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In spite of the premature obituaries you may have read elsewhere, the long-term outlook for private equity remains strong. Yes, the contraction of credit markets is challenging for a sector that thrived on a diet of cheap, plentiful debt. And yes, some very large, risky buyouts at the top of the business cycle have dented PE’s claim to be a credible owner of the very biggest companies. But to conclude that private equity is a busted flush would be to ignore a number of salient facts about the sector.

The private equity model, when well executed, has shown that it can outperform public equity markets in a wide variety of economic and capital market conditions. The qualifier is important. While the average PE fund’s performance has approximated to — or even lagged — the S&P 500 Index over the past 15 years, the top quartile of funds outperformed public equities by a wide margin and, importantly, came persistently from a relatively small cohort of leading PE firms.

Moreover, this investment performance was less dependent on leverage than often assumed. Our review of European buyouts by leading firms in the 10 years to 2005 found that investment returns had outpaced public equities in this period, even when the impact of higher leverage was excluded. To be sure, PE firms were happy to use leverage to further increase returns to equity. However, the root of their outperformance was not balance sheet bravado but rather a shareholder-oriented approach to corporate governance that allowed them to drive operational improvements and widen profit margins more quickly than companies listed on public markets.

Neither are leveraged buyouts necessarily the high-risk investments you might think. With the exception of some of the large top-of-market deals, PE firms have tended to buy relatively stable businesses to begin with. While debt may be higher than public market peers in the early years of the buyout, often it is paid down during the period of private ownership. By the time PE-owned companies come back to public markets they often carry less leverage than their listed competitors. Academic work suggests that the riskiness of PE investments, at least up to 2005, is about the same as that of the S&P 500.

All this suggests that the better PE firms have got what it takes to deliver competitive risk-adjusted returns even in an era of higher borrowing costs and less forgiving lenders. Some big investment institutions are starting to arrive at this conclusion. The Ohio Public Employees Retirement system last month announced plans to double its private equity investments to around $2 billion per year. CalPERS and CalSTERS, the giant public pension funds for California state employees, are making similar though less dramatic moves. With returns from public equity and debt markets expected to be low over the next few years, these investors see private equity – again, well-executed – as having an important role to play.

This is not to say that it’s business as usual in the PE world. As befits a more cautious environment, new funds will be significantly smaller than those raised before the financial crisis. This will challenge PE firms both to reassess investment strategies and, since smaller funds mean less income from management fees, to downsize their organizations. Equally, expect investors to negotiate harder on fees before committing capital.

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