Why Private Equity Is Eating the World

A guest column in the Allocator by Summation Capital CIO Roger Vincent

Thirteen years ago, Marc Andreessen published the provocative essay “Why Software is Eating the World.” He observed the increased penetration of software into the economy and predicted this trend would continue. Boy, was he right. The weighting of software in the S&P 500 was 6.6% of the index at the beginning of 2010. By 2021 it had grown to 15.9%, resulting in $5T+ of market cap gains.

You wouldn’t be criticized for thinking someone with this insight would go on to start a software company to ride this wave, particularly someone with a proven entrepreneurial background (Marc was behind the foundational internet company Netscape). But he didn’t do that. In fact, on the surface, he did something quite surprising: He started a finance business. And not just any finance business, but a private equity firm (using the modern parlance which includes everything from venture capital to growth equity to buyouts). In doing so, Marc might have inadvertently joined an even bigger trend than the one he was observing: the growth of private equity.

Despite becoming an increasingly prominent part of the investment world over the past 40 years, PE is once again sparking controversy and criticism. Looking over the modern history of private equity, there have been four major retrenchments: 1) the collapse of the junk bond market in 1989, 2) the DotCom bust in 2000, 3) the impact of the GFC in 2008, and 4) the current interest rate cycle. The market is now grinding its way through a dreaded “denominator effect,” industry jargon for when investors’ allocations to the asset class become uncomfortably over-weight due to a fall in the value of other assets, such as the rapid decline in public equities during 2022. Despite equity markets having recouped their loses, the effect is like a car on a crowded highway braking suddenly, causing a propagation effect that slows traffic long after the original driver is on their way.

Too much of the conversation today is around the drop in fundraising levels and the lack of liquidity from existing holdings. Investment committees and financial advisors are swamped with discussions on continuation vehicles, private credit, and quasi-liquid solutions for accessing PE. But take a long-term perspective and you will see that we are still in the early days of the private equity revolution. My theory is that we are witnessing a dramatic shift in the financing of businesses away from public markets and individual investors (usually the proverbial ‘friends and family’) toward the PE market.

Capital markets exist to provide capital to those who can profitably employ it and to distribute the financial risks (and rewards) across those best able to bear them. Of the more than 18 million companies in the U.S., fewer than 4,600 are public and thus have access to traditional capital markets for their equity needs. That number keeps dropping, with barely half as many publicly funded companies today as in the mid-90s, as public markets become an increasingly poor path for most companies. An even larger problem exists for startup companies at the other end of the spectrum. How many people want to take all the career risk of starting a business and come up with all the capital, shouldering the entirety of the investment risk as well? And how many private businesses don’t expand, how many jobs aren’t created, and how much GDP goes unproduced because the internally generated cash flow of the business can’t finance the opportunities at hand?

Private equity, in all its various forms, addresses a major problem of public markets by bringing an active, incentivized, and professional owner to the equation versus the inactive, fickle, and disinterested ownership model of public markets. Benjamin Graham illustrated this in the form of Mr. Market, a personification whose emotions fluctuate wildly from day to day, often without any logical basis. Ask yourself what it must be like to build a business with Mr. Market as your financing partner. Private equity also addresses the major problem of individual financing of businesses by spreading the risk. Every private equity transaction, from the largest take-private to the smallest seed investment, funnels the risk of the business through the PE ecosystem and ultimately to the balance sheets of endowments, pension funds, sovereign wealth funds, individual PE investors, and others. These investors are able to size the risk according to their appetites and benefit from the power of diversification.

The numbers speak for themselves: Performance has been impressive with median returns exceeding public markets in virtually every mature vintage year, per multiple analyses of the topic, and the number of PE backed companies has grown from a fraction of to a multiple of those that are public. Over the last ~20 years the estimated AUM has grown almost 15x reaching $8 trillion, according to a Carlyle report published in April. Naysayers consistently point to this growth and the perceived mountain of ‘dry powder’ to call for a pull back in the asset class, or a decline in the performance to something no better than public markets. But this view continues to be proven wrong. Rather than think of PE as an asset class that needs to mean revert, consider it as a competing capital market that is taking share from two other inferior capital markets.

Look around and you’ll see that private equity is permeating the economy. Today, companies as disperse as carwashes, sports teams, and AI startups are looking to the industry to help them outperform and outgrow their less well capitalized competitors. Once you start looking, you won’t be able to go more than a few minutes without grabbing a beverage, trying a new restaurant concept, or getting a good night’s sleep on a mattress that hasn’t been backed by a PE firm.

The flip side of the coin is that the funding which feeds the PE industry is coming from an ever-wider group of investors. The major endowments, which have historically funded the industry, have all essentially maxed out their allocation to PE and are becoming a smaller piece of the capital base every year; in other words, the market has reached peak endowment. Into the vacuum, a wide assortment of institutional investors are increasing their allocations, but the real capital behind the next leg of the industry can only come from new entrants, aka the ‘democratization of private equity.’

The industry has begun to improve investor accessibility and the hope is that the benefits of allocating to PE will be made available to an increasing number of investors going forward. However, some obvious pitfalls exist that will likely trap the newcomers as they periodically trapped those who came before them. Chief among these are the inherent illiquid nature of the underlying companies, the risk of investing in an undiversified set of small businesses, and the costs and complexity associated with gaining high-quality, diversified exposure.

I for one will be maximizing my exposure to private equity, but I will do so within the context of my overall risk and illiquidity tolerance. I am willing to pay for quality management but will carefully evaluate the value I’m receiving and will focus on maintaining strong alignment as capital flows from me, the asset owner, through the PE ecosystem and back again.

Roger Vincent has more than 25 years of private equity investment experience across venture capital, growth equity, and buyout markets as both a direct investor and an allocator. He is the founder and CIO of Summation Capital Partners, an endowment-style PE investment fund. Previously, Roger spent more than a decade leading the private equity portfolio at the Cornell University Endowment. You can reach him at rvincent@summationcapital.com.