Insights Chart of the Week

Infrastructure: Finding the Sweet Spot Between Risk and Return

Infrastructure investments span four risk strategies: core, core-plus, value-add and opportunistic, each offering unique characteristics and risk/return profiles across a spectrum. Core investments are intended to provide lower risk with bond-like characteristics. These assets look to offer current income with strong downside protection and are often brownfield assets with strong operating histories and highly or fully contracted revenue streams. At the opposite end of the spectrum, opportunistic infrastructure investments are more stock-like with a higher risk tolerance. They often involve development projects, asset-light businesses, higher leverage and little-contracted revenues, seeking to offer returns largely through capital appreciation. 

Core-plus and value-add strategies exist between core and opportunistic and seek to maintain infrastructure’s hallmark downside protection, while unlocking additional upside potential at an appropriate level of risk. When we look at the dispersion of returns across strategies, core plus and value-add stand out as the sweet spot for infrastructure investing. The historical net return floor of +6% nearly matches the core median return, while simultaneously maintaining a much tighter range of outcomes than opportunistic returns without limiting the potential for net returns in the mid-teens. Infrastructure is known for its historical risk-adjusted outperformance, and we believe core-plus and value-add strategies offer the best of both worlds: strong downside protection with compelling upside potential.  

Following the (Fundraising) Money

This week's chart illustrates a clear trend in buyout and growth equity fundraising, with a considerably larger number of sub-$2 billion funds per vintage year compared to larger funds. SMID funds, which primarily target smaller companies, are in a unique position to drive substantial growth through hands-on management and targeted strategies like M&A and operational improvements. Given their smaller scale, these companies can more readily achieve transformational growth, which PE managers are increasingly valuing in today’s market, and which has become less driven by multiple expansion. The emphasis on active engagement and tailored growth plans positions SMID managers as key players in driving returns amid evolving economic conditions. Can your portfolio capture this market segment?

Diminishing Debt/EBITDA Levels for Buyout Deals

This week’s chart examines median net debt-to-EBITDA ratios at acquisition for buyout deals versus MSCI World companies, showing that leverage levels for buyout deals have modestly declined in recent years. While GPs have utilized debt as one of the many tools for value creation, recent acquisitions reflect a more cautious approach with higher equity contributions. This trend may represent a strategic response to tighter lending conditions, leaving some sponsors positioned to potentially refinance with lower-cost debt as credit markets become more accommodating.

If the competition in credit markets intensifies, these over-equitized deals could see rising leverage as sponsors seek to rebalance capital structures, creating renewed opportunities across senior, mezzanine and equity financing options. This cautious deployment of leverage may open pathways for strategic recapitalizations and a shift in capital structure dynamics for more recent vintages.

Can Big Infrastructure Exits Come from Lower Multiples?

Average EV/EBITDA multiples have increased for large-cap infrastructure transactions over the past 10 years, partially driven by the growing number of large/mega-cap funds in tight competition for the same deals. Over the past 5-10 years, large-cap deals have transacted at an average premium of ~30% to small-to-mid cap (SMID) transactions. Meanwhile, small- and middle-market deals have maintained more attractive pricing, creating opportunities for outperformance in the transaction space. Lower entry pricing allows for growth initiatives, such as developing new projects or completing bolt-on acquisitions, to actually ‘move the needle’ in the middle market and create significant value. 

Optionality at exit is another attractive characteristic of the SMID market, as a wider audience of potential buyers can take action on small- and medium-sized businesses. This buyer pool includes a vast number of other middle-market funds, strategic buyers and a growing number of large- and mega-cap funds, which must deploy ever-growing sums of capital. In contrast, at the upper end of the market, the path to exit can be more limited, as there are fewer funds or companies with sufficient capital to execute a large- or mega-cap acquisition, which can increase the reliance on the public markets for exiting via an IPO.

Why Selectivity Matters

The marketing materials for many private equity funds suggest lofty return targets of 20% (or more!). Have they delivered on those ambitious return targets? An examination of net returns suggests that nearly two-thirds of private equity funds fall short of the 20% return threshold. Many of those funds are concentrated in vintage years or time periods that benefited from robust bull markets. At first glance, this seems like unwelcome news for investors in those funds. 

The good news for investors? The majority of private equity funds produced mid-teens or higher net-of-fee returns, where the median was 14.4%. In the context of returns on other assets, this performance is excellent and suggests that the average historical private equity fund beat the performance of global equities by 475 bps, a welcome outcome for private equity investors.

Choose Wisely: Sector Composition Can Impact Performance

Not only is strategy allocation an important portfolio construction consideration, but sector composition within the portfolio is also a key component to proper portfolio management. In this week's chart, we examine the sector composition of private equity deals over time and observe noticeable shifts. The information technology sector has (unsurprisingly) become more popular while we have noticed a decline in the number of consumer discretionary deals in recent years. Sectors such as industrials, health care and financials have neither waxed nor waned in popularity. The upshot? Savvy LPs should keep underlying sector diversification in mind when building their portfolios, especially as some sectors may exhibit more cyclicality than others.

Infrastructure Builds Historically Resilient Portfolios

In today’s unpredictable market, many investors are seeking stability in their portfolios. This week’s chart shines a spotlight on why private infrastructure stands out as a resilient investment option. Infrastructure is recognized for its potential to generate stable returns with low volatility. But unlike public equities and public infrastructure, which are often swayed by market fluctuations and investor sentiment, private infrastructure assets have historically provided more consistent performance. Additionally, private infrastructure exhibits low correlation with public equities (0.46), public infrastructure (0.35), and even private equity (0.65), offering valuable diversification potential and bolstering portfolio resilience during uncertain times.

High Sharpe ratio, anyone?

Infrastructure may be a relatively nascent asset class for investors, but it has quickly become a key component in many portfolios due to favorable return characteristics, including low correlation to other asset classes and the potential for both downside protection and an inflation hedge. Our data shows that private infrastructure has historically achieved a notably higher total return compared to public infrastructure alternatives and with lower volatility – even after adjusting for smoothing effects in performance reporting. High Sharpe ratio, anyone?

Fund Size ≠ Average Returns

This week we examine the differences in dispersion of small-cap buyout, middle-market buyout and mega/large buyout. Interestingly, the median IRRs do not differ drastically between the three fund sizes, all hovering in the mid-teens. This suggests there is not a strong correlation between fund size and average returns.

Top-quartile, middle-market managers, however, have historically posted stronger returns than their peers in the mega/large space. While top-quartile returns are high, the dispersion of returns for middle-market buyout also remains wide, showing the upside potential and downside risk. That dynamic stands in contrast to mega/large funds, which exhibit a tighter dispersion. This relationship is even further pronounced when looking at small-cap buyout relative to the other buyout buckets. Small-cap buyout displays the highest top-quartile returns, while also having a sizable increase in return dispersions. Strategic planning and prudent manager selection remain crucial to targeting outperformance, especially in small-cap and middle-market investing where the wider dispersion of outcomes can introduce more downside portfolio risk considerations.

Marathon-style Performance

Rewinding the clock, private and public markets saw robust growth through 2020 and 2021. That reality drastically changed in 2022 as a result of rates moving higher and a dash of geopolitical uncertainty. Our chart this week looks at the cumulative returns of private and public markets since the last peak in Q4 2021. After a sharp decline to start 2022, public equities rebounded sharply and have performed well, driven largely by a handful of tech-focused, mega-cap names. We observe that, recently, private equity has underperformed public markets in the short run. Buyout outperformance has historically been most pronounced during periods of mediocre or negative public market returns.

Conversely, credit has benefited from the current sovereign rate environment and infrastructure continues to generate respectable yields with cost-passing and capital preservation benefits, showing strong performance relative to publics in both of those asset classes. While public markets may experience sharper movements over short-term periods (< 3 years), we believe private market strategies will continue to outperform in the long run.

Current Rate of Distributions vs. Pre-2021

We focus a lot on risk and return, but liquidity is another major consideration when thoughtfully constructing private market portfolios. In this week’s chart, we observe the rate of distribution across all private markets as the total amount of distributions as a percentage of NAV. Also shown are the annual amounts to illustrate the magnitude of distributions per year, demonstrating distribution activity in two ways. Investors experienced diminished distribution activity in 2023 compared to the record amounts in 2021 and 2022, and it is unlikely to see distributions of that magnitude based on 1H 2024.

Distribution rates, however, show some evidence of recovery from the all-time lows they saw in 2023, which was the lowest annualized rate of distribution over the past 10 years. This can be attributed to minimal exit activity during that year, but it appears to have begun picking up traction in the start of 2024. Still, the distribution pacing declines are more a function of NAV growth, rather than a massive decline in absolute distributions, as distributions continue to be on pace or exceed those of pre-2021 levels.

Want Historically Premium Returns? See PE.

For this week’s chart, we explore 10-year annualized returns on a rolling basis. Over a long time horizon, private equity has bested listed equities over most 10-year periods and across various market cycles. In fact, when compared to the MSCI World index, private equity outperforms in every time frame. Even when taking into account the most recent period of public market volatility, private equity continues to substantially outperform.

Private equity outperformance is typically most pronounced during periods of mediocre or negative public market returns. This disparity arises more from the volatility in public markets than from the nature of private markets themselves. When public markets are strong, private equity's outperformance diminishes; in any other environment, it increases. Regardless of market volatility and market cycles, private equity continues to generate premium returns that investors cannot access from listed equities.

When Saying "No" Can Add 2 – 3%

Top-quartile fund performance can be one of the many drivers in a private markets portfolio. However, there is also meaningful upside to avoiding bottom-quartile funds. Shown this week is the impact of top and bottom-quartile funds by vintage year for all private markets funds. It’s important to note that even without the top-quartile funds (dark blue), on a pooled IRR basis, private markets have still performed quite well.

That begs the question of how much alpha can be added by only selecting top-quartile funds. While this varies by vintage year, the chart illustrates that roughly 3-5% can be added by selecting top-quartile funds. That is a substantial premium that comes with good portfolio management. While everyone strives for the best of the best, what can be said of simply avoiding the bottom-quartile funds? Does that have as drastic of an impact to pooled performance? Not quite; however, roughly 2-3% can be added by avoiding bottom-quartile funds. In either scenario, the importance of portfolio management is evident and careful manager selection – knowing who to choose and avoid – can drastically impact returns.

Will M&A Accelerate PE Performance in 2024?

A common question we hear among investors is what to expect from private equity during market crises and downturns. We’ve looked at a few significant market crisis environments: The dotcom bubble in the early 2000s as well as the Global Financial Crisis (GFC) and compared them to equity market drawdowns over 2022 and portions of 2023. During both the dotcom and GFC eras, the public market decline continued well past three quarters and took five to six years to reach breakeven. The downturns in buyout, however, were much more muted than those of the public markets. In addition to taking less of a hit, the private markets recovered sooner than public markets during both crisis periods.

At the start of 2022, we saw another market downturn, though much less severe than previous eras. Private markets once again showed more resilience and muted aspects, including breaking even prior to the publics. But there’s something noticeably different this time around: The sharp rebound in the public markets from 2023 through 1H 2024 has not yet been matched by the private markets. Perhaps a rebound in M&A activity will provide a boost to private markets... It is safe to say, however, that the downturn seen in 2022 is nothing like what we saw in the dotcom bubble or GFC era.

Diversification: Increasing the Likelihood of Success

We’re celebrating Chart of the Week’s first anniversary with one of the charts you all found most interesting over the past year: the distribution of portfolio returns.

The goal of successful portfolio management is mitigating downside risk while creating the best chance of achieving your target returns. Diversification plays a major factor in that success. Here we see the return distribution of portfolios of varying levels of diversification by strategy. The first chart shows the distribution of returns for portfolios investing in one fund every vintage year. The second chart shows increasing the portfolio to invest in 10 funds each vintage. As you would expect, the dispersion of returns is wider for the more concentrated portfolio.

When the number of funds per year is increased from one to 10, the spread of returns tightens drastically. Credit and infrastructure have limited upside potential in this scenario, but they have the tightest dispersion and therefore greatest likelihood of achieving a set return. Narrowing the dispersion in any strategy increases the certainty of portfolio return, which reduces idiosyncratic risk. These figures do not imply optimal diversification but rather illustrate the impact of diversification in portfolios. Importantly, careful manager selection may also increase the likelihood of achieving target returns.

Where $100+ Million Companies Thrive

This chart shows public and private companies with revenue greater than $100 million over the last 12 months. 

Private equity can represent a target-rich environment, the market potential of which studies show is larger compared to publicly traded companies. 

Globally, there are over 140,000 private companies with annual revenues over $100 million vs. approximately 19,000 public companies with the same annual revenues. 

This highlights the breadth of investment opportunities available in the private capital universe, where the opportunity set across different strategies, sectors and regions is likely to be much wider and more available than the public landscape. As such, we believe that private markets offer investors the unique potential to outperform and diversify their overall portfolio.

The New Allocation Blueprint

The 60/40 portfolio has long been the blueprint for a so-called “diversified” portfolio. A 60% allocation to public equity and a 40% allocation to bonds has been shown to provide some ballast and better potential risk-adjusted returns than a 100% public equity-only portfolio.

However, this has not always held true in all market environments. In fact, this may be the outdated diversified portfolio; the “new 60/40” investors are looking to more frequently now includes a mix of private assets as well.

This table shows the return and risk (standard deviation) outcomes of different allocation variations to private equity and private credit, scaling down public equity and bonds in the overall portfolio. Adding some private equity and private credit, we find there is an improvement in the long-term return, risk and Sharpe ratio when compared to the traditional 60/40 portfolio.