Private Capital has become a mainstay of many institutional and individual portfolios over the past 10 years, weathering challenging economic and market environments. As an asset class, it has provided investors the opportunity for returns in excess of the public stock markets in exchange for less liquidity and different risks. Based on our 2014 Capital Markets Forecast, Private Capital is projected to be among the highest returning asset classes over the coming investment cycle, but it is most suitable for Qualified investors with long time horizons (more than 10 years) and spending requirements that are modest relative to portfolio values.
Returns from Private Capital arise from a combination of pursuing new ideas early and helping them grow, the use of leverage and the marking up of an investment when it is sold in an IPO or to a private buyer. In contrast, common stock returns come from growing earnings and rising price earnings ratios. Private equity provides a minor diversification benefit, as correlation with equities is fairly high. In contrast, correlation with fixed-income investments has been slightly negative in the past decade.
Any assessment of an investment area needs to start with the risks and then look at the returns. Private equity returns are driven by the credit quality of the investments, the level of interest rates, the growth prospects of the investments, and the pricing differential between buying at private market valuations and selling at public market valuations.
Risks for Private Capital are different from a portfolio of high-quality companies such as in the S&P 500 and should be measured by the quality of the investments, the leverage employed, the stage of the investments and geographic focus. To a great degree, risk can also be summed up by the quality of the investment management team.
Another important factor is how popular the asset class has been in recent years. When fund raising has been strong, there are more investment dollars chasing the same group of potential private equity deals. This can drive the prices up too much, reducing the future return potential. The funding picture is currently mixed, as the overhang from older funds has been deployed but new funding is again rising, although not to extreme levels.
When investing in Private Capital, an investor trades off liquidity and transparency for illiquidity, modest transparency and higher risks, with the expectation that returns will markedly exceed stock market returns. Historically, private equity has delivered returns of 1.5 to 1.6 times the public markets, and this roughly matches our forecast risk premium calculations. For example, if the S&P 500 earned 10 percent, private equity was expected to earn 15 to 16 percent. That ratio remains reasonable today, despite our concern over growth in the number of funds and the rising amount of money being raised.
A separate area within Private Capital is investment in natural resources, which have their own unique trends. Commodity prices are a strong determinant of returns in the natural resources space—principally prices in the energy, metal, and timber segments. Energy prices, particularly in natural gas, are being driven by the advent of shale gas. It is an exciting development for the U.S. energy market because it offers a cleaner alternative to coal, and its supply is still growing rapidly, helping to keep prices in check. While solar and wind have gained media attention, they are not expected to be major sources of power for many years. For other types of resources such as water, pricing is less important than supply and sustainability.
Especially given the likely low returns from public investments and the risks we see in those areas, Private Capital could offer an attractive opportunity for Qualified investors, both in private equity and natural resources.