McKinsey on Mainstream Private Markets

The 2019 edition of McKinsey’s annual review of private investment markets is now available.

One of the themes of the new edition is that private markets have gone mainstream. Since 2002, private equity’s net asset value has grown twice as fast as global public equities. Looking at that growth from the other side, seeing the growth in the companies backed by private equity firms, the bottom line is even more impressive. In 2006, there were roughly 4,000 PE-backed companies in the US. By 2017, that number had more than doubled. That is a stark contrast with the public side of the corporate world. The number of US-based publicly traded firms fell 15% over that same period.

With growth, the report says, “comes maturity.” The growth of the PE world has caused a scaling up of secondary investments, that in turn has “made the asset class easier to access and to exit.” Related, co-investment has become normalized after shaking off “concerns about adverse selection.” The fear was that PE funds would use co-investment opportunities selectively to curry favor with specific investors with whom they would building a relationship. In that case, (so went the thinking) co-investment might constitute a cream-skimming exercise, and the ordinary’ investors in the PE’s funds may be left with inferior stuff. The fear sometimes pointed the other way too: maybe co-investors were being talked into taking the dregs and the fund LPs were getting the cream. Neither fear seem to have eventuated, though, and co-investment has normalized.

Record Fundraising

The year 2017 was a record for fundraising in private markets. 2018 fell somewhat short. In North America in particular, private equity raised $33.2 billion less in 2018 than it had in the year before. Closed-end real estate raised $8.9 billion less; private debt fundraising was down year-to-year by almost as much ($8.1 billion), though natural resources and infrastructure-oriented funds made (smaller) increases. This nets out to a year-on-year decline for private market fundraising of 7.9%.

Globally, the corresponding figures are:

Source: McKinsey & Co., Private Markets Come of Age (2019), adapted from Ex. 1, p. 7. Data from Preqin.

Size matters in the private markets. Megafunds are attractive to investors and over time they’ve been absorbing a larger portion of the funds raised. Consider funds with between $5 billion and $10 billion in assets. In the years 2007-2012, 32 such funds were raised—75 in the years since. In 2018, funds of that size constituted 20% of private market fundraising. This was up from 12% the year before.

Private Equity Returns

Private equity remains the largest of the private markets. The McKinsey report observes the huge dispersion of returns in private equity. This is intuitive. In the world of US Equity Mutual funds, where everybody is looking over everybody else’s back, dispersion is narrow.

Picking, though, is a tricky business. It isn’t just a matter of “picking the manager who outperformed last year.” Because persistence in outperformance is declining. Since 2007, the McKinsey report says starkly, “bottom quartile funds have been nearly as likely to outperform as top quartile funds.”

The volume of deal activity

Private equity deal activity has dried up considerably in India and China, declining about 60% in those two countries in 2018. This created a decline in volume in Asia as a region (-42%).

But globally, PE deal activity was up, totaling $1.4 trillion. Deal count is down slightly, but average deal size is up. This increase in deal size isn’t coming from a few outliers. It is broad-based and, in the U.S., it has been driven in part by changes in tax policy.

Beyond tax policy, McKinsey observes that GPs are confident that they’re buying higher-quality assets now than have been available in recent years. Consequently, “they’re willing to pay higher multiples to own them.”