The alternative asset class with a rosier return outlook than stocks

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Overheated equity markets and persistently low interest rates highlight the appeal of listed private equity, an alternative asset class whose time has come, says Pengana Capital.

Private equity can deliver sustainable returns untethered from other asset classes and with liquidity sufficient for many investors, says consulting economist Steven Milch. In a series of recent whitepapers, he references several studies of long-term performance and draws comparisons with equity markets and listed real estate in making the case for the asset class.

Private equity, in its most basic form, dates back to a 1901 deal struck in the US between J.P. Morgan and Carnegie Steel Co. But as an investable asset class, especially in a listed private equity (LPE) structure, it remains an evolving sector.

LPE enables private equity investment via publicly-traded securities listed on major stock exchanges. Though unlisted private equity is commonly criticised because of several characteristics, including a lack of liquidity, Milch outlines several ways the listed structure eliminates or minimises these. It does this by providing:

  • Ready access to a “permanent” portfolio of underlying PE assets (since the proceeds from investments can be recycled into new transactions) without liquidity, size or timing constraints.
  • Flexibility, with the conditions and the investment exposures of the underlying portfolio able to be altered in line with investor preferences.
  • Diversification across a range of maturities, styles, sectors and geographies with less “cash drag” than traditional PE – where performance is sometimes curbed by capital remaining uninvested early – and often for years.
  • Transparency in terms of daily market pricing, strict disclosure, reporting and governance requirements associated with listing on a regulated exchange.
  • Transaction and ‘search’ costs that are significantly lower for listed versus traditional private equity.
  • More predictable cash flows, because listed trusts typically pay regular distributions.

Given some of the characteristics of PE relative to equities, such as lower liquidity and inflexible timing, investors typically expect a return trade-off often referred to as a risk premium. 

The Pengana papers point to a “PE premium” of at least 3% between LPE investments and the MSCI World equity index, and almost 5% relative to the S&P/ASX200 between December 2008 and June 2020. They also refer to a 2010 study that shows little variation in the returns generated by LPE versus the unlisted equivalent asset class.

While LPE retains the superior returns of traditional private equity, features such as liquidity and daily pricing may be accompanied by higher volatility than traditional private equity. And LPE’s closer correlation to broad market equities reduces, to some extent, the diversification that traditional private equity can bring to a portfolio.

A longer-term perspective on returns

We can take our analysis a step further (and add a degree of precision) by considering returns in the current environment. For this, we use global fund manager BlackRock’s3 latest 10-year return expectations for shares and private equity (see the below table).

Compounding an initial $1 investment at the 10-year annual PE return expectation of 12.4% yields a final value of $3.22. Discounting this at a required rate of return of 7.6% (here using the 10-year expected return for Australian Equities) results in a value today of $1.55. This means the capitalised value of the return premium in this example is equivalent to a 55% premium above net asset value (NAV) today.

But the economist Milch emphasises that not all LPE securities will always trade above NAV, and also highlights the role of a professional investment manager in overseeing the portfolio.

Where are the future opportunities for PE?

The Pengana papers refer to external studies from J.P. Morgan and BlackRock in discussing accelerating pace and scope within the private equity universe. These include:

  1. a geographic expansion of PE investment opportunities, particularly in emerging markets, 
  2. the opportunities created by innovation, disruption and the digital economy.

But Milch also notes that private equity also faces some headwinds.

“Rising PE allocations have led to an accumulation of cash to be invested – potentially lifting price multiples on underlying assets which may, in turn, curb excess returns,” he says.

But balancing the above influences, he views the strategic economic and financial market environment as overwhelmingly positive for the sector.

“J.P. Morgan assigns a higher long-term return expectation to private equity than to global shares (8.8% per annum versus 6.5%),” says Milch. “But we note J.P. Morgan’s more conservative private equity outlook compared to Blackrock’s (8.8% per annum versus 12.4%).”

Learn more about investing in Private Equity

Pengana Capital have put together a series of white papers to help readers better understand the opportunities and risks associated with private equity investments. To access the 4 part series, please click here.

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