Warren Buffett says, “Only when the tide goes out do you discover who’s been swimming naked.” For nearly two decades, private equity thrived on low rates and revenue growth. But since 2021, the tide has turned, exposing flaws in the old allocators’ playbook and demanding a new one.

The Traditional Private Equity Playbook

Historically, the private equity playbook for allocators has been a straightforward, bottom-up approach. Allocators developed beliefs about strategies that would outperform, met lots of managers, selected those that fit their beliefs, and invested in their funds. These managers would buy companies, own them for several years, and sell.

As an investor’s pool grew, they would re-up with managers by committing larger sums to maintain a stable or growing allocation in their portfolio while ensuring a steady stream of capital through distributions. The approach provided consistency but relied heavily on predictable market conditions.

The Changing Environment

The surge in commitments leading into 2021 exposed cracks in the old playbook. Distributions from private equity have remained relatively stable, but the dollars invested are now three times larger than they were ten years ago.^[1] This shrinking distribution yield on a private equity portfolio has created liquidity challenges.

In response, innovations like continuation vehicles (CVs), NAV loans, and minority purchases have emerged. But these tools come with their own complexities and incentive misalignments.

Private Equity Portfolios Today

Private equity portfolios today are comprised of companies with a wide range of holding periods — from businesses GPs intend to buy, improve, and sell within a few years to those they intend to own and compound over time.

Allocators typically own portfolios across the spectrum – a compromise that may not align with their true beliefs. For example:

• One CIO I spoke with recently is frustrated by CVs for good businesses, where GPs earn incentive fees while acting as passive owners. He believes GP holding periods should be short and intense but finds his portfolio to be a mixed bag of ownership durations.

• Another CIO I spoke with oversees long-duration liabilities and wants to own great businesses indefinitely but is perplexed by GP incentives that compel shorter than optimal holds.

Both CIOs manage portfolios that do not match their distinct beliefs with what is best for their investment programs.

Further, this portfolio construction makes it difficult for CIOs to know how to respond to changes in the environment. How does a CIO answer difficult questions about manager selection, commitment sizing, CV participation, co-investments, direct investments, and terms without a clear understanding of their investment philosophy in the space?

Refining Investment Beliefs

To develop a game plan going forward, investors must think carefully about what they believe. CIOs can consider these critical questions to inform their investment decisions:

• What private equity strategy generates the highest returns: ownership of great businesses that compound over time or ownership of businesses where sponsors buy, make improvements, and sell?

The former implies an investor’s goal is to build a portfolio of private companies to own for the long term. The latter implies returns will be higher if the portfolio has short-to-medium-term turnover, refreshing each time with a business at an inflection point.

• How should you address liquidity needs: within the private equity portfolio, outside of the portfolio, or both?

The existing model requires distributions to match contributions. Estimating both exits and drawdowns is an inexact science, leading investors to be more conservative in their deployment.

Next-generation models might focus liquidity needs outside of private market allocations, leading to smaller private equity allocations but more aggressive or longer-duration deployment within the portfolio.

By articulating clear preferences, investors can more easily answer questions about manager selection, CV participation, and other innovations:

• For shorter-duration believers: Pass on managers inclined toward long-term ownership and focus on those who drive operational excellence during intense holding periods. Reject CVs unless GPs can demonstrate tangible value creation during the next chapter of ownership.

• For long-duration believers: Lean into managers who source, buy, and hold great businesses. Invest in CVs featuring high-quality businesses capable of compounding value independently over time.

• For those without conviction on duration: Carefully define liquidity needs and build a diverse portfolio by duration focused on best ideas. Consider the purpose CVs serve in the mix and use that lens to develop a CV strategy.

Private Equity Investing in 2030

The tide has gone out. Five years from now, allocators who refine their understanding of what delivers the best returns in private markets will have a portfolio that reflects those beliefs. They will make comparative judgments about manager strategies and narrow their focus on getting paid for illiquidity.

The sooner allocators fine-tune their fundamental beliefs about what adds value in private investing, the sooner they will move toward optimal portfolios suited for this period of transition. Those who adapt thoughtfully will be well-positioned for success in the evolving landscape of private equity investing.