Alternative investments Due diligence is key

Due diligence is key

Private markets have become increasingly more mainstream as smaller asset managers and family offices began to look for exposure and minimum investments declined. Given the illiquid nature of private markets, however, due diligence, fund and manager selection are paramount.

Private equity has become more and more popular in recent years, but this development has come at a cost. Asset valuations and competition for investments remain the key industry concerns, covenant-lite debt has returned and new entrants continue to challenge the industry’s profits.

Expanding private markets

That said, private markets are almost twice as large as a decade ago, the rise of secondary funds offers depth and differentiated exposure, while the average deal is typically less levered. For investors, a larger universe brings with it better diversification potential. In 2020, we expect private equity (PE) to deliver a total return of approximately 8% per annum, somewhat below the historical average of 9.2%. Less supportive conditions for credit, high levels of undeployed capital but also lower overall risk limit expected returns. That said, PE still offers a fair illiquidity premium over public equities.

Access to better pricing and longer-term potential

PE funds can help improve portfolios’ riskadjusted returns as they target companies exposed to fundamental long-term growth in otherwise inaccessible private markets. PE entry deal prices depend on the state of capital markets, while exits normally reflect the significant evolution of a business which is less correlated to capital markets developments. Therefore, PE offers some diversification for investors. However, the higher than historical investment volumes and the lower risk profile of investments imply that expected returns are likely to diminish over time.

Against this backdrop, we favor seasoned PE managers sourcing proactively outside the core markets. Such investments should benefit from lower valuations compared with the stronger growth potential of businesses. Moreover, historical return analysis shows that the funds of the managers in the top quartile tend to stay in the same quartile about 30% of the time (sample period from 1980 to 2015 based on Preqin data). Thus, in the current environment of low growth and perceived late-cycle risks, some exposure to seasoned managers invested in otherwise inaccessible markets should help mitigate some of those late-cycle risks.

Private equity assets under management (in USD trn) and in % (RHS)

Significant investment volumes targeting private equity

Private equity assets under management (in USD trn) and in % (RHS)

Focus on top providers and defensive strategies

We believe that PE can also generate excess returns over liquid markets in an increasingly challenging environment. But given lingering uncertainty and historically low interest rates, we favor strategies that offer PE-like upside with some downside protection, for instance real assets and growth capital. Key risks include illiquidity, long-term investment horizons, leverage and the complexity of transactions. These risks can be mitigated through diversified investing over the cycle and by selecting skillful and experienced managers. Due diligence, fund and manager selection are paramount given the illiquid nature of private markets.