Publications

Private debt has experienced significant growth over the past decade, driven in large part by institutional investors increasingly turning to private debt over traditional fixed income investments. This trend has been amplified in recent years especially by rising interest rates around the world. But how should investors think about allocating to private debt? What do returns to the asset class look like? What risk factors exist? And how does private debt fit within an overall investment portfolio? This discussion considers these questions in some depth, studying the various factors that have contributed to private debt's growth, the diversifying benefits it may offer to existing portfolios, and the ways in which the asset class may continue to evolve in the face of challenging macroeconomic conditions.

In recent times, artificial intelligence (AI) has taken center stage in news headlines. This quarter, Professor Josh Lerner from Harvard University explores the significant impact of AI on the private equity market. Drawing insights from historical technological breakthroughs, his analysis provides a valuable perspective on navigating the complexities introduced by AI in private capital investments. Furthermore, Professor Lerner offers insights into potential advantages and pitfalls that both General Partners (GPs) and Limited Partners (LPs) may encounter as they integrate AI into their investment processes.

The private market continues its recovery, but at a slower growth rate. As of Q2 2023, the overall private equity market reported a 1.8% return, slightly lower than the 2.1% return achieved in Q1. Private Debt funds were the sole strategy demonstrating positive return growth, reporting a robust 2.61% return in Q2. In contrast, Buyout and Venture Capital funds posted returns of 2.3% and -0.16%, respectively, both of which were lower than their Q1 performances. Across all strategies, Information Technology, Health Care, Industrials, and Consumer Discretionary stood out as the four largest sectors in terms of holdings’ NAV exposures as of Q2 2023.

In light of rising interest rates and a cooling PE market, LPs have increasingly favored larger funds since 2022 in their manager selection. During our discussion session, we analyzed performance dispersion among PE funds based on fund size and attempted to quantify the correlation between fund size and performance to assess the potential safety associated with investing in larger funds.

As the second piece in a series exploring the important and timely topic of private market asset valuations, this quarter, professor Josh Lerner from Harvard University continues investigating the significance and caveats of interim valuations in calculating and reporting PE performance. The article reviews the existing academic literatures that studied the issues surrounding interim valuations in depth, on the topics of biases in valuation, predictability of interim valuations on the eventual fund performance and potential manipulation from GPs of interim valuations over the life of a fund.

The private equity index posted an overall return of 1.22 percent in Q4 2022, a positive turnaround after negative returns in all three prior quarters in 2022. While Buyout and Private Debt funds both generated positive returns of 3.22 and 3.07 percent respectively, Venture Capital saw loss of -5.49%, resulting in its worst annual performance since the dot-com bubble. Industrials sector led the performance among all sectors in Q4 with a positive return of 5.68%. Energy funds followed closely with a quarterly return of 4.47%. Information Technology sector posted a -2.25% return and was the only sector to report a negative return for Q4 2022.

Despite significant declines in private equity activity in 2022, the private equity returns have yet to witness a performance contraction as severe as that occurring in public markets. As the net asset valuations of private equity are often “stale”, with the current price of the asset not fully reflecting the most recent information available, the current private equity performance might not be reflecting the current market conditions. Professor Josh Lerner from Harvard University, Leslie Jeng from the Private Capital Research Institute and Sam Holt from Bella Private Markets survey the existing literature on the existence of “stale” pricing in the private markets and its implications for private market investors who face allocation limits, such as a total private asset value to total asset value target, on their portfolios.

The overall private equity market posted a negative return of -1.36 percent, with Buyout and Venture Capital strategies remaining in the negative territory. Private Debt funds continued to lead the group with a positive return of 0.68 percent, while the Buyout and Venture Capital funds experienced -1.44 and -1.99 percent returns respectively. Energy funds continued to outperform the other sectors for the third quarter in a row, followed by Industrials and Health Care funds. All sector funds other than the Energy funds yielded negative returns. Information Technology funds continued to post the lowest return across all sectors for the third quarter in a row.

The linkage between the private and public markets can have direct effects on limited partners’ investment decisions in diversification, risk management and liquidity provision. In the discussion section, we estimate the public exposure of State Street’s Private Equity Index and investigate how such exposure has developed over time, by sub-strategies of Buyout and Venture Capital funds.

Concerns about inequality in the American economy have grown ever more substantial over the years. Often, discussions of this issue are linked to those about the "financialization" of the economy—worries that financial transactions can enrich the few while detrimentally affecting many others. Professor Josh Lerner from Harvard University, Leslie Jeng from the Private Capital Research Institute reviewed the latest academic evidences about private capital and jobs, and summarized some practitioner's views around the Equity Ownership Programs, Standards for Labor and Limited Partner's influence.

In Q2 2022. the overall private equity market posted a negative return of -4.71 percent, with all strategies turned into negative territory. Private Debt funds led the group at -1.99 percent, followed by Buyout and Venture Capital funds respectively. Energy funds held their lead among the sectors for the second quarter in a row, followed by Industrials and Consumer funds. All other sector funds yielded negative returns. Particularly, Information Technology funds experienced the worst returns across all sectors.

Despite negative returns, the overall private market still outperformed the public market amid an overall market downturn. In the discussion section, we further looked at the co-cyclicality of private equity cash flow in SSPEI universe and the public market business cycle before and after the 2008 Great Financial Crisis.

The Federal Reserve started to raise interest rates aggressively in an effort to control the rising inflation rate. While the impact of rising interest rates on the overall economy is widely discussed, its impact on private equity has been given relatively less attention. Professor Josh Lerner from Harvard University, Leslie Jeng from the Private Capital Research Institute and TzuHwan Seet from Bella Research Group survey the existing literature on the implications of rising interest rates for the returns of the two most common private equity strategies, buyouts and venture capital. The authors further discuss what these findings indicate for the industry today.

The overall private equity market posted a marginally negative return of -0.64 percent in Q1 2022, with Private Debt funds leading the group for the first time since 2014, followed by Buyout and Venture Capital funds respectively. Energy funds outperformed all other sectors followed by Industrials and Financials funds. The remaining sectors swung back to losses after recovering from the COVID crisis in Q1 2020. Information Technology funds lagged behind all other sectors for the first time since 2012.

In Q1 2022, after two years of steady growth, the valuations of Venture Capital funds dropped. Their investment activities have slowed and net cash flows turned negative. In the discussion section, we take a closer look at Venture Capital's performance at its sub-strategy level.

With the university endowments, sovereign funds and large pensions being the main investors in the asset class, private equity has attracted many other investors, who often lack access to private equity funds or true outperformers. Thus, the investors, as well as researchers, have been intrigued by the idea of replicating private equity returns with public securities. A few firms and a panel of researchers and practitioners have attempted to do so with seemingly some success. However, there are still obstacles that could potentially hinder the growth of replication strategies. In this article, professor Josh Lerner from Harvard University will outline the methodology and results of the replication research by Erik Stafford, discuss the challenges and obstacles in practice and provide some insights into the impact these efforts could have on the industry.

For the performance of private equity in Q4 2021, the overall market returned 5.74%, with Buyout funds leading the group, followed by Venture Capital and then Private Debt. Industrials funds continue to outperform this quarter, and energy funds rallied to top three among the sectors.

As Growth Equity has become a highly sought-after PE strategy in recent years, it sure has drawn a lot of attention from clients and our State Street research team. In the discussion section, we look at the growth of Growth Equity using SSPEI dataset from various perspectives - strategy, fundraising, return profile, dry powder, and comparison with traditional Buyout and Venture Capital.

The secondary market for private equity has risen from obscurity, with a tremendous growth in transaction volume exceeding $100 billion in 2021. These markets were no longer viewed solely as vehicles for LPs to provide liquidity. Rather, they have shift to enable complex GP-led restructurings of mature funds. In this article, professor Josh Lerner from Harvard University and Leslie Jeng from the Private Capital Research Institute, analyze the motivations behind and differences in some aspects of the two types of secondary transactions, LP- or GP-led. Moreover, authors outline possible explanations of strong performance in LP-led secondary investments, such as price discounts, and lower risks associated with more mature assets in the PE funds; whereas in GP-led deals, such discounts may be offered relatively smaller due to the asymmetric information issues.

Using previously unexplored custodial data, we examine alternative investment vehicles (AVs) in private equity (PE) funds over the last four decades. By 2017, AVs reached 40% of all PE commitments. Average AV performance matches the PE market, but underperforms the main funds of the partnerships sponsoring the AVs. Limited partners (LPs) with better past performance invest in AVs with better average performance, even after conditioning on the general partners' (GPs') past records. This result is largely driven by preferential access of top LPs to top AVs. Returns in PE increasingly depend on the match between GPs and LPs and both parties' outside options.

The investing success enjoyed by university endowments has attracted the attention of many observers, including critics. During the fiscal year ending on June 30, 2021, U.S. college endowments has posted best annual performance since 1986 with a median return of 34% for large endowments. Professor Josh Lerner and Leslie Jeng engage in a discussion about the commonly encountered criticisms of the endowment model, and express two concerns about the future sustainability of this approach to investing: 1) growth potential of the asset class 2) increasing political pressure.

Healthcare in the United States is a massive and rapidly growing industry. This growth has not gone unnoticed by private equity investors who have shown increased interests in recent years. In this article, the panelists - Josh Lerner, Leslie Jeng, and Jake Ledbetter from Harvard University and the Private Capital Research Institute - reviewed two recent data-driven, yet somewhat contradictory research studies on the effect of PE ownership on healthcare firms, one suggesting positive impacts, another paints a darker picture. In addition, the panelists highlighted several viewpoints from industry practitioners that also shed lights on understanding the nature of PE-owned investments in the healthcare industry.

Special Purpose Acquisition Vehicles ("SPACs") have exploded onto the mainstream financial scene in the last two years. In 2020 alone, nearly 250 SPACs representing over half of the number of IPOs in the US were raised, compared to just 7 SPACs a decade prior. This boom continued into Q1 2021, where nearly 480 new SPACs were raised, representing nearly 90% of IPOs during that time and with proceeds totaling $145 billion. SPACs are supposed to increase access to opportunities in investing private companies. However, research suggests potential concerns regarding SPAC structure and performance. There has been some discussion around regulatory changes and the future of the market.

The private equity industry has seen a significant structural transformation in the past two decades, in which a variety of alternative investment vehicles – co-investments, parallel funds, feeder funds and more - have been increasingly offered by general partnerships (GPs). Led by professor Josh Lerner from Harvard University, Antoniette Scholar of MIT, Nan Zhang and Jason Mao from State Street, a recent research uses novel data from State Street and documents, for the first time, several key facts about these alternative vehicles (AVs) over the past 40 years, and suggests its rapid growth potentially answers some of the most enduring puzzles in private capital.

Subscription lines of credit (SLCs) have become a staple of the private equity (PE) industry. A recent study has shown that at least 47% PE funds1 use these vehicles. It is widely acknowledged that the use of SLCs can be helpful for both LPs and GPs. However, both observers and academics have pointed out some challenges stemming from the use of SLCs. Professor Josh Lerner Harvard Business School discusses the latest academic research and practitioners’ opinions on what effect SLCs might have on the industry amid the turmoil in global markets.

In a recent working paper led by Josh Lerner, researchers explore VC activity and VC-backed innovation during recessions. They found that VC backed innovation seems to suffer during downturns, particularly early stage VC investments suffers greater retrenchment than late stage.

In the past decade, there has been an extraordinary surge of interest in direct private market investments among asset owners, who have started with traditional funds, and are now eager to expand their capabilities to co-invest alongside their private equity managers. In a workshop at Harvard Business School at a Private Capital Research Institute, leading asset owners, general partners, and academics explored this exciting territory. The panelists discussed the academic research - each shared by Victoria Ivashina from Harvard Business School, Tim Jenkinson of Saïd Business School, Oxford University, and Josh Lerner from Harvard Business School - around co-investments and alternative investment vehicles in private equity market, focusing on the assessment of their return distribution, and performance relative to their main funds.

In this article, the authors propose a risk estimation model that addresses both smoothness and idiosyncratic risk dynamics of narrow private equity portfolio returns. The authors subsequently apply the model to a broad set of private equity return streams with tightly controlled diversification properties. They show that increased model complexity is detrimental to the model's forecasting power and that idiosyncratic risks increase as one goes between hypothetical investment in a broad (albeit noninvestable) private equity index and a real-life, narrowly diversified portfolio of private equity funds. The authors also find that private equity returns have demonstrated a level of exposure to public equity markets that may be considered surprisingly low and offer a possible qualitative justification for this phenomenon. Finally, the authors incorporate the newly obtained private equity risk model into a general portfolio construction framework and demonstrate how to study the inevitable trade-offs between the costs and benefits of increased portfolio diversification.

The landscape of China's private market has changed rapidly in recent years. With the shift to VC-backed entrepreneurs driving the economic growth and the pursuant of new business models which are technology and innovation driven, the private capital investing in China has grown and evolved sharply since late 2000s, opening up a tremendous amount of investment opportunities and strategies. On the event at PBC School of Finance at Tsinghua University in Beijing, China, the panelists outlined the driven forces that enabled these changes, as well as their opinions on the unprecedented stress the industry is facing internally and externally, such as slowing GDP growth and trade war with US.

A major focus of financial policymakers around the world has been the creation of second-tier exchanges. Shai Bernstein, Abhishek Dev and Josh Lerner seek to understand the drivers of the creation and success of new second-tier second markets, focusing specially on the role of countries’ legal provisions for shareholder protection. They find second-tier exchanges are more likely to be introduced in countries with stronger shareholder protection. In addition, the researchers also analyze the mechanisms behind the importance of shareholder protection.

There has been a clear trend in declining of public equity market listings over the past two decades. It is important to understand the root causes of this pattern, and how this decline in public market would impact future private equity. Professor Josh Lerner explores several possible explanations of this pattern, including regulatory changes, business environment changes and investor taste changes. The projections of the private equity market depend on the belief of the root cause of the decline in U.S. listed equities.

In an increasingly socially-conscientious world, investors have become more aware of the social implications of their investment decisions and are turning to impact investments. Professor Josh Lerner reviews the pioneering academic researches featured in the Harvard Business School workshop on Impact Investing last September. These cutting edge researches investigated the measurement and evaluation of impact funds, the investor behavior of Community Development Venture Capital funds, and the novelties in the GP-LP and GP-portfolio company contracts of impact funds.

It is quite often the case that investors form views on private equity program return and cash flow profiles by analyzing broad-based swaths of the private equity industry, while side-stepping idiosyncratic risks associated with narrower, realistic baskets of private equity pools. This article remedies this by performing an empirical analysis of private equity historical performance while accounting for program diversification. Comparing a private equity program to peer group averages is somewhat unfair, as such methodology favors larger programs, arguably without merit. The authors explain a way to correct for this bias. Finally, the authors present a probabilistic strategic asset allocation framework for private equity programs that help make informed trade-offs between breadth, strategy mix, and associated costs.

Venture Capital (VC) fundraising has rebounded from post-crisis lows, but both GPs and LPs face new challenges and start rethinking the traditional VC model. Professor Josh Lerner highlights a few insights from an academic panel of the growth of new models in entrepreneurial finance. He points out that VC groups have responded the new challenges in three important ways: being a value-added partner, rethinking investment decision-making process, and focusing on capital efficiency and long-term value creation. Application of artificial intelligence in screening potential investments is a long-run challenge for VC groups.

Professor Josh Lerner discusses the new research he and Antoinette Schoar from MIT collaborated with Nan R Zhang and Jason Mao from State Street. This research, Investing Outside the Box: Evidence from Alternative Vehicles in Private Capital, undertakes a comprehensive analysis of alternative investment vehicles in private equity, using unexplored custodial data about 112 limited partners over four decades. The data show a rising trend of the proliferation of alternative vehicles in recent couple of decades. Alternative vehicles were far more likely to be offered by larger and North America-based buyout funds. The average performance of these alternative vehicles lagged that of the GPs’ corresponding main funds. The best LP performance was among endowments, private pensions, and insurers. Finally, LPs with better past performance invested in alternative vehicles with better performance, even after conditioning on the GPs’ past records. This result suggests that bargaining between GPs and LPs leads to gradation in investment performance based on the parties’ outside options.

After a prolonged period of low interest rates, leverage in PE deals has risen significantly in recent years. Professor Josh Lerner reviews the impact of debt to private equity returns. He points out that the leverage could be even higher than what the EBITDA multiple data show, as more deals had EBITDA adjustments in recent years. Lessons from past downturns suggest that the industry may have become better at managing leveraged investments. Meanwhile, the central banks played an important role by keeping the interest rate low during downturns.

It is reasonable to expect that changes in private equity valuations should bear some correspondence to public equity performance, because both private assets and public assets respond to common influences such as changes in discount rates. But it is also reasonable to recognize that changes in private equity valuations should depart to some extent from public equity performance owing to differences in risk, liquidity, and cash flow expectations. These differences affect the degree of correspondence. In this paper, we explore an additional influence on private equity valuations that affects not the degree of correspondence, but rather the symmetry of the correspondence. We argue that because private equity managers are less constrained than public market participants by the forces of no-arbitrage pricing, they have greater discretion to introduce biases into their valuations. Based on an extensive sample of private equity valuations, we find persuasive evidence that private equity managers produce positively biased valuations that appear to be rationalized by information that should not be relevant.

With President Trump signing the Tax Cuts and Jobs Act, Professor Josh Lerner reviews the academic research on tax policy and shows the potential impact of current policy changes. He points out that while the overall impact on venture capital is likely to be muted, for buyout firms, the consequences of an interest deductibility cap will be more dramatic. In the long run, this policy change will likely accelerate the transition of the private equity industry from financial engineering to an operational emphasis.

Traditional equity factors such as the leveraged equity risk premium, the small-cap premium and the value premium have had high historical returns on average, as has the buyout fund industry in aggregate. Previous research has argued that these factors explain the excess performance of private equity. However, time series regression analysis reveals that these factors explain surprisingly little variation in buyout performance. In contrast, other factors such as the credit premium and dynamic sector selection are more effective at explaining variation in performance of the buyout industry over time.

Venture Capital has traditionally been an US game. However, in the past decade, the historical pattern of geographic performance have reversed. The venture returns outside of US, particularly in China and India, have done considerably better.

Once-robust persistence of performance in buyout funds has weakened in post 2000 funds, while the venture capital funds still show persistence after 2000. Professor Josh Lerner discusses recent academic researches on this topic and summarizes views on where to find performance persistence in today's PE landscape.

The State Street State Street Private Equity Index posted an overall return of 3.95% in the first quarter of 2017, the highest quarterly return since Q3 of 2015.

Direct investing has been on the rise in recent years. Processor Lerner discusses the performance of direct investments and the challenges it brings to investors.

The State Street State Street Private Equity Index posted an overall return of 2.58% in the fourth quarter and 10.36% for 2016.

Private equity investments in the Emerging Markets may face additional challenges in the new Trump era on top of the existing ones such as weaker fundraising and disappointing performances. Through his analysis, Professor Lerner offers a new prospective on the Emerging Market private equity returns.

The State Street State Street Private Equity Index posted an overall return of 3.80% in the third quarter of 2016.

Professor Josh Lerner talked about the historical private equity performances relative to the public market under U.S. Democratic and Republican administrations.

The State Street State Street Private Equity Index posted an overall return of 2.70% in the second quarter of 2016, the highest quarterly return since 2015Q2.

In this quarter's PE Insights, Professor Lerner talked about the implications of Brexit on the Private Equity markets.

The State Street Private Equity Index posted an overall return of 0.65% in the first quarter of 2016.

In this quarter's PE Insights, Professor Lerner talked about the seeming disparity between the record venture capital fundraising and the cooling VC market in general, which was an interesting parallel to the year of 2000 in many respects.

The State Street Private Equity Index saw an overall return of 1.11% in the fourth quarter of 2015 and 6.55% for the full year.

In this quarter's PE Insights, Professor Lerner discussed the possible root cause of PE industry cycles: the economy-wide cost of borrowing. and how today's market environment looked compared with the past.

The State Street Private Equity Index dropped 1.37% in the third quarter of 2015, the first negative return after 12 quarters of uninterrupted gains.

We use a proprietary database of private equity returns to measure the excess return of private equity over public equity and to partition it into two components: an asset class alpha and compensation for illiquidity. Our evidence suggests that private equity managers, as a group, generate alpha by anticipating the relative performance of economic sectors. If we assume that manager-specific alpha is fully diluted across a broad universe of provate equity managers, we can interpret the balance of excess return as a premium for illiquidity. This result suggests that investors can capture the asset class alpha of private equity by using liquid assets such as ETFs to match the sector weights of private equity investors. This decomposition of private equity performance has important implications for portfolio choice, which we explore in this paper.