On a risk-adjusted basis, well-constructed portfolios of private equity investments outperform their publicly quoted equity counterparts over the medium and long-term. This is to be expected and justifies, in part, the illiquidity premium required to access the private equity ‘alternative asset’ class. In other words, additional compensation for the fact that shares in privately held companies cannot be traded as easily as those quoted on public stock exchanges.
Modest correlation between private and public equities
Perhaps unsurprisingly, it is generally assumed that private equity has a high degree of correlation with publicly traded equities - increases and decreases in their returns would be expected to move closely in sync. After all, some of the key drivers of private equity returns – corporate profitability, as well as purchase and exit pricing – are certainly influenced by many factors that also underpin public equity performance.
However, our research suggests that the correlation is not as high as many investors might think, and it changes over time.
The following chart shows the correlation (three-year rolling) between North American and European Buyouts (i.e. North American and European private equity) pooled returns and their respective public market indices (MSCI North America and MSCI Europe) since 2003.
Correlation between private equity and publicly traded equities
Source: Burgiss private equity data – European and North American Buyouts ($) pooled returns. Refinitiv Eikon public markets data.
North American Buyout correlation
The three-year rolling correlation of pooled North American Buyout returns with the MSCI North America equity index returns has fluctuated from below 0.5 to above 0.9, but mostly in the 0.7 - 0.9 range. At an average correlation of 0.82 since 2000, this would suggest that the addition of a portfolio of North American Buyout funds can provide some diversification benefits to a portfolio of North American public equities.
Over recent quarters, the correlation between these two metrics has gradually increased following a 4-year period of being less than 0.8, and it currently hovers around 0.8 – 0.9. It is interesting to note that a similar trend was observed during the bull market leading up to the 2008 global financial crisis and its aftermath.
European Buyout correlation
The three-year rolling correlation of pooled European Buyout returns with the MSCI Europe equity index returns has fluctuated to a much greater extent - from below 0.0 to around 0.9, but mostly in the 0.2 - 0.8 range. At an average correlation of 0.57 since 2000, this would suggest that a portfolio of European Buyout funds (i.e. European private equity) provides robust diversification benefits to a portfolio of European public equities.
However, it is notable that correlation has increased since 2015 (generally in the 0.6 – 0.9 range, with an upward trend), and it remains to be seen whether this represents a more permanent shift.
Potential explanation of correlation differences
How can the notable correlation differences between North American public and private equity market returns and European public and private equity market returns be explained?
One factor could be North American private equity firms using DCF valuation techniques and/or comparable public market valuation metrics vs their European counterparts, which have generally been known for adopting more conservative valuation approaches. Some evidence of this can be seen when portfolio companies are exited – in Europe, when comparing the valuation at exit versus two quarters prior, the average uplift typically oscillates around 15% - 25% as noted below. Over the same time period in North America, valuation uplifts have generally trended 5% lower.
Valuation uplift at exit compared with two quarters prior
Source: abrdn private equity data – valuation uplift at exit from two quarters prior for European and North American portfolio companies
Another factor could be the sector weighting differences between public and private markets in North America relative to Europe. In particular, the sectoral weightings of the average diversified North American Buyout and European Buyout portfolios are likely to be more closely aligned to that of the MSCI North America index, compared with the European equivalent – for example, there have been historically higher weightings in the North American portfolios for IT, but relatively lower Industrials and Consumer Staples compared with Europe as noted in the chart below. Significant differences in global sectoral performance over time can thus reduce correlation where portfolio weightings differ markedly.
Difference in sector weights between MSCI Europe index and MSCI North America index
Source: MSCI Europe index and MSCI North America index fact sheet, November 2022
Key takeaways
There are clear diversification benefits from adding European private equity to an equity investment portfolio
This may be due to idiosyncratic factors, a less efficient European private equity market, and/or more fundamental differences. Certainly, we observe European private equity portfolio valuations showing significantly lower volatility than European public markets through the cycle.
In rising markets, we expect to see private portfolio companies exiting at notable premia to their current valuations reflecting underlying latent value in buyout portfolios. In recessionary environments, particularly in periods of muted corporate activity, there may be a more notable difference between a manager’s portfolio valuation and what it may reasonably expect to receive if it had to exit its portfolio companies in short order. Private equity secondary market pricing (as a premium and discount to NAV) changes over time support this view.
- Correlation of private equity to the public markets in Europe is notably lower than for US counterpartsThis may be driven by: (i) the greater similarities in sector exposures between the public and private markets in North America; and (ii) North American private equity firms’ greater use of DCF valuation methodologies and/or more closely aligning their valuations to the listed markets, whereas European firms have often tended to adopt a more conservative approach.
Fund specific factors are important
Research indicates that beyond pooled returns, at the underlying private equity fund level, correlation is markedly lower (particularly between European funds and public equities). Many fund-specific factors (such as geographic and/or industry focus) are likely to net each other out at the portfolio level, with systematic factors in common with public equities, such as growth and interest rates, remaining.
In summary, we believe the above analysis supports our contention that an actively managed private equity portfolio can improve portfolio diversification and excess returns compared to benchmark equity indices only. This is notwithstanding an increased correlation between European buyout and MSCI Europe index returns in recent years.