Our position as both an OCIO search consulting firm and an alternative investments due diligence provider at Manager Analysis offers an interesting vantage point: while we see how OCIOs allocate into alternative investments, we also see a decent sampling of the quality of alternative investment opportunities that the OCIOs are assessing. We observe that, while compelling opportunities continue to present themselves, average return prospects have also greatly diminished, evidenced by greatly reduced IRRs and very slow distribution rates now persisting for the last three years.
Nonetheless, many OCIOs hope for a recovery in PE performance and liquidity. They continue to advocate for building out PE portfolios, diversified by class year and strategy grouping. We have not yet seen OCIOs accept a prospect for diminished privates returns. Rather they observe that PE markets have recovered very quickly from past down-cycles in subsequent years, so they believe it is critical to sustain the pace of allocations during times of weak performance.
Have return prospects actually changed for private markets? Should OCIO behavior be a concern for OCIO clients? What would we want OCIOs to do in the current PE market?
After Adjusting For Sector Selection, Has Private Equity Really Outperformed?
The existence of widely dispersed investment returns among private equity and venture managers makes these markets a compelling choice for any allocator that believes they have skill in manager selection. We meet few allocators who don’t believe they have such a skill, but nonetheless even without exceptional manager selection skills, hitting the average was still a success over the long term. Allocators for private equity have typically sought excess returns of 3% to 5% over comparable public market returns, and private equity’s long-term returns have, until at least 2022, supported that premise.
But is that outperformance a reflection of private equity managers making skillful selections of enterprises for investments, or something else? For instance, PE managers have had a strong bias toward information technology-related businesses over other sectors. The Russell Technology Index earned an average of 19.7% over the last 10 years to May 30, 2025; compared to 11.0% for the S&P 500 and 5.1% for the Russell 2000. When we consider that the typical private equity fund has a 36.6% allocation to information technology [IT], compared to 14.0% for the Russell 2000 [figures are from Cambridge Associates https://www.cambridgeassociates.com/insight/us-pe-vc-benchmark-commentary-first-half-2024/], the typical PE Fund should outperform public markets. For example, using public market equivalents [PMEs], the higher return from the higher IT weighting creates an alpha versus the Russell 2000 of 5.8%. The IT sector weight in the S&P 500 is about 27.5%; the extra tech weight there adds only about 0.9% alpha versus this large and megacap index over those 10 years.
Looking at performance through June 30, 2024[1] we see that Cambridge’s PE index outperformed the Russell 2000 by 8% and the S&P 500 by 2% over 10 years through June 30, 2024.[2] In fact, our sector-adjusted PME estimates for PE explain much of the actual performance: about half of the outperformance versus the poorly-performing Russell 2000, and 1 percentage point of the 2% outperformance versus the S&P 500.
[1] Performance may appear stale but this data was released in March 2025 and does not overly rely on interim estimates.
[2] Our PME adjusted alphas for the 10 years through June 30, 2024 are close to those through May 30, 2025: 3.65% versus the Russell 2000 and 0.87% versus the S&P 500.
Have Private Markets Fundamentally Changed?
From our diligence work, we observe that investing in Private Equity markets has become more difficult. For private equity, we see the following challenges:
Middle Market Company Underperformance Also Impacts Private Equity Investing
PE performance has been set back because the earnings of America’s middle-market companies have vastly underperformed the experience of America’s publicly traded companies. In a study prepared jointly between Marblegate Asset Management, a distressed private debt investor, and RapidRatings, a credit assessment firm, the authors found severe financial deterioration among middle-market companies with sales between $100 million and $750 million per year—prime hunting grounds for private equity managers. Their 2024 update paper is “Dragged Out to Sea: The Ongoing Stress and Distress in the U.S. Middle Market – an Update to 2023’s “Riptide: The New Era of Acute Financial and Operating Stress in the U.S. Middle Market”” [see FundFire article https://www.fundfire.com/c/4852394/660564/middle_market_train_wreck_marblegate_warns?referrer_module=sideBarHeadlines&module_order=0], and they expect to release an update showing similar results shortly. The authors incorporate full year 2023 financials from RapidRatings data for over 1200 private non-financial middle market companies and a cohort of public companies from the Russell 3000, to show the ongoing deterioration in the financial performance of the middle market companies as predicted in their original paper. A few tables from their paper highlighting this deterioration are quite revealing:
The study shows a surprising amount of distress among middle market companies. Net Profit After Taxes [NPAT] fell almost 80% from 2019 to 2022, and showed net losses in 2023. EBITDA fell almost 40% over four years to 2023 while borrowing increased 45% and leverage 1.4x. Servicing debt alone is very difficult, with interest coverage falling 73%. Marblegate concludes that “This dramatic decline for middle-market companies likely reflects a combination of higher input costs, increased debt service expense and limited pricing power.”
Unsurprisingly, the struggles of middle market companies seem to be reflected in public market equivalents. It is helpful to observe graphically the performance over the last 10 years, with the S&P 500 [middle line] having vastly outperformed the smallcap Russell 2000 [bottom line], and IT stocks [top line] achieving the highest returns:
Given the more recent challenges of the middle market, should we care more about shorter-term performance than longer-term performance as an indication of PE market’s return profile? Looking again at Cambridge’s PE performance table, PE has vastly underperformed the S&P 500 from June 2021 to June 2024 [6.9% vs 10.9%], while outperforming the abysmal performance of smallcaps [6.9% vs -1.4%]. So from this viewpoint, PE does appear to be adding value versus smallcaps, likely reflecting a mix of skill in avoiding the more problematic middle market companies, selecting and managing sound businesses, and a bias toward investing in IT businesses.
The net result is that PE returns reflect the successes and struggles of the broader middle market, with a bias toward IT businesses. PE might be characterized as a competing allocation for small and microcap stocks, with similar return and diversification benefits. The approach of using PE to build an asset allocation model with a small/microcap framework might be more suitable than assuming PE returns of “market plus 3%” with unbelievably low volatility.
This public-markets equivalent viewpoint on PE modeling mirrors my previous look at venture capital markets, albeit from the other end of the market capitalization spectrum. See “Venture Capital Versus the Magnificent Seven” which we published in January 2024. In this paper we assert that the large R&D budgets of megacap firms, which are collectively larger than capital deployed annually in venture capital, means that investors in these firms are already meaningfully allocated to the more successful part of venture investment activities. Conversely, the Cambridge venture capital return data does not show, on average, compelling venture performance versus public market equivalents. Nonethless, truly exceptional investors in venture capital can still experience truly exceptional results.
Ramifications of Lower PE Returns on PE Investment Strategies
At Manager Analysis Services we believe that investors’ frustrations with their recent PE returns reflect the dynamics of companies in America’s corporate middle market. We are seeing PE managers respond to the environment by trying to protect their businesses’ earnings potential. With PE funds’ underlying portfolio companies performing far below expectations, we believe that PE managers are holding investments in these companies longer, hoping for a recovery so they can meet their hurdle rates and potentially earn some carry.
The consequence of this “hold for longer” dynamic is that exit rates for PE funds have slowed dramatically over the last three years, leaving markets to find alternative sources of liquidity. The rise of secondary funds reflects market demand for liquidity. PE managers themselves are also embracing new investment structures that allow their funds to hold investments for longer, and in some cases, reset their carry terms through continuation vehicles and other structures. Purchases of captive investors like insurance companies, creation of interval funds, and efforts to access retail sales channels represent a combination of aggressive distribution strategies and a repositioning for future illiquidity.
These strategies indicate a likelihood that investors must be extra vigilant that the PE managers for their future investments have both the will and the capability to execute a PE strategy that is consistent with the investors’ expectations for timing of return of capital. They also indicate a stress upon the reliability of the historical experience, that buyout and growth PE funds would typically be able to return capital on average every 4 to 7 years. We believe that investors in PE today should be prepared for the prospect of much longer effective commitment horizons for new PE investments.
Is Your OCIO Smarter than the Ivy League Endowments?
While the endowment and foundation world has historically looked to the Ivy League endowments for ideas and inspiration, their more recent performance has reflected the challenges we discuss in this Briefing. Illiquidity is a huge problem. The following chart shows the extent to which Ivy League endowments have overextended their commitments to private markets, with unfunded commitments consuming on average 45.6% of their liquid assets, according to a study by Markov Processes:
https://www.markovprocesses.com/blog/a-private-equity-liquidity-squeeze
The combination of any future recession alongside material cuts in government grants for these schools could create major challenges for these institutions.
https://www.markovprocesses.com/blog/elite-u-s-endowments-government-funding-and-liquidity-pressure
While these very respected endowments remain committed to keeping large PE allocations, some are clearly responding to being overextended. Both Harvard and Yale have announced curtailments or sales for portions of their private holdings. They will likely be disappointed with the secondary market values for their holdings.
What We Are Thinking About OCIO Allocations to PE
We do believe that PE markets have achieved maturity and that on average PE managers will struggle to outperform public market equivalents. We question the historic assumption that PE markets will rebound simply following the historic pattern of rebounds. Instead, we think PE markets will reflect the subsectors into which the PE funds have allocated, and the fate of America’s middle market. If the middle market recovers, so will PE; if they continue to struggle, so will PE.
We believe that past use of public market equivalents made faulty comparisons to large cap markets, and that the small and microcap markets are more suitable benchmarks. We question how PE is classified as a separate class within equities, and we think that OCIOs should pay closer attention to the underlying sector allocations of their PE fund holdings. OCIOs should ensure that the sum of their PE funds’ sector exposures are in line with the OCIO’s overall desired market sector exposure.
Despite these observations, we do believe that PE markets continue to offer very attractive investment opportunities for sophisticated investors. The very high dispersion in returns across PE managers and their funds offers evidence that having exceptional manager-picking skills in PE markets is imperative. Moreover, we caution embracing the skeptic’s view, that PE markets just don’t add value after adjusting for sectors. Rather, the PE managers’ embrace of entrepreneurialism is exactly what caused them to concentrate in the best-performing investment sector, information technology, over the last ten years, creating substantial value for investors.
OCIOs should focus their PE investment efforts on areas where they have the strongest quality-sourcing capabilities for private investment opportunities. If the OCIOs believe, as do we, that PE funds tend to track the performance of the middle market and its underlying business sectors, then it is somewhat less important to have a truly diversified PE portfolio, because public market equivalents are available. Instead, OCIOs can maintain higher liquidity for clients while targeting scarce resources on sourcing the best managers in sectors they find compelling for their clients. What we have seen working best is a sort of barbell by PE manager type: investing in already-established relationships with a small set of capacity-constrained, highly performing premiere PE managers; sourcing boutiques and sector pros who avoid “auction markets” and who can find their own management talent to run their portfolio companies; and avoiding the “asset gatherers” who will struggle to add value compared to relevant public market equivalents.
Information about us is on our website www.manageranalysis.com, and we would welcome a conversation with you about this Briefing.
Sincerely,
Chris Cutler, CFA
President
Manager Analysis Services, LLC
917-287-9551