Performance of unlisted companies: perspective from the world’s largest SWF

A common perception in Luxembourg is that private equity, in its widest definition, outperforms the public markets. The reality is more nuanced once you dig into the details. In the second part of a series, Delano looked into the extensive review recently carried out by Norges Bank Investment Management.

We that the performance of private equity funds has shown mixed signs of recovery, as per Pitchbook data for 3Q23. However, the situation was more challenging in the venture capital industry.

A timely opportunity to jump in or to reflect on alternative options?

Given the resources allocated to the task, Delano decided to revisit the decision process of the largest sovereign wealth fund in the world, Norges Bank Investment Management, which recently advised its owner, the government of Norway, on the .

Late last year, NBIM, Norway’s $1.6trn wealth fund manager, petitioned policymakers at the country’s ministry of finance to allocate 3% to 5% of its assets with large and mid-sized private asset managers with the intention, over time, to become co-investor. As for authorised private assets, its Government Pension Fund Global may currently invest only in unlisted real estate and infrastructure for renewable energy.

NBIM claimed that the share of private equity allocation for its peer group is “more than 9%” (CEM Benchmarking, 2021). As a major global investor in listed equities (NBIM owns shares in about 9,000 companies worldwide), Delano understands that NBIM does not want to see its investment universe ever more restricted as it already owns, on average, 1.5% of all listed companies in the world (NBIM is not permitted to hold more than 10% of the shares in a listed company) a level that is up from 1.0% in 2009. NBIM also noted that the rapid growth of private equity has “coincided with the stagnation in the number of companies in public equity markets.”

Private assets: A story of mixed historical performance

NBIM reviewed the suitability and performance of leveraged buyouts (LBOs), venture capital, and growth equity. It found that LBOs “have meaningfully outperformed public equities” on average by 3% to 4%, annually.

However, it observed that venture capital and growth equity “have underperformed by 1% to 2%, on average.” It also pointed out that recent performance of venture capital looked “more positive.”

NBIM reported that the sample covered funds with vintage years from 1986 to 2016.

Adjusting for the peculiarities of the product

NBIM stressed that its analysis looked at different performance measures and accounted for “market risk and other risk factors.” Not surprisingly, the asset manager reported that the performance “is highly dispersed” and depends “on strategy, timing, and manager selection.”

Using Preqin data, it calculated that the differences in the performance between the top-and-bottom quartile were as high as 12.1, 14.7 and 15.8 percentage points for buyouts, growth equity and venture capital, respectively. Without a doubt, the selection of the fund manager is key in all markets.

The review also noted that the direct alpha (performance of private equity over public market with the same timing) was prone to be repeated on successive vintages for some buyout funds, but it also warned that “persistence has fallen over time.” Consequently, reviewing several vintages is advised to identify the best managers.

Many ways to build value

NBIM’s review of the literature suggests that the value creation for buyout and growth funds comes from improvement in more than one of these following categories: operation, governance and financing.

It noted a shift of value creation drivers from leverage and into operations, which it assessed as more challenging to execute than tax and financial structuring.

When comparing the governance model of private equity and public markets, NBIM concluded that “neither model is definitively superior.” Investors in public markets reduce their lack of access to internal company information with greater diversification to mitigate firm-specific risks, whereas private equity mitigates the more concentrated company-specific risks “through better monitoring, control, and incentive alignment.”

As NBIM has declined to answer our questions, it is unclear whether it thinks that the shift of focus on governance and operations as a primary source of value creation instead financing and leverage will reverse the underperformance trend for growth equity venture capital. Not surprisingly, NBIM noted in its report that the higher competition for PE deals increases the valuation of targets, making it more challenging to extract value over the purchase price.

VC: Too much of a gamble?

While the analysis of buyout and growth companies relies on business models with a track record and competitive positions, the weaker performance of VC--coupled with NBIM’s observations that literature on VCs suggest that early-stage investors tend to rely on an “existing management team” with professional experience and education--may give the fund and the government a sense of a high level of speculation that may not be adequate when confronted with public money oversight.

Solution to high fees: Co-investment may lower the costs but also performance

The pay structure of these funds may also be a source of concerns for the government, as it aims at the most cost-efficient way to invest the country’s wealth. It is not a surprise as there are multiple reports of pension funds infuriated by the stubbornly elevated fee levels imposed by the private asset industry.

In its review submitted to the government, NBIM admitted that the “costs of investing in private equity are considerably higher than for public equity and other unlisted assets,” such as real estate assets. It noted that PE costs are “more than four times that of US listed small-cap stocks” and are commonly 2% of the committed capital plus performance fees of 20% also known as carried interest when exceeding certain thresholds.

However, NBIM reported that some US pension funds are paying “significantly lower fees than their peers” when investing in the same funds. Besides, NBIM observed that some investors are co-investing with the funds to enhance their “after-cost performance.” However, NBIM observed a mixed performance for such an alternative on the back of principal-agent issues or conflict of interest as general partners may not propose their best investment opportunities to co-investors.

Nei foreløpig (not for now)

Yet the request from NBIM to dive into private equity investments was rejected by the Norwegian government. In a , its minister of finance expressed the wish to collect more information and intend to establish a new independent and “external expert council for the fund” in 2024 to assess the appropriateness of investing in unlisted equities.

It is reasonable to think that PE and VCs’ potential performance may not have been seen by the government as high enough to offset the lack of transparency and the principal-agent conflicts to name few issues when investing in a private funds.

Apart from a question on methodology, Norges Bank Investment Management declined to answer to Delano’s questions for this article.

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .