Private equity - The state of play

Readers of MarketWatch will be familiar with the case for investing in private equity in the long run. For example, the asset class taps into an exceptionally deep set of opportunities, has consistently demonstrated its ability to outperform public stock markets, and has done so in a manner which is diversifying to a traditional portfolio. It is, however, an illiquid type of investment so won’t be suitable to all mandates but if an investor has the ability to commit a portion of their capital to a private markets investment programme, its potential for strong performance can have a pronounced effect on the overall returns of their portfolio.

That rationale feels comfortable in the long run. But after a strong run of performance in both the public and private markets over the past decade, how should investors feel about allocating to private equity today?

Much ink has been spilled on the state of today’s private markets. The strong performance of the asset class, as well as a lowered cost of debt, has attracted vast amounts of capital. In 2010, private equity assets under management amounted to $1.7 trillion; at the end of 2020 that figure was $4.4 trillion according to Prequin. As of August 2021, the top 25 private equity firms had a combined $500 billion dollars in dry powder (i.e. capital yet to be invested) as noted by S&P. Much as the valuations of public stocks have grown over that period, that inflow of capital has contributed to higher valuations on average for private companies.

The average price paid in the buyout of a private company in the US in 2010 hovered at a multiple of approximately nine times earnings, whereas today that multiple is north of thirteen as identified by CHANNELe2e. In part, this is due to a preference for companies with strong growth potential which typically trade at higher multiples of current earnings (also seen in the public markets). But in part, it’s due to more buyers of private assets with more money, which has increased competition and, as a result, the price. This appetite for private assets has also supported fundraising by new managers, or the expansion of investment programmes into new areas by existing managers. In our view, the average quality of private equity manager has somewhat diminished, as it’s become easier to attract investment.

How do we think about these factors when deciding whether to allocate to private equity today? As a base case, while we don’t think that the returns experienced by private equity in the next decade will mirror those received in the period since 2010, we still expect private assets to return a healthy premium relative to public equity options. For example, we expect the current transformative economic regime to continue, with every sector of the economy still adjusting to change – much of it tech-driven. Private equity investors are buying into innovation – be it in technology, healthcare, or other fields of intellectual property. Whether investing in newly-emerging business models or seeking to reposition established companies, private equity has always been much better positioned to generate and profit from transformational change. That is to say, we still expect to be compensated well for investing in these less liquid assets.

Our view is that the dispersion of returns generated by private equity investments will continue to be high and may even increase. That is to say, there will be a considerable difference between middling private equity managers and the top performers – much more so than in public equity markets. So we are exceptionally selective in picking our investment partners. Of a universe of thousands of funds, and an annual focussed pipeline of over one hundred funds that meet our initial screening criteria, we will allocate to approximately four to eight funds annually.

We avoid inexperienced management teams and also avoid managers who are showing price indiscipline, or stretching to deploy their capital. Specifically, within our buyout book we look to invest with managers who can get operationally involved in businesses and have a proven track record of creating value, as these managers have the ability to potentially deliver strong returns even in difficult market environments. The managers with whom we partner often assume valuation contraction in their investment cases, meaning that they only take on deals where, even if they end up exiting at a lower multiple, earnings growth is expected to produce profits for investors.

We continue to stress the importance of being diversified in private equity – with respect to geography, sectors, and strategy type. We seek buyout, growth, and contrarian opportunities – all of which result in widely differing investments and all of which put capital to work at different times. For example, we saw contrarian managers call capital very quickly during the initial COVID-19 sell off to invest in dislocated markets, at a time when most other capital was sitting on the sidelines.

As a final point, we recognise that building exposure to private equity is not something that happens today or tomorrow. Phasing capital in to private assets over a longer period of time, ideally through the business cycle, helps reduce the risk of investing at the “top of the market”. The best portfolios are built by establishing partnerships with good custodians of capital who will deploy that capital as and when opportunities arise. That is to say, we are not investing with just the prevailing markets in mind, but with a 5 to 10 year view. On that time horizon, we find few better opportunities for investment.