By Brian Kelly at Baillie Gifford: Most private equity outlooks focus on expected returns, distributions, continuation funds, private credit and, more recently, the ‘SaaSpocalypse’¹. These topics, however, are too nearsighted to help inform decisions for the next decade, and expert forecasts are often too inaccurate or conflicted to matter.

Instead, we highlight how the forces that generated returns in each asset class have changed over the past 20 years, and what that means looking ahead.

Buyout: not what it used to be

Buyout is the largest private asset class. It earned that position after more than four decades of unassailable returns. Forty years ago, sponsors used to risk just 10 or 20 percent of equity in acquisitions. And the sponsor playbook could produce immediate gains through lower headcount, reduced capital expenditure and higher prices. Even just a few points of margin expansion could increase investment returns by 2-3x after all the leverage.

The next 20 years will look nothing like the past 20 for three reasons.

First, the macro backdrop. Buyout benefited from three tailwinds over the past two decades: economic growth, rising deal values as a multiple of earnings, and a rapidly declining cost of financing. All three now risk slowing or reversing.

Second, competition. As buyout became more competitive, sponsors paid higher prices and internal rates of return fell. In many cases, the winning investor is now the one willing to accept the lowest return.

“In future, buyout’s risk profile will secure its place as an anchor allocation in portfolios, but investors should expect less from it.”

Brian Kelly, Investment Specialist at Baillie Gifford.

Third, the return maths. Cutting costs and raising prices is no longer enough to generate target returns. Buyout now needs much stronger earnings growth than it did a decade ago. Studies suggest buyout now needs 12 percent earnings growth to meet return targets versus 5 percent a decade ago. That has pushed the asset class further into technology and software, areas now facing fresh disruption from large language models.

In future, buyout’s risk profile will secure its place as an anchor allocation in portfolios, but investors should expect less from it.

Venture: more competition, longer timelines

For several decades, venture was the engine of outperformance. From my own family office days, we saw small venture capital fund investments increase family wealth by about 10 percent. Historically, venture was a cottage industry. In aggregate, it raised relatively modest sums of $3-5bn per year through the 1980s and 1990s, and $10-20bn per year in the early 2000s. That is almost unrecognisable today, when single seed rounds can approach a similar scale.

It was also far less competitive. When Phil Knight built Nike, for example, it was funded entirely by bank loans.

The outlook today is cloudier. Incredible opportunities remain, and a handful of AI companies have generated over $1tn of wealth for their venture backers. But competition has increased dramatically. Venture firms no longer have a monopoly on startup financing. They now compete with accelerator funds such as Y Combinator, SOSV and Neo.

Companies are also staying private for longer than the 10-year life of a typical fund, with an average age at initial public offering of 12-to-14 years (IPO). At the same time, venture investors are being diluted by ever-larger growth-stage rounds.

The best venture firms now look more like asset managers, raising multi-billion-dollar funds and writing ever-larger cheques. These platforms should continue to offer real value to companies and investors, but the return maths is becoming harder to justify.

Growth: expanding as public markets shrink

Growth equity – minority private investments in companies with fast revenue growth – is a relatively new asset class. Historically, many such companies went public at this stage. But after the global financial crisis, businesses moved from raising tens-of-millions before an IPO to raising billions privately and creating trillions of dollars of value to private growth shareholders.

Over the past seven years, growth has given investors reasons to be cautious. It reached a frothy peak during Covid, then suffered a sharp drawdown when interest rates rose in 2022. It now appears in headlines alongside $500bn AI companies and trillion-dollar space IPOs. Valuations can look elevated relative to buyout, while outcomes may appear less asymmetric than in venture.

“But after the global financial crisis, businesses moved from raising tens-of-millions before an IPO to raising billions privately and creating trillions of dollars of value to private growth shareholders.”

Brian Kelly, Investment Specialist at Baillie Gifford.

Yet the outlook for growth remains promising. The upper limit of company size has increased dramatically, over the past 20 years, from $300bn to $5tn-plus today. And the advantages of staying private are only getting stronger: greater access to capital, better shareholder alignment behind bold long-term investment, and less pressure to meet short-term cash flow targets.

As investor participation broadens, growth can continue taking share from public markets and easing competition among general partners.

Our four most recent investments illustrate this shift. On average, they have market capitalisations of about $10bn, close to $1bn in revenue, 75 percent average annual revenue growth and, in two cases, profitability. If that growth continues over five years, valuation multiples could fall by 65 percent and investors could still capture a 5x return.

Looking forward

Investors should consider how asset class evolution may shape future returns. Most private equity outlooks focus on past performance and current frustrations. But the next decade’s returns are more likely to accrue to those who carefully underwrite the drivers of future outcomes and are comfortable with unknowable uncertainty.

That is exciting work. This is investing.

¹‘SaaSpocalypse’ refers to a shakeout in the software industry as retailers and businesses rein in spending on subscription-based tech platforms, questioning the value of overlapping tools and consolidating suppliers.

This article is a paid promotion by Baillie Gifford. The article can in no way be seen as any investment advice or any other kind of recommendation.