Capital allocation: a leverage for change

PE fund managers can also generate meaningful synergies across their portfolios, and an increasing number of fund managers have decided to specialize their competencies around specific sectors where they have developed most expertise.

Another major driver for better alignment lies in the longer investment horizons imposed by PE investors. Private investors, in particular VC fund managers, can support loss making companies over several years, therefore enabling them to prioritize on product development, which in turn generates a higher degree of innovation. Companies under private equity ownership can have a longer term vision for implementing their strategic initiatives as they do not face the same stakeholder pressure to meet and beat quarterly earnings forecasts.

Most alternative asset classes will require a specific set of performance measurement tools. PE is no exception and there are usually three performance indicators that are most commonly used. The total value to paid-in ratio, or tvpi, will sum the distributions received to the residual value of any investment and divide it by invested capital. The dpi ratio, or distributed to paid-in, will measure the level of “realization” of any investment, and divide the amount of distributions received by the amount of invested capital. The dpi indicates how close below or above payback (dpi = 1.0x) any specific PE investment currently stands. Finally, the internal rate of return (IRR) as a money-weighted performance measure, is most adapted to PE investment, as the timing and amplitude of cashflows need to be taken into account to judge a fund manager’s performance.

Comparing returns of PE fund investments with those of traditional asset classes has always required academics to adapt either side of the asset class measurement toolkit to fit the other to allow for such comparison. As a result, many hypotheses need to be taken in these exercises and any private vs. public performance analysis can arguably be criticized. One of such approaches is the public market equivalent (“PME”) method. It does have several advantages and has become commonly accepted by industry experts despite some of its limitations. As PE fund investors do not control the timing of the cashflows (capital calls and distributions), the principle is to replicate those cashflows on an equivalent public market index in order to assume identical entry and exit points. This means that for every PE capital call a number of shares of the public stock index will be purchased and for every PE distribution a pro-rata amount of shares will be sold. This methodology allows for an IRR calculation of all cashflows which can then serve as a common ground for performance comparison between private and public indices.

Vintage year performance

Applying the PME methodology to long term median returns of private equity shows a persistent and long term overperformance of the asset class. The private equity portfolio beats the public market equivalent in every single year reviewed below. Most recent vintage years are excluded from the analysis below as it typically takes 3-4 years for PE performance to become meaningful. It has to be mentioned that although the analysis indicates persistent overperformance of the asset class, applying proper selection remains key when investing in private equity as the dispersion of returns is extremely high among fund managers (the spread between the bottom quartile vs. the top quartile performers).

Asset managers worldwide are increasingly looking to integrate a supplemental, non-financial, dimension to their monetary performance objectives. These can be expressed with various forms of commitments towards any societal, environmental or even philanthropic goal. On the supply side, fund managers have been quick to provide solutions to fulfil these objectives, and a myriad of “sustainable”, “impact”, “responsible”, or “net zero” strategies have emerged.

There is currently no consensus on the various Environmental, Social and Governance (“ESG”) frameworks to apply, and some investors are hoping for regulators to step in to provide clarity. The EU Commission’s Sustainable Financial Disclosure Requirements (SFDR) is an example of such, albeit at its early debuts. The disclosure framework suggested by the EU is evidently lacking the needed pragmatism that asset managers require for implementing a “twin purpose” investment approach, i.e. integrating one or several ESG components in their investment approach and ultimately achieving financial and non-financial goals.

One useful framework that considers mainly the “E” of the ESG equation is Planetary Boundaries. The planetary boundaries framework defines a “safe operating space” for humanity based on the intrinsic biophysical processes that regulate the stability of the Earth system. This framework relates to nine global environmental dimensions, and their respective boundaries within their respective safe operating spaces. Four of the nine planetary boundaries — biodiversity loss, biogeochemical flows, climate change and land-system change — have now been breached. To avoid breaching further any of these boundaries, we must understand how to adapt our capital allocations to this new reality.

The framework uses several objective criteria such as concentrations of greenhouse gases, or biodiversity loss. It then attempts to establish how far each of these can change without risking to cause irreversible damage to the environment. Pictet has developed a proprietary model that quantifies the environmental impact for every USD 1m of annual revenue businesses generate within the framework of Planetary Boundaries. If a company’s activities lie within the safe levels of operation for each of the nine dimensions over the whole of the product value chain, then the firm can be viewed as being environmentally sustainable; if not, then the company is contributing to the global environmental degradation.

We believe this framework helps solving the major issue of data collection by allowing to better track the environment sustainability of companies. It helps to highlight those that actively make a contribution to solving environmental problems and help others to become aware and potentially to reduce their environmental footprint.

Investing in private equity is investing in the real economy and in companies that shape our world every day. As a long-term asset class, fundamental and sustainable value creation lies at the core of the superior return generation for fund managers of PE and VC funds. The incentive mechanisms for investors and managers are a catalyst for innovation and for strong returns. PE investors can support shaping new trends and participating in next generation economies by allocating capital to thematic oriented funds. These specialized funds focus their investment universe around segments of high conviction. More recently, there has been an emergence of sustainable and impact focused strategies that do not necessarily compromise on return expectations but have a dual objective of offering financial and non-financial goals to their investors.