Private Equity Will Outperform Public Markets in 2016

Equity markets are expected to be volatile — or downright bearish — in 2016. Public and private markets were both awfully strong in 2013 and 2014, but last year was a rude awakening for a lot of investors. Fortunately, private market deal-makers have a lot more to be optimistic about in the new year, especially in fields like health care, infrastructure, and technology.

History tells us that rising public markets are good for capital fundraising, although they are probably bad for average private equity returns. It’s been a long climb back on top for all equities from seven years ago, but it seems clear that this year will be different. With struggling public equities in 2016, private equity IRRs have a chance to widen, especially in the middle-market space.

The Long Climb Back on Top

Private equity funds suffered large write-downs coming out of the financial crisis of 2008-09 and fundraising stalled. The boom years of 2005-07 saw record prices on the back of sky-high multiples and unprecedented leveraging, only to come crashing down like the rest of global equity activity when the Great Recession hit.

The revival started slow, but it’s generally accepted that U.S.-based private equity funds had stable or improving net IRR by mid-2011 (data is notoriously difficult to trust in PE thanks because the industry lacks the disclosure requirements of public markets). In 2012-2014, we saw record cash flow into both venture and buyouts in the wake of ultra-low interest rates and fast-growing global financial assets.

The total size of private equity capital reached approximately $4.2 trillion by June 2015. According to Preqin, buyout funds raised almost as much money between 2012 and 2015 as venture, growth, secondaries, mezzanine, and fund of funds combined.

Public markets kept pace with private equity growth until 2015. In fact, research from Preqin suggests that global public markets outperformed private equity funds in every year between 2006 and 2014. In North America, public markets won every year except for 2007. (Europe is a different story; European public markets have underperformed every year since 2000.)

If tides turn for the worse in public markets this year, it could leave some capital on the sideline in a flight to safety. Private equity deals in 2016 might be fewer in number than in 2013-14, but they’ll likely see higher returns because asset prices will be less inflated and rising rates might bring sellers to the table.

Public Market Outlook

We’ve already seen struggles in public markets, especially in Asia and Europe. The emerging market space continued its nearly decade-long disappointment after the Chinese stock market crashed repeatedly between August and January. Global markets have to deal with a strange divergence in monetary policy between the United States, which saw the first Federal Funds rate hike in seven years in January, and the Eurozone and Japan, who’ve decided on negative interest rates.

The International Monetary Fund recently estimated that each 1% decrease in China’s investment growth could reduce global public market growth by 0.1%. Eurozone countries could struggle most, since as much as 30% of Eurozone exports come from Asian manufacturers. All this even before the Chinese National Bureau of Statistics and CNN released news that 2015 was China’s worst growth year in a quarter-century. And that doesn’t even account for the massive banking problems in Eurozone nations.

Mark Williams, chief China economist at Capital Economic, said China is probably overreporting growth figures by as much as 2.3%, and that Chinese policymakers have proven “inept” when interfering with the equity market.

Investors Expect Private Equity Premium, Looking at SMB Buyout Funds in 2016

Christopher Elvin, head of Private Equity Products at Preqin, wrote in his Global Private Equity and Venture Capital Report that, “Private equity has been the best performing part of many investors’ portfolios over recent years, delivering superior returns compared to all other asset classes over the long term…many investors have indicated that they are preparing to allocate more capital to the asset class in the year ahead.”

Money should continue to roll into buyouts in 2016, especially in the small to mid-market. Preqin’s surveys suggest that the majority of active PE investors (73%) want to invest in SMB through mid-market buyout funds. Despite some concerns about recent vintage year vehicles keeping up with expectations, pricing continues to suggest strength.

ACG New York, a leading association of middle market deal makers, released a separate survey in January predicting private equity investments would outperform the S&P 500 in 2016. A full 83% of participants were more bullish on PE than public markets, even though only 50% expect deal making to improve over 2015.

Keeping with the same theme, a Probitas Partners survey of 104 institutional PE investors found that “midmarket buyout funds, defined as funds ranging from $500 million to $2.5 billion in size, ranked as the most popular strategy” for 2016, followed closely by small buyout funds.