Can Private Equity Continue to Produce Excess Returns Above What Is Available in the Public Markets?

Can private equity produce excess returns above what is available in the public markets? It’s a question we’re getting from many individual investors as private equity investing opportunities have become more accessible through evergreen products. 

In answering this question, we start by looking at historical returns and some of the factors that have driven private equity’s outperformance relative to the public markets over time. We then address why we think private equity is positioned to continue outperforming in the future.

Private Equity has Historically Outperformed Public Markets Across Time Horizons, But Why?

Over the last 25 years, the Global PE Index has outperformed the MSCI World Index by more than 500bps annualized on a net basis¹. We think a large component of this outperformance is due to the active role private equity investors play as owners and operators of businesses. They engage deeply with management teams to implement a focused strategy, and they have a long-term approach to creating value. At KKR, we often like to say that our investing philosophy comes down to “buying good businesses and making them great.”

We highlight two important differences in private equity’s approach relative to that of public investors:

Private Equity Managers Directly Contribute to Strategy and Value Creation

• Many public managers try to influence the strategy and direction of companies through informal engagements with management teams, or even going public with their views. However, their influence over day-to-day decisions, strategy and operational best practices is not comparable to that of a private manager owning the business and partnering with management on long-term value creation with full alignment of interests.

Private Equity Managers Are Focused Beyond the Next Quarter

• Because private equity managers are focused on the long-term, they have the patience to undertake strategies and large investments that can take years to bear fruit. While there are several types of public investors, many tend to be more focused on quarterly results and shorter-term performance. Where public investors may exit at any time in favor of other near-term opportunities, private managers are focused beyond the next quarter on helping portfolio companies achieve long-term, durable business performance.

Not surprisingly, then, private equity backed companies exhibit higher growth and better margins, on average, than publicly traded firms (Exhibit 1).

EXHIBIT 1: Revenue and EBITDA Trends in Private Equity-Owned Businesses Compared to Publicly Traded Businesses

When we look at KKR’s track record specifically, we calculate that more than two-thirds of our performance has come from selecting the right themes and then implementing value creation plans to make our portfolio companies more valuable over time. These value creation plans leverage KKR’s operational improvement playbooks, our firm’s global resources and our emphasis on human capital and broad-based employee ownership.

Can Private Equity’s Outperformance Persist in the Future?

It’s true that today’s private equity investing environment is different than in the past, whether one considers the early days of buyout investing when transactions benefitted from significant operational and capital structure inefficiencies, or the zero interest rate policy periods from 2008-2015 and again from 2020-2022 when cheap financing drove a large volume of transaction activity.

But for managers that focus on active value creation and have been disciplined about deployment – meaning that they avoided overinvesting when valuations and sentiment were running high and invested actively when others may have been on the sidelines – today’s growing opportunity set and constrained liquidity environment make this a “buyer’s market.”

In terms of the opportunity set, the number of U.S. publicly listed stocks is on the decline, having already shrunk from over 7,000 companies in 2000 to about 4,500 companies today (Exhibit 2). Many fast-growing companies are staying private for longer. We think private equity investors have a larger, more diverse set of companies to invest in than ever before, while the universe of public companies is increasingly concentrated with much of the market performance coming from a few large companies.

EXHIBIT 2: The Number of Public Companies has Declined Meaningfully in Recent Years

Additionally, we think there should be interesting opportunities to buy companies that are already owned by other private equity firms. Dry powder, or capital that private equity firms have raised, but not yet spent, is moving to all-time lows relative to the aggregate remaining value of existing private equity portfolio companies (Exhibit 3). These companies will eventually need to find a new home, and firms with the scale to buy them may find themselves with plenty of choices.

EXHIBIT 3: Current Dry Powder Levels Appear Attractive Relative to NAV in the Ground

Interestingly, many investors seem to be under the opposite impression: that private equity firms have raised too much money, resulting in too much capital chasing a small number of deals. The reality, however, is that growth in private equity’s capital base has generally tracked the growth in the overall market’s value (Exhibit 4A and 4B).

EXHIBIT 4A: U.S. Private Equity Dry Powder

EXHIBIT 4B: Private Equity Dry Powder as a Percentage of Total U.S. Market Cap

Is This a Good Time to Consider Investing in Private Equity?

Private equity is about long-term investing, and we don’t believe in attempting to time the market. Instead, we have seen that our approach to creating value has delivered results across market environments. That said, we do think this is a particularly interesting time to lean into private equity.

Capital markets issuance activity (across IPOs, leveraged loans, and high yield bonds) is improving, but still very low relative to historical standards (Exhibit 5). Historically, some of the best private equity vintages have been deployed in similar conditions (Exhibit 6).

EXHIBIT 5: Capital Markets Liquidity (TTM) as a % of GDP (IPO, HY Bond, leveraged Loan Issuance)

EXHIBIT 6:  Private Equity Outperformance Across Liquidity Regimes, 1997-2023

We are seeing a growing number of opportunities to take public companies private and carve businesses out of larger corporations (Exhibit 7A and 7B). Small cap valuations are historically attractive, and large conglomerates are shedding under-managed, under-loved subsidiaries in order to focus on their core competencies.

EXHIBIT 7A: Take-Private as % of Total Deal Value, North America and Europe 

EXHIBIT 7B: Carveouts as a % of All U.S. PE Deal Count

Capital market forecasts for future public equity returns are muted relative to those of recent years, and private equity tends to outperform the most when publicly traded stocks are more subdued. 

EXHIBIT 8: PE Outperformance vs. Public Market Returns

Buyout transactions are being executed at the 47th percentile of their valuation range over the last 20 years. Large-cap public equities, on the other hand, are trading at the 96th percentile of their range over the same period. 

EXHIBIT 9: Cross-Asset Valuation Percentiles (relative to 20-year average)

Conclusion

The outlook for private capital remains strong. The ratio of dry powder to invested capital across the industry sits at historical lows and has barely kept pace with the growth of the public markets, while market liquidity more generally continues to be constrained. This backdrop creates ample opportunity for sponsors with dry powder to acquire attractive companies and implement value-creating strategies. This is reflected in current private equity deal valuations and in the mix of transactions getting done today, with greater prevalence of corporate carve-outs and take-privates.

For more details and for content across asset classes, please see our recent publication from Henry McVey and our Global Macro and Asset Allocation team on An Alternative Perspective: Past, Present, and Future.

¹ Cambridge Associate LLC Benchmark Statistics as of December 31, 2023. Data reflect actual pooled horizon return, net of fees, expenses and carried interest. For funds formed between 1986-2023.