Advisors still positive on private equity despite recovery in publicly traded stocks

Let’s talk private, shall we?

Private equity that is.

For those that may not remember (or choose to forget), stocks, as measured by the S&P 500, lost over 18 percent in 2022, placing that 12-month span in the bottom decile of stock returns over the previous century. Meanwhile, bonds, as measured by the Vanguard Total Bond Index, lost 13.3 percent in 2022, making it the worst year ever for U.S. fixed income investors.

Yes, 2022 was a dismal, utterly forgettable year for investors in public markets.

Private equity, on the other hand, boomed in 2022. Private equity posted its second-best year ever in terms of asset growth in 2022, according to Bain & Company, riding a wave of momentum coming off the industry’s record-breaking performance in 2021. That is, until June 2022 when US central bankers issued the first in a series of three-quarter-point interest rate hikes.

And over the course of that volatile year, financial advisors raised their private equity allocations in client portfolios to heretofore unseen levels. Tired of relaying to their anxious clients the drubbings of their publicly-traded portfolios, wealth managers clamored for private investments that were not marked-to-market each day.

As a result, financial advisors effectively waved goodbye to 60/40 stock/bond portfolios and said hello to 60/20/20 schemes, with that last piece being private equity. Or 50/40/10. Or any combination that put private equity in the mix to stop the red ink bleeding onto client statements and screens.

Until, of course, the bleeding stopped and publicly traded stocks took off the following year.

The S&P 500, led by the AI-powered Magnificent 7, surged 24 percent in 2023. And it’s up almost 16 percent so far in 2024. Over on the fixed income side, the yield on the benchmark 10-Year Treasury rose to a healthy 3.75 percent at last check, satisfying bond investors who had survived on nothing for so long.

So with the public equity markets still flirting with record highs and bond investors finally sated with adequate guaranteed payouts, where does private equity fit into advisor plans going forward?

Robert Pearl, co-founder and wealth advisor at G&P Financial, says the businesses and assets that private equity purchases have benefited from the additional capital in the space, pushing asset and business valuations to new all-time highs. However, he is unsure whether there will be sufficient buyers at higher valuations when private equity funds need to create liquidity for shareholders in coming years.

“I have a favorite quote from Charlie Munger regarding PE,” says Pearl. “And that is ‘Private equity, as practiced today, often involves significant amounts of leverage. That can make the outcome look great in good times, but it’s dangerous because it multiplies the impact of bad outcomes. Leverage is a two-edged sword.’”

As a result, Pearl is not currently recommending PE investments to clients and most likely will not be recommending them for the foreseeable future. 

Brooks Harrington, CIO Private Equity at Federated Hermes, however, is less worried about private equity valuations – especially when compared to the nosebleed levels of publicly traded equities, especially the S&P’s leading companies.

“Within private equity and especially within the lower end of the market where there's more companies and more opportunity and less competition, there's less price efficiency,” said Harrington.

“We're trying to find founders that have built their business up for a number of years. They're looking for a partner to take them to the next level. They're not necessarily maximizing price. They're looking for a partner to then professionalize the business. So in the lower end of the market, specifically where we focus, valuations are still very much acceptable,” said Harrington. 

Meanwhile, Matt Malone, head of investment management at Opto Investments, says he is being cautiously optimistic and selective in private equity over the next year. In his opinion, exposure to PE is a core allocation of any diversified private markets portfolio and, if suitable, he generally guides clients to invest in the sector as part of their strategic policy.

“While the expected falling interest rate environment should generally result in a tailwind to PE managers, rates remain relatively high overall compared to the previous decade and we continue to closely scrutinize managers that rely on high levels of leverage to execute on their strategy and instead focus on operationally intensive strategies,” said Malone.

Added Malone: “With the mega cap managers continuing to grow and decreased liquidity in this space, there are tactical opportunities to allocate to secondaries and managers targeting smaller companies that can exit to larger strategic buyers to potentially drive alpha.”

Elsewhere, Joseph Spada, private wealth advisor at Summit Financial, continues to see private equity as a long-term diversifier for the many benefits it provides. These benefits include the potential for higher returns than stocks and bonds, a hedge against inflation and currency risk, lower correlation to stocks and bonds reducing market volatility and risk, and access to a broader universe of unique investments.

On average, Spada’s clients are about 10 percent allocated to private equity, a number that varies from client to client based on factors such as risk tolerance and liquidity needs.

“Endowments, family offices, and pension funds have about 30 to 50 percent of their assets in alternative investments. On average, retail investors are only at about 5 percent,” said Spada. “If anything, we expect to increase our exposure to private equity in the next year, however, not in any significant way.

In terms of which vehicles he uses to gain that PE exposure for his clients, Spada likes diversified private equity investments such as Blackstone’s Private Equity Solutions fund, Hamilton Lane’s Secondaries fund, and Hamilton Lane’s Private Assets Fund.

Ted Brooks, founder of Nordwand Capital, also has a positive outlook on private equity for the next 12 months. If base interest rates decline while the US economy holds up, then he thinks that bodes well for the financing, distribution, and valuation environment for private equity. 

And on the flip side, he is “less enthused” with aspects of the public equity markets – particularly in large cap US stocks.

“Our client base is generally ultra-high net worth and family offices, and we tend to allocate to private markets in the higher percentages similar to those for the endowment and foundation space,” said Brooks. “We don’t see that changing in the near term and would expect to continue allocating in a similar vein.”   

Elsewhere, Will Sterling, partner at TritonPoint Wealth, is “constructive” on private equity, believing that capital markets and M&A activity remain below historical averages, but are improving. In his view, this should bode well for secondaries and buyouts. 

“For many years, PE total returns, when decomposed, were driven predominantly by market multiple expansion and leverage,” said Sterling. “With higher financing costs, finding GPs who focus on value creation to drive revenue growth and margin expansion will be critical,” said Sterling, adding that there remain “pockets of value in the private equity space from a multiple perspective that should allow GPs to continue to capitalize on.”

In terms of portfolio construction, Sterling does not employ a model strategic private markets target allocation. He says his allocations and portfolio construction are specific to the individual circumstances of his clients. In terms of vehicles, he uses interval Funds, evergreen structures, and traditional drawdown structures for PE exposure. 

Finally, Rafia Hasan, chief investment officer at Perigon Wealth Management, says the demand for private equity investments continues to be high given the returns the asset class has experienced in recent years. However, she sees the sector as a “long-term asset class.”

“Investors should look beyond one year when considering private equity,” said Hasan.

Private Equity opportunities still available for savvy buyers, says Federated Hermes strategist