging about 1,000 basis points (bps). In higher-return environments for public equities, this outperformance narrows to around 400bps. He notes that given recent forecasts from firms like BlackRock and Vanguard suggesting lower returns for US equities in the coming decades, the appeal of private markets for achieving policy goals will likely increase.

Smith adds that for private credit, despite challenges such as transitioning from low to high interest rates, the asset class has shown resilience, with consistent growth in assets under management (AUM), deployment volumes, and performance. The private credit model’s inherent flexibility and close borrower-lender relationships enable it to navigate market stress effectively. This proximity allows private credit managers to tailor loans to the specific needs of businesses, providing a framework for continued strong performance.

Fronckowiak believes that, moving forward, with increased pressure to get the best deals due to the more competitive and crowded environment, investors need to do their homework, be data-driven, and reach the most promising founders to keep up the performance.

_{The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin accepts no liability for any decisions taken in relation to the above.}