Private Equity Report 2015 — The Allocation Shift

Institutional allocations to private equity rose materially in this period. The standard explanation — that private equity outperforms public markets and institutions were increasing exposure to a better asset class — is incomplete in a way that matters.

The dominant driver was the failure of the fixed income portfolio.

A typical institution — a pension fund, an endowment, an insurer — has a required return. For a pension fund it is set by its liabilities; for an endowment, by its spending policy. That required return has to come from a portfolio.

Historically, a substantial portion came from bonds, at low risk. Following the post-crisis policy response and the negative-rate developments described in the 2016 global report, that stopped being possible. A portfolio allocated substantially to high-quality bonds could not produce the required return.

The institution faced three options, all uncomfortable: reduce the required return (which for a pension fund means acknowledging underfunding), increase contributions (which requires a sponsor able and willing to provide them), or increase risk.

Most chose the third, and private equity was a principal destination.

This matters because the driver determines the discipline. An investor allocating because they have carefully assessed an asset class and concluded it is attractive is a price-sensitive buyer who will stop if prices rise. An investor allocating because they need a return they cannot obtain elsewhere is a less price-sensitive buyer, because the alternative is not a different investment — it is accepting a shortfall.

That distinction explains a great deal about what happened to private market pricing over the following decade, and it is the mechanism the 2017 private equity report picks up when dry powder reaches record levels.

What the illiquidity premium actually costs

Private equity's excess return over public markets is frequently attributed in part to an illiquidity premium: investors are compensated for accepting that capital is locked up.

The premium is real. It is worth being precise about what is being compensated, because the cost has a specific and awkward timing.

The commitment structure. An investor commits capital that is drawn down over several years and returned over roughly a decade. During that period they cannot access it, cannot rebalance it, and cannot respond to a change in circumstances.

The costs this imposes:

• No rebalancing. If a portfolio drifts away from target allocations, the private portion cannot be adjusted. This is exactly the denominator effect described in the 2022 global report.
• No response to a change in view. An investor who concludes the asset class is overpriced cannot exit an existing commitment.
• Uncertain cash flow timing. Capital calls arrive when the manager decides; distributions arrive when exits occur. Neither is predictable, which complicates liquidity planning.
• The cost is highest when it is least affordable. In a market decline, an investor may need liquidity. That is precisely when private assets cannot be sold and when secondary prices are worst.

That last point is the essential one and it is systematically underweighted:

Illiquidity is not a constant cost. It is near-zero in good conditions and severe in bad ones. It is priced as if it were constant, and paid as if it were not.

The 2023 experience — institutions unable to fund commitments because distributions had stopped, and the secondaries market becoming the only exit — is what this cost looks like when it is actually incurred.

Appraisal-based valuation and apparent risk

Private equity's reported volatility is substantially lower than public equity's, and this feeds directly into risk-adjusted return statistics that flatter the asset class.

The reason is methodological rather than economic.

Public equity is marked to price, continuously, by a market. Every fluctuation appears in the return series.

Private equity is marked to appraisal. A manager values holdings quarterly using comparable company multiples, discounted cash flow, and recent transactions. This process is genuine and audited, and it has a specific statistical property: it smooths.

The smoothing arises from several sources:

• Quarterly rather than continuous measurement removes intra-quarter movement entirely.
• Comparable-based valuation uses trailing multiples, which lag current market conditions.
• Judgement introduces anchoring to prior marks — not through impropriety, but because a valuation process that starts from the last valuation naturally produces gradual change.
• Holdings are valued individually, so idiosyncratic movements partially offset rather than compounding as they do in a market-wide repricing.

The consequences for anyone comparing across asset classes:

• Reported volatility understates true volatility. The economic risk is not lower; the measurement is smoother.
• Sharpe ratios are inflated, since volatility is the denominator. A smoother series produces a better ratio at the same return.
• Measured correlation with public markets is understated, because the lag decorrelates the series mechanically.
• Portfolio optimisation using these inputs over-allocates to private assets, systematically, because the inputs make them look better than they are on exactly the dimensions the optimiser weighs.

This is not an allegation of mismarking. Appraisal valuation is appropriate and required for illiquid assets. The point is that the resulting statistics are not comparable to market-priced ones, and treating them as comparable produces a systematic bias in favour of the appraised asset.

Adjusting for it — through unsmoothing techniques or by comparing on measures less sensitive to volatility — materially reduces the apparent advantage.

Dispersion and the availability of the average

A feature of private equity that distinguishes it fundamentally from public markets, and that is central to whether an allocation makes sense, is the spread between good and poor managers.

In public equity, the dispersion between top-quartile and bottom-quartile active managers is relatively narrow. Most cluster near the index. This is the basis of the argument for indexing: since managers cluster, the fee saving from indexing is a reliable edge.

In private equity, dispersion is far wider. The gap between top-quartile and bottom-quartile funds of the same vintage is large enough that the difference between good and poor manager selection dwarfs the difference between the asset class and public markets.

Two consequences follow, and they point in opposite directions:

• The asset class's average return is not the relevant number for an investor. What matters is the return of the managers they can actually access.
• There is no index alternative. An investor who cannot access good managers cannot fall back on cheap beta the way they can in public equity. The choice is a good manager or nothing.

Access is the binding constraint, and it is unevenly distributed. The best-performing funds are frequently oversubscribed and closed to new investors. An institution with a long relationship, a large cheque and a reputation as a reliable partner can access them; a new entrant frequently cannot.

This creates a genuinely awkward situation for an institution increasing its allocation for the reason described at the outset. They are increasing exposure to an asset class where the average is not achievable and access to the achievable part is constrained — while allocating for reasons that make them less price-sensitive than a discretionary buyer would be.

That combination is the strongest argument for caution about the allocation shift, and it was less discussed than the return statistics.

Fees under scrutiny

Fee structures came under genuine regulatory examination in this period, and the focus was not where public commentary assumed.

The headline structure — a management fee on committed capital plus a share of profits above a hurdle — was well understood and disclosed.

The scrutiny focused on what was less visible:

• Expense allocation. Which costs are borne by the fund and which by the manager, and whether the allocation matches what investors were told.
• Monitoring and transaction fees charged to portfolio companies by the manager, and how much of that revenue is shared with the fund.
• Accelerated monitoring fees, where a multi-year agreement with a portfolio company is settled in a lump sum at exit.
• Operating partners and consultants, and whether their cost is a management company expense or a fund expense.
• Disclosure adequacy — whether investors had enough information to understand what they were paying in total.

The resulting improvements in disclosure were genuine and durable. Standardised reporting templates were adopted, disclosure of fee and expense detail improved, and several arrangements that had been common became less so.

The general lesson is about where fee analysis should focus. The headline rate is disclosed, negotiated and understood. The cost that is hardest to assess is the one that is not stated as a fee at all — and that is where the examination found the issues. Total cost of ownership, not headline fee, is the correct measure, and obtaining it requires asking specific questions rather than reading a term sheet.

Where private equity returns actually come from

An allocation argument is stronger when it can state what produces the return. Private equity's return decomposes into identifiable sources, and separating them clarifies which are durable and which were features of a particular period.

Leverage. Debt amplifies equity returns because it is repaid at face value while the equity captures the residual. This is arithmetic, and it works in both directions. Its contribution depends on the cost and availability of debt, both of which vary with the credit cycle.

Multiple expansion. Selling at a higher multiple of earnings than the purchase multiple. This depends on market conditions at exit and is not within the manager's control. Over a period of rising valuations it contributed substantially to returns industry-wide, which flattered the apparent contribution of skill.

Earnings growth. The business generates more profit than when acquired — through revenue growth, margin improvement, or acquisitions. This is the only source that is unambiguously attributable to what the manager did, and it is the one most emphasised in marketing and least isolated in performance reporting.

The illiquidity premium, discussed above, which is compensation for a real cost rather than an excess return.

Why the decomposition matters for an allocation decision:

• Leverage and multiple expansion are cyclical. A period in which both contributed positively is not evidence about a manager's ability to generate returns when neither does.
• A manager's historical return reflects the conditions they operated in as much as their capability. A record built through a period of falling rates and rising multiples is a record built with two tailwinds.
• The question that matters is what happens when the tailwinds reverse, which requires isolating the earnings growth component. Some managers publish this decomposition; most do not, and asking for it is a reasonable diligence question.

The 2015 relevance is specific. The allocation shift described in this report was occurring near the end of a long period in which leverage was cheap and multiples were rising. Institutions were increasing allocations on the strength of records generated under conditions that were unlikely to repeat — which is a recurring pattern, and the same one the 2021 US venture report describes at the level of a single vintage.

What an allocator could act on

Ask for the return decomposition. How much of the historical return came from leverage, from multiple expansion, and from earnings growth. A manager who cannot produce this has not analysed their own performance; one who can has given you the only useful basis for assessing what they will do in different conditions.

Adjust the risk statistics before comparing. Reported private equity volatility is smoothed by appraisal-based valuation. Comparing a smoothed series to a market-priced one systematically favours the smoothed asset, and portfolio optimisation using unadjusted inputs over-allocates to it as a mathematical consequence. Unsmoothing methods are imperfect; applying one imperfectly is better than applying none.

Assess access, not just the asset class. Dispersion between top and bottom quartile managers is wide enough that the asset class's average return is not the relevant number. The relevant number is the return of the managers you can actually access, and if that is not the top quartile, the allocation case must be made on those managers' expected returns rather than on the asset class's.

Model the illiquidity cost as state-dependent. It is near-zero in good conditions and severe in bad ones — no rebalancing, no exit, capital calls arriving when cash is scarce. Pricing it as a constant understates it, and the understatement is concentrated in exactly the scenarios where it matters. The 2022 denominator effect and the 2023 liquidity constraint are what this cost looks like when incurred.

Measure total cost of ownership, not headline fees. The headline structure is disclosed and negotiated. The costs that are harder to assess are expense allocation, monitoring and transaction fees charged to portfolio companies, and how those are shared. Standardised reporting templates exist for this reason and asking for one is routine.

The strongest version of the private equity case is that it provides access to businesses and to operational improvement unavailable in public markets. That case is real. It is weakened rather than strengthened by risk statistics that are not comparable to the alternatives.

What 2015 established for private equity

• The allocation shift was driven by the failure of the bond portfolio, which made institutions less price-sensitive buyers than a discretionary allocator would be.
• The illiquidity premium was clarified as compensation for a cost that is near-zero in good conditions and severe in bad ones.
• Appraisal-based valuation was shown to bias risk-adjusted comparisons systematically in favour of private assets.
• Dispersion was established as the defining feature, making access rather than allocation the binding constraint.
• Fee scrutiny shifted to expense allocation and disclosure, establishing total cost of ownership as the correct measure.