Private equity
Long-term rewards
Patient private equity (PE) investors with access to best-in-class managers should be able to achieve an attractive excess return over public markets. As PE requires a long-term commitment, we note the importance of a measured approach with well-diversified investments over the cycle. Sound due diligence and access to top managers with proven track records are key success factors.
The COVID-19 shock led to an initial slump in PE investment activity, but it increased the upside potential for venture and growth investments by creating disruption and incentivizing innovation in traditional sectors. It also presented distressed PE vehicles with a broader set of sectors, as previously healthy companies in areas such as travel, dining, and leisure saw a drop in cash flows. Moreover, portfolio rebalancing following the COVID-19 shock should open up previously inaccessible opportunities for funds in the PE secondary market (so-called secondaries). Traditional PE valuation metrics indicate some improvement in the pricing of PE deals, also compared with public markets. Overall, this should underpin the expected long-term excess return of PE over public markets, rewarding a long-term commitment of funds.
Leverage ticking up
In the COVID-19 environment, PE companies increasingly used cheap credit for liquidity and investment purposes. The financial leverage on new buyout transactions rose sharply, according to Preqin, a provider of data for alternative assets. Although this requires attention, we do not perceive it as a concern for the industry yet, for three reasons. First, the larger proportion of debt used is senior compared with developments before the 2008 global financial crisis. Second, the industry is now better versed in risk and liquidity management, as evident in lower return volatility, as established managers hold a growing amount of capital. Third, buyouts, the most leveraged PE strategy today, account for about 27% of assets under management in private markets (40% in 2008/09). Finally, Refinitiv LPC’s latest Middle Market Lender Outlook shows a more conservative stance from lenders. Therefore, we think that the risk of an excess use of leverage should be contained.
Track record counts
The COVID-19 crisis led to a temporary rise in investor concerns with regard to PE, but it did not diminish demand for the asset class. Following the shock, US regulators allowed US retirement plans to invest in buyout firms, and banks to take stakes in venture capital funds. The increasing popularity of PE leads to more transparency and intensifies competition for deals. We think that PE managers with a solid track record, deal sourcing and client base should continue to outperform the overall market. Over the long term, we believe that well-diversified PE exposure to managers and across strategies, vintages and geographies should be preferred for private investors to achieve an excess return over public equities. We also highlight impact investing, as the PE industry is well positioned to express a long-term view on topics like climate change and education, while allowing for diversification when actively seeking to increase value.
