Silencing the Private Equity Haters and Doubting a Rate Cut Rally

March 8, 2024

In the March investment edition of the Wealthy Behavior podcast, I spoke to our Chief Investment Officer, Bob Weisse, about:

  • February’s U.S. and international stock and bond market moves and the reasons behind year-to-date performance.
  • Historical research on Fed rate hiking cycles and the S&P 500’s performance following final rate hikes.
  • The unfair criticism directed at private equity, what to look for when investing in private equity funds, the differences between it and venture capital, and the outlook for future private equity opportunities.

Below are some highlights from the conversation condensed for clarity. Full episode available here and wherever you get your podcasts.

March Market Update & A Primer on Private Equity vs. Venture Capital

March Market Update

  • February was a good month, continuing a positive year in the markets. The Global stock market is up, led in the U.S. by tech and AI stocks and Novo Nordisk (the weight loss drug company) internationally. Bond yields have risen a bit this year with expectations for early and often Fed rate cuts diminishing, which has hurt prices a bit far year-to-date.
  • Valuations in Developed International markets are attractive relative to the U.S., and Japanese and European stocks are performing well. Valuations are also attractive in the emerging markets, but there is additional risk there not faced in the developed markets (i.e. political risk in China).

Effect of Rate Cuts on the Stock Market

  • Looking at U.S. stock market performance over the past 14 Fed rate hiking cycles going back to 1929 you would think that when the Fed starts cutting rates stocks perform extremely well, but in that pause between the final hike and first cut (which we are likely in now), stock market performance is not so great. However, that narrative is misleading according to Bob. If you draw a line before and after 1982, it’s a different story. Stocks have done well in the last 42 years during that pause period between rate hikes and cuts, and the performance isn’t so great after the first cut. Bob posits that the Fed is getting better at its job and knowing when to cut rates, and that investors may also be pulling forward some returns into the pause period that precedes the first cut. This is important to manage expectations for 2024 returns. It’s not as simple as saying stocks will go up when the Fed cuts rates.

Private Equity

  • There are private equity critics who question how good the performance is, are critical about how performance is reported, and assert that the returns are better only because of leverage and the fact that the portfolio values are not updated daily.
  • Bob likes private equity, believes it belongs in certain client portfolios, and shares that it has generated excess returns over publicly traded stocks. He posits that the critics have their own agendas, namely, that private equity is a hard asset class to research and implement for clients and some wealth management firms criticize it because they don’t want to do the work to offer it to their clients. He also shares that some of the criticism is from investment firms that don’t have private equity products of their own to offer.
  • Beyond this, there is a big dispersion between the performance of private equity firms unlike with publicly traded stock managers. Looking at the average returns for private equity isn’t the same as looking for average stock manager returns because of this dispersion and manager selection really matters with private equity.
  • To improve your odds of finding a good manager, Bob recommends looking at whether a fund is raising too much money and has too many products on their shelves and focusing instead on smaller raises and fewer funds, whether the fund’s general partners are committing significant dollars to the fund, a performance incentive fee that kicks in after the fund has earned returns of around 8%, and private equity firms that have a history of improving their companies through operational improvements.
  • Venture capital is much more speculative early-stage investing so it’s riskier without an average return premium over private equity so he is not as optimistic on venture in client portfolios.
  • Look at the two measures of performance when assessing private equity returns – Multiple of Invested Capital and Internal Rate of Return. Looking at one without the other can lead to misleading performance conclusions.
    • Per Investopedia, “Multiple on Invested Capital (MOIC) is a ratio or ‘multiple’ of money received (or will receive) relative to the investment amount. Simply put, if a fund invested $1 and received $3 from the investment, the fund has a MOIC of 3x.”
    • Internal Rate of Return “is the annual rate of growth that an investment is expected to generate.”

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