An April 2014 article by McKinsey’s Sacha Ghai, Conor Kehoe, and Gary Pinkus highlights new research that shows private equity has generated better returns than previously thought, as well as Limited Partners’ heightened expectations from their GPs.

New research shows PE returns beat public indices

According to the McKinsey authors, more recent data suggests that over the long term, returns from PE investments have outperformed the public indices by a minimum of 300 basis points. McKinsey’s analysis for the World Economic Forum in 2011, covering funds created in 1995, shows that return from these funds has “meaningfully outperformed” the S&P 500, as per the graph below.

1-pe-returns Private Equity

New insights into PE fund management

Together with this new assessment of PE profitability, the authors find that firms do not generate top-quality returns as consistently as earlier. Not only that, PE returns also appear to have become more correlated with public markets and increasingly draw the comment that PE is no longer as “alternative” it once was.

This new-found inconsistency, and the congruence with public markets have also put into uncomfortable focus the fees charged by PE managers – Limited Partners increasingly find these to be exorbitant.

Again, the growth of private equity from a 1.5% share of global equity capitalization in 2000 to about 3.9% in 2012 has placed fresh demands for dependable and transparent data on results, returns and methodologies of the industry and its data bases.

PE managers are also increasingly focused on effecting operating improvements in portfolio companies as opposed to simple financial engineering – this means that the industry is seeing an increasing dispersal in performance returns – another challenge for Limited Partners deciding which fund manager to bet on.

“With persistence waning and dispersion still significant, selection risk remains as high as it was in the 1990s, but it has become tougher to predict which firms will deliver top-performing funds,” say the authors.

 

PE industry on the cusp of a new wave of growth

The outperformance of returns from the PE industry, compared to those from the public markets, is expected to draw new inflows from large bracket investors such as institutions and high net worth individuals.

Private Equity

The size of these new inflows, as well as the new level of risk, place a heavy burden on the shoulders of Limited Partners to select the right general partner. “General-partner selection is becoming more focused on understanding the capabilities that have driven past returns and assessing whether those capabilities are still present, relevant, and sufficiently differentiated to continue to drive outperformance into the future,” says the article.

And that will require limited partners to expend substantial effort in the research and due diligence of the proposed fund managers.

General partners to be more forthcoming on their track records

On the other hand, general partners will need to be more introspective and identify clearly the driving factors of their past track record of returns, as well as capabilities that will differentiate them from their peers in the management of new investments.

“Knowing how a differentiated value proposition and strategy for the future generates performance can help a general partner articulate one that sets it apart from both its private-equity competitors and from limited partners that aspire to invest directly,” observe the authors.

The authors also suggest that GPs could engage more with investors by helping them manage the non-PE portion of their investments, or even shift some of their business ‘exits’ to existing investors who might want to purchase these businesses for their own expansion. These create mutual ‘win-win’ situations for both.

On the vexing question of fees, the authors suggest that GPs should offer innovative options that are more oriented towards a pooling of carried interest rather than simply management fees.

“This is not a zero-sum move; rather, it should increase the size of the profit pool that general partners and their investors share,” observe the authors.

GPs could also offer more fee structures such as either “1 and 20” or “2 and 15.”