Is There Still a Case for Including Traditional Private Energy Managers in Portfolios?
Kevin Rosenbaum
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Yes. Although investors do need to be mindful of the long-term transition occurring in energy markets, we don’t believe that mindfulness should preclude new investments in top-quality traditional private energy managers. In examining our data, the average private energy fund’s performance has been solid, both in absolute terms and relative to public market equivalents. Further, the industry’s performance has been different from that of broad equities, liquid real asset options, and other private investment strategies, indicating private energy managers have provided diversification benefits.
These managers—which primarily provide third-party management teams with equity lines of credit to acquire oil & gas assets—came under pressure during the recent downturn in energy commodity prices, with a few high-profile funds being forced to take significant write-downs on portfolio assets. These funds notwithstanding, technological advancement has helped alternative energy sources to be increasingly cost competitive with fossil fuels, raising concerns about the utility of locking up capital with traditional private energy managers.
However, these concerns stand against a solid long-term record. When looking at funds from the beginning of our data set in vintage year 1986 through 2010 (the last year we consider seasoned) traditional private energy funds have generated an average net internal rate of return of 12.7% and a net total value to paid-in capital multiple of 1.8. Relative to equity investments in public energy companies, private energy funds have outperformed by an average of nearly 500 basis points, as calculated on a Cambridge Associates modified public market equivalent basis.
Standard correlation measurements between quarterly private investment returns and many other asset classes are often quite low, suggesting that substantial diversification potential exists. However, these measurements are biased by private investments’ infrequent pricing. To help address this bias, we calculated unsmoothed returns for private investments. Using these returns, our analysis shows that private energy funds have offered diversification benefits to common portfolio holdings, such as real estate funds, buyout funds, and equities.
Perhaps most importantly, private energy has generated a compelling risk/return trade-off over the long term. Like correlations, standard deviations of private investment returns—a widely used, though imperfect measure of risk—are biased by these investments’ infrequent pricing. Using unsmoothed returns again, private energy has generated a more favorable trade-off than a host of investments, including global equities, natural resources equities, and private real estate.
In assessing the private energy opportunity today, one key risk is the potential for a greater-than-anticipated disruption in traditional energy markets from advancements in alternative technologies. Such a scenario would almost certainly impact market values for hydrocarbon-linked assets, challenging performance for traditional private energy funds. But most major energy forecasters do not expect fossil fuel production to dwindle in the next couple decades. In fact, the US Energy Information Administration forecasted earlier this month that from 2016 through 2040—the last year of its forecast—global crude oil and natural gas consumption will grow by close to 17% and 43%, respectively.
To be sure, these forecasts are likely to differ from the way global energy needs evolve in the next decades. Perhaps a greater-than-anticipated disruption in energy markets will occur. However, the best way to position portfolios isn’t to avoid the industry altogether, given its strong record of performance and that long-term energy needs are likely to require a diverse mix of sources. Instead, investors should understand their portfolio’s underlying energy exposure, ensuring that risks are prudently diversified and entrusting capital only to capable managers. Ultimately, in our view, being mindful of the transition in alternative energy does not mean traditional private energy no longer has a place in portfolios.
Kevin Rosenbaum is a Senior Investment Director on Cambridge Associates’ Global Investment Research team.
Originally published on September 26, 2017
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