North American Buyout Funds Have Provided Returns in Excess of Public Equities

Low and declining borrowing costs have helped bolster buyout returns

Most North America-focused buyout funds that Preqin tracks have continued to provide returns in excess of public equity markets. As Fig. 1 shows, the weighted average net IRR of buyout funds has also exceeded returns attainable through investing in the US small-cap space. What is driving this outperformance, and how can we best measure it?

Buyout funds have become an increasingly important part of institutional investors’ portfolios. This comes as allocators seek alternatives to actively managed public equity funds. A structural decline in long-term treasury yields has been key to driving flows into the asset class, as well as proving a crucial contributor to its performance. The US Treasury 10-year yield was more than 4.5% at the end of 2005, compared with close to 1% today.

Fundraising and strong performance have helped North American buyout funds soar in value in recent years. Total assets under management (AUM) stand at $1.38tn as of June 2020, a 3.7x increase since 2005. Average annual fundraising for North America-focused buyouts has been $117bn per year since 2005, but reached a high of $278bn in 2019, prior to the impact of the pandemic. AUM growth has also been helped by consistently strong performance.

Benchmark Selection Is Important for Effective Comparison
The selection of a suitable underlying benchmark is key to performance analysis. To effectively compare the returns of buyout funds with public market investments of similar size, we opted for a public market equivalent (PME) benchmark based on the US small-cap Russell 2000 Index. The returns of the most recent vintages have been omitted because they are still heavily impacted by the J-curve effect and results are as of the end of 2019. 

While the much larger S&P 500 Index is often seen as the default for public market returns, its constituents are significantly larger than the typical buyout deal. The median market capitalization of S&P 500 constituents is close to $26bn, but Preqin data shows the average size of a North American buyout deal was $0.7bn over the past 10 years. By comparison, the Russell 2000 has median company sizes of $0.8bn.

To compare buyout returns directly with the Russell 2000 Index would be ineffective. Obviously, the level of capital that an investor will have invested in the fund varies over time due to the flow of capital calls and distributions. In order to adjust for this, the PME benchmark matches each capital call and distribution with a positive and negative allocation to the benchmark respectively. The net IRR is then computed for each fund before being aggregated to reach the weighted net IRR for all funds. 

Part of the excess return generated by private equity funds over their public market benchmarks will be explained by the additional debt that buyout funds typically employ, compared to what is held by companies in the public equities benchmark. But, of course, the use of leverage will amplify returns whether they are positive or negative. To better understand the true level of alpha that has been generated by buyout funds, investors may want to adjust the PME benchmark upwards to account for the difference in leverage.

An Increase in Long-Term Inflation Expectations Would Pose Risk to Outlook
Going forward, we expect long-term US Government bond yields to remain at low levels. This should underpin continued strong performance of the asset class by helping financing costs stay low, and potentially facilitating further multiple expansion. However, downside risks could stem from an increase in longer-term inflationary expectations, which could prompt a sell-off in longer-term treasuries. While we recognize some near-term inflationary risks at present, we expect them to be mainly transitory in nature. A Preqin survey in late 2020 found that only 7% of global investors considered rising interest rates to be a key challenge to return generation for private equity over the next 12 months.   

Another key risk to the future performance of the sector would be a material dislocation in financial markets. This could impede the flow of financing to buyout funds and prompt a sharp correction in exit multiples. While 2020 provided a difficult test for financial markets, the impact was comparatively muted thanks to a strong monetary policy response and intervention by the Federal Reserve in the corporate bond market. While 2021 is likely to present additional risks to buyout fund performance, the outlook remains favorable overall.