How private equity can sustain its performance
We don’t expect a decade of stellar returns to come crashing down, even if the US sinks into recession. A decade of quantitative easing in the wake of the 2008 financial crisis has distorted asset prices across capital markets globally, both public and private.
Prolonged low interest rates and government asset purchases have helped to inflate bubbles across equities, fixed income and property. The S&P500 has soared more than 300% since 2009, including the correction in October this year.
Valuations have become similarly stretched in parts of the private equity universe. Low rates have encouraged PE firms – run by General Partners (GPs) – to borrow heavily to fund acquisitions. At the same time, investors have poured money into PE firms in search of higher yields. Private Equity GPs in the US raised a record $224 billion last year alone.*
Private equity GPs are now estimated to hold more than $1 trillion in unallocated capital, or dry powder. **
This wall of capital has intensified competition for buyout deals, leading GPs to pay premium prices in their search for value. It has increased the risk that they will overpay for assets, which would eat into the returns they provide to investors.
This year to end-September, GPs in the US paid an average of 11.9x EBITDA for portfolio companies – just below the peak purchase prices seen in 2008.* Anecdotally, while all segments of the market are fully priced, larger-cap deals continue to trade at multiples 3-4x greater than those at the smaller end of the spectrum.
Now that major central banks have started to unwind their accommodative measures and the US Federal Reserve has taken the lead by embarking on a rate-rising cycle, GPs are faced with rising costs for servicing their debts.
These pressures could mount further following the latest tax reform, which comes at a time when the US economy is at its strongest in 40 years. The new tax legislation threatens to drive up inflation and compel the Fed to counteract that by raising rates more aggressively. That would push up costs for consumers and businesses, and curtail spending and investment.
A protectionist approach to global trade also threatens to crimp company profitability both at home and abroad. Add in geopolitical tensions around oil prices and the prospect of a stock-market reversal from record highs, and the US could be facing recession in a few years.
The question to consider is whether private equity can continue to deliver superior returns. Based on Cambridge Associates data through Q1 2018, the pooled median return for the past 25 years from private equity was 13.6% net of fees, compared with 7.4% for global public equity and 5.3% for fixed income.***
Clearly stock market declines would hurt the valuations and performance of PE-backed companies. GPs would find it harder to realise value by taking private ventures public.
While it remains to be seen whether the S&P 500 is already headed into a prolonged correction, the likelihood of a reversal increases as we move into 2019. We remain cautious about highly cyclical PE companies, as well as those with high debt levels.
But it’s worth bearing in mind that GPs have traditionally performed well in volatile markets, able to look beyond short-term noise and disruption to focus on long-term value. Those with dry powder at their disposal could look to capitalise on an economic downturn by buying companies at discounted prices.
General Partners have traditionally performed well in volatile markets, able to look beyond short-term noise and disruption to focus on long-term value.
We note, too, that the vast majority (85%+) of inflows into the private equity industry have been directed at the largest PE firms that deal in big buy-outs.
Valuations are far more compelling for firms run by GPs who invest in small or mid-sized private businesses – typically those with an enterprise value of less than $250 million. Often these businesses are managed by founder-owners and have not transitioned to an institutionalised management structure. GPs can use their expertise to add value by helping them to scale up.
We see stronger return potential in this lower mid-market segment, buying at lower entry multiples before eventually selling to large buyers – either strategic acquirers or bigger private equity firms.
We can still find enough targets for takeovers at reasonable prices. In the US there are less than 4,000 public companies, but six million private companies. Many of these are potential targets for PE investment.
Smaller companies also tend to have more restricted access to debt funding, giving them stronger debt-to-equity ratios and leaving them less vulnerable to risks from rising rates.
We see further opportunities to invest in GPs that have also been expanding into new markets, including China. Sectors such as consumer, health care and services – which all benefit from China’s growing consumption – are rich in private market opportunities. It’s true of venture capital as well, where companies stay private for longer and offer more value creation for private investors.
That is a pattern we expect to continue. There are opportunities to invest in early-stage tech companies, for example. While the so-called ‘unicorns’ – $1 billion-plus start-ups such as Air BnB, Uber and Pinterest – continue to garner much of the attention, there are many chances to invest in big data, AI, automation and the cloud. While not traditionally the realm of GPs, many are tapping into this market through strategic partners, who can nurture growth ahead of a profitable exit further down the line.
We are confident that investor demand for private equity exposure will continue to grow, not shrink. Many insurance companies, pension funds and foundations in the US have invested just 10% of their assets, or less, into the private markets. We expect many institutions will increase their exposure to 15-20%+ over the medium term.
Our expectation is that the private equity market in the US and beyond will remain well-placed to continue to deliver an illiquidity premium regardless of what happens in the public markets. To capture it investors just need to know where to look for value.
* US PE Breakdown, Q3 2018, PitchBook Data Inc.
** Preqin, Q3 Quarterly Update: Private Equity, 2018.
*** Buyout & Growth Equity Index, Q1 2018, Cambridge Associates.
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