Year by year, PE investors have ridden a roller-coaster of returns over the decades, magni?ed by PE’s use of leverage and by the expansion and contraction of purchase multiples. But less visible among the upward and downward gyrations has been a longer-term secular decline in returns, as the industry has matured and competition intensi?ed. 

Despite the volatility, PE remains one of the top-performing asset classes for LPs. The rise in the stock markets during the ? rst half of 2011 made short-term returns from public equities jump. But taking a longer-term perspective, PE has consistently generated better returns than listed equities, hedge funds and real estate, on average. By the middle of 2011, PE fund portfolios had ? nally recovered ground lost following the equities market crash in late 2008. Indeed, all categories of PE—buyout, mezzanine, venture capital and fund of funds—have produced positive returns over the short, medium and longer term, with buyouts leading the pack. 

Viewed against that overall positive background, PE returns through the ? rst half of 2011 were strong as portfolio valuations continued to rise, powering short-term gains. But while a healthy pop in returns is always welcome, the conditions that have steadily driven up returns over the past two years are now coming to an end and are not likely to be repeated. The consistent quarter-by-quarter gains PE investors have seen were the by-product of the con? uence of the equity market implosion following the 2008 ? nancial crisis and the PE industry’s transition to mark-to-market accounting rules set out under FASB 157. When equities took their hard hit that autumn, PE ? rms acted cautiously and promptly and sharply wrote down their portfolio company net asset valuations (NAVs). Not knowing where the markets would ultimately bottom out, GPs wanted to get the bad news out to their LPs all at once rather than through a series of successive restatements that would require repeated, con? dence-sapping explanations.

As economic conditions improved and the public markets recovered, GPs continued to value companies conservatively with a result that private valuations have lagged the recovery of public valuations. Subsequent restatements since the second quarter of 2009 have gradually and smoothly lifted the depressed PE NAVs out of their deep hole.

With PE assets now appraised close to their intrinsic value, returns going forward will become more volatile as they more closely track the ups and downs of the public markets. But it is far from clear what external market forces, or “beta,” will power the next wave of PE returns. Certainly, the familiar combination of factors that PE funds relied on in the past—GDP growth, multiple expansion and leverage—do not look nearly as favorable in the current recovery as they had in past ones, and particularly not in the developed markets where fragile economies teeter on the edge of falling back into recession. 

Recent valuation multiples and purchase prices remain high, making the likelihood of their further expansion limited at best. The LBO-friendly debt markets of early 2011 have given way to conditions of costlier and less available debt that are more akin to the less favorable environment of 2010. 

While weakness appears likely to continue in the traditional sources of market beta, returns that depend on them do not look poised for a great leap forward. To continue to produce returns that will sustain PE’s edge over other asset classes, GPs will need to dig deeper to generate alpha, the returns that rely on the superior management talent of PE ?rms to lift the performance of the assets they control above that of comparable public companies. 

(Excerpts taken from Global Private Equity Report 2012 by Bain & Company. Hugh H. MacArthur is the head of global private equity at the firm.) 

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