Sizing Private Equity Allocations

How to think about the relative size of private and public markets
 

By: Daniel Rasmussen

The famed Yale investment office allocated only 14% of the endowment to public equities as of 2020. In contrast, Yale had 38% in private equity and venture capital.

While most endowments haven’t gone quite as far as Yale in terms of the relative weights of private and public equities, Cambridge Associates reports that the endowments they track have an average of 42% in public equity and 20% in private equity.

Yale has 2.7x in privates what it has in publics, while the median endowment has 0.5x in privates what it has in publics. What’s the right way to think about how much to allocate to private equity relative to public equity?

The logical place to start is to weight by aggregate market capitalization and think of this as the passive benchmark weight. According to the World Federation of Stock Exchanges, there is $107T in public equity market capitalization globally. Private equity assets under management today stand at $13T, according to data from McKinsey. A market cap–weighted approach suggests a 0.1x ratio of privates to publics. For a 60/40 investor, a roughly 5% weight in private equity would get you to benchmark, whereas, for a 100% equity investor, a 10% weight would be required.

The private equity industry tends to focus not on comparing its market capitalization to that of public equities but on comparing the number of private companies to the number of public companies, showing statistics that suggest that, say, 87% of firms with >$100M in revenue are private.

But we believe looking at companies by count is misleading for two reasons.

First, private companies are much smaller than public companies. The US Census reports that there are ~20K firms with >500 employees. Of these, 12% are public, roughly in line with the statistic that 87% of firms with >$100M in revenue are private. But 55% of the total number of employees work in the 12% of companies that are public. And although less than 1% of US companies are public, public companies account for >30% of total employment. The employment data demonstrates the significant difference in size between private and public companies.

Second, private equity only owns a small percentage of the total number of private companies. Of the 20K companies with over 500 employees in the United States, 2,300 are public, while private equity owns 2,200, according to the American Investment Council. This means that only 13% of private companies are owned by private equity.

Private equity may seem like a big asset class, but it’s useful to stare at these numbers when thinking about allocation decisions and remember that private equity represents only about 10% of total equity. We believe anyone allocating more than 10% of their equity portfolio to private equity is overweighting the asset class. That means, in our opinion, the average endowment is about 5x overweight, given their total equity allocation. Yale, meanwhile, is almost 30x overweight.

If large pools of capital keep moving more overweight to private equity, the inflows of money risk dislocating prices beyond what fundamentals would justify. Small changes in capital flows can drive big price movements in illiquid asset classes.