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Canadian and Danish pension funds have been backing away from new US private equity allocations. And Chinese sovereign wealth funds have turned off their money tap to the industry more comprehensively. But even investors in countries that haven’t been threatened with annexation or been made subject to eye-watering tariffs should reassess their exposures to private equity.
Critics have long caricatured American private equity as an outsized manager remuneration scheme attached to a basket of leveraged small cap stocks. This is not completely fair. But a combination of elevated borrowing costs, lofty US public stock valuations and a softer economic outlook all make for a hostile investment landscape and point to weaker returns.
Moreover, the steep uptick in US policy uncertainty that has accompanied the first 100 days of Donald Trump’s second presidential term creates profound challenges for investors. “Policymaking has been volatile bordering on erratic. And valuation is negatively correlated to volatility,” says John Bilton, head of global multi-asset strategy at JPMorgan Asset Management.
This volatility throws a spanner in the works of the private equity machine. Unlike listed markets, it is hugely expensive to make and then reverse private equity allocation decisions. So, when faced with a spike in policy uncertainty, private market investors tend to hit the pause button on fresh commitments, creating a real challenge for fundraising.
Stock market gyrations that come with policy flip-flops also create challenges in the buying and selling of companies in the private market. As Ludovic Phalippou, professor of financial economics at Oxford university, tells me, private company valuations are benchmarked to public market peers, and when prices are flailing, dealmaking grinds to a halt.
That is also bad news for existing investors. According to PitchBook, a market research firm, around $1tn of the $3.5tn total US private equity assets under management consists of “dry powder” — capital that is contractually committed by investors, but has not yet been called upon.
While the mountain of dry powder is often trumpeted as a key strength for managers, being able to provide a trillion dollars of cash when needed can be a problem for investors. One source of cash in their liquidity calculus are forecast distributions from the private equity funds they already hold. And to make distributions, funds must sell portfolio companies or engage in financial engineering.
But according to Bain & Company’s Global Private Equity Report, distributions as a percentage of net asset value have fallen from an average of 29 per cent in the period from 2014 to 2017 to only 11 per cent today. PitchBook estimates there are more than 12,000 US portfolio companies — around seven-to-eight years of inventory at the observed pace of exits. This is much higher than the five-and-a-half-year median exit time they’ve observed across the industry to date. When anticipated distributions fail to show up, investors need to look elsewhere for cash to meet capital commitments they’ve made to other private equity funds.
Yale University — pioneer of the “endowment model” of alternative-heavy investments under David Swensen’s leadership — looks like a case in point. It is reported to have appointed advisers to find buyers for up to $6bn of assets. While sales may be an effort to get ahead of potential tax hikes on university endowments being discussed by Congress, they also look necessary if the fund wants to stop its allocation to private equity from shooting up. According to quantitative analysis firm Markov Processes International, Yale has just over $8bn of unfunded capital commitments to private equity funds outstanding at the end of 2024.
Michael Markov, the firm’s chief executive, tells me that capital calls could typically have been expected to be funded by distributions from existing private equity holdings. But, given the slower pace of distributions, it’s unrealistic to count on this cash. Markov estimates that without offloading existing stakes, the share of Yale’s total endowment allocated to private equity may rise from 47 to perhaps 55 per cent. Not ideal.
Given its diversification characteristics, private equity has a role in portfolios. But in a world of weaker growth and higher interest rates, returns are likely to be lower. Furthermore, while it is never simple for investors to manage cash calls and illiquidity, overwhelming US policy uncertainty intensifies the challenge. Moments like these remind us why investors in illiquid assets should demand additional returns to compensate for risk.