The looming risks in private equity returns

The writer is a managing director at Van Lanschot Kempen

The stock market has run out of exuberance, but private equity has not. That is leading to some extreme distortions in the correlations between the public and private markets.

Stock markets are seeing large and fast declines as the largest single US buyer of financial securities — the Federal Reserve — switches to selling while raising rates.

The private equity world remains more insulated, still primed after booming fundraising years with an abundance of “dry powder” — uninvested but available money. Bain estimates the industry had its second-best fundraising year in its history, capping a five-year run that has netted $1.8tn in new buyout capital.

But it is clear that investors should not see private equity as a means to hide from the economic cycle. Traditionally, there is a trickle-down effect on equity valuations between public and private markets. This relationship can be distorted at times by factors such as illiquidity of private investments as well as capacity of buyout groups to take on more debt to pay more. But over time, distortions typically should be reduced by arbitrage — if nothing else, via initial public offerings and delistings.

So when the dislocation between private and public equity gets too large, alarm bells should start ringing. The pain might be delayed but eventually, there is a reckoning.

Even if the fall in wider asset valuations is not reflected in the current estimated worth of unlisted portfolios, eventually private equity groups have to exit their investment given the finite holding periods set for them. The clock ticks on for delivering an internal rate of returns, the industry’s profit benchmark. According to PitchBook data, these slowed in the third quarter of last year to 6.8 per cent compared with rates above 14 per cent in the first two quarters.

While illiquidity provides the incentive to do proper homework and think in the long term, it also breeds complacency. Less immediate valuations of assets can cloak performance.

And there is an unfortunate congruence between the fundraising and economic cycles. When investment and markets are booming, private equity funds can raise money more easily. This means they are under pressure to allocate sizeable funds for investments at valuation levels at risk of being problematically high.

McKinsey estimates that by net asset value, the global private equity industry has grown by a factor of nearly 10 since 2000, outpacing growth in market capitalisation in public equities nearly threefold over the same period

But this has led to tremendous amounts of capital chasing a limited number of deals, as well as an arms race where companies with the lowest cost of capital triumph. There was an industry shift from asset performance to asset gathering; a trend that might be less in the interest of the end investors — or limited partners — and more in favor of the general partner, the managers of the private equity funds.

If returns suffer, that could particularly affect less experienced investors in private equity, many of whom have only recently been able to put money to work in the asset class as it has democratised with greater retail access.

However, we still believe there are opportunities and real value in private equity. An example are the funds that focus on small to midsized companies, where private equity owners have the opportunity to professionalize and internationalise or consolidate fragmented industries. These areas enjoy the double benefit of a bigger pond of deals to fish from, with fewer fishermen around. This lowers the risk of “overpaying” while the idiosyncrasy of portfolios decreases the reliance on the economic cycle.

Likewise there will be good opportunities for funds that focus on megatrends such as energy transition, digitalisation and urbanisation. Real assets — real estate, infrastructure and land — are a strong beneficiary of these trends. This asset class is likely to grow in weighting under the private markets umbrella.

One example is that in order to achieve climate goals, there is a critical need to upgrade existing buildings. This provides value-added opportunities for real estate managers who can make an impact while enjoying valuation uplifts as they improve their buildings’ energy labels.

Such themes offer a practical way to invest responsibly and enjoy secular growth against a murky macroeconomic backdrop. They also might provide private equity investors with returns closer to those they have grown used to.

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