A golden age of private equity has ended and debate is rising over contrasting interpretations of the asset class. One has it as a megatrend – an interesting idea – of which investors should, like most megatrends, be part of. The alternative, more critical, interpretation has it compared to a pyramid scheme.
These are two diverse views, on what is an important alternative investment class for investors.
The megatrend perspective is a new take on familiar territory. A continuation of the upbeat outlook that has dominated since the financial crisis, where private equity received a boost from ultra-low interest rates and was welcomed by institutional investors looking for yield.
This was evident in 2021, which was a record year for the asset class with investment activity surpassing the trillion-dollar mark for the first time.
Such moves by investors have proven well placed. Private equity delivered strong annualised total returns of about 13% during the past 15 years, on a risk-adjusted basis, against around 8% for the S&P500, according to Morgan Stanley.
It is not surprising, therefore, that some people refer to this period as the golden age of private equity.
Bottom of the pyramid
The pyramid scheme allegation is more complex. The issue of private equity firms selling their assets to each other at inflated prices is where this idea has developed. It is an unedifying and worrying investment spectacle – hence the pyramid scheme comparison – and one that has slowly become more prevalent in private equity.
Stephen O’Neill, head of private markets at Nest, agrees that this is an issue. “It can certainly seem like some private equity funds sell companies to each other at ever higher valuations and that in some instances, a company’s post-IPO stock price suggests those valuations might have been inflated,” he says.
“Such examples are notable for their rarity and tend to occur in either the large cap space or amongst young companies in the venture capital/technology space,” he adds.
But Nest has a way of staying away from this scenario. “That’s why at Nest we focus primarily on middle market companies and growth equity, where the private equity manager can implement a clear and intuitive business plan and expand a company’s margins – which in turn warrants a higher valuation for that company and hence good returns for investors,” O’Neill says.
The situation can be dealt with from an investor perspective in other ways. Matthew Cox, investment director at charity Esmee Fairbairn Foundation, which has around 35% of its assets in private equity (see page 14), has another approach.
“As with any asset class, it depends on who you partner with to manage your money,” he says. “We have seen private equity come and go. It is not just about being in the asset class, it is about being with the right manager within that asset class.”
The “old normal”
There is, on the face of it, much to recommend the megatrend outlook, mainly because despite the current environment, private equity is doing well.
The value of private equity deals topped $819bn (£724bn) in the first three quarters of 2022, which is higher than any previous annual figure except for the mammoth numbers seen in 2021, according to the latest private equity report from PitchBook, a data company.
Given the many economic and market storms it has had to endure over the past few years, private equity has sailed through some choppy waters.
And although the $819bn is behind the 2021 figure – $1.235trn (£1trn)— albeit with a final quarter to go, it does indicate a real private equity boost, and could mean the asset class has, in fact, returned to the “old normal”, is how the report describes it.
In addition, last year the top quartile of private equity managers was far ahead of the public markets, research from management consultant Bain found, with annualised returns exceeding 20%.
For alert investors it is worth noting that private equity activity has proven particularly strong in the technology and healthcare industries.
And investors have naturally benefited from holding private stakes in companies. Buyout and venture capital funds were Harvard’s best-performing asset this year. The leading endowment’s venture capital holdings gained “high-single digits” for the fiscal year, according to Narv Narvekar, chief executive of Harvard Management Corporation.
Conversely, some have missed out. Calpers, the largest public pension plan in the US, has made the extraordinary admission that its decision to put its private equity programme on hold for 10 years had cost it up to $18bn (£16bn) in missed returns.
Compressing illiquidity
Workplace pension scheme Nest is early in the ramp up phase of investing in the asset class, O’Neill says. “We are structurally underweight private equity, which is itself defensive – but also our fund managers are alive to the macro risks and hence are carefully selecting deals to invest in companies which can be resilient in the face of these challenging conditions.”
O’Neill reveals that private equity is set to become a somewhat larger portion of Nest’s portfolio in the next three to five years, as this ramp up of its allocation takes place. “We don’t see that the asset class itself will change fundamentally. However, there are various efforts being made to make private equity more accessible, including to defined contribution (DC) pension schemes,” he says.
“More money flowing into the asset class could, on the one hand, compress the illiquidity premia available,” he adds. “But, on the other hand, a wider and more engaged investor base should enhance stewardship and ESG standards in the industry, which will add value.”
Jason Bermont-Penn, director of institutional business at Octopus Investments, also identifies opportunities for DC schemes. “Whilst defined benefit schemes have long embraced private equity – indeed, it is one of the most established asset classes within private markets and its maturity has led to an institutionalised and developed market – this has not yet been taken up by DC schemes.”
Therefore, he adds: “Given the substantial need for growth amongst most DC members, and that most DC schemes have limited, if any, private market exposure, adding private equity to DC portfolios could be a good way of improving diversification and delivering the growth that members need.
“As DC schemes increase in size and scale, the concerns around liquidity, operational mechanisms and fees should start to reduce, making an investment into private equity more viable.”
Although on a different note, Harvard’s Narvekar said the endowment was “cautious about forward-looking returns in private portfolios”.
Private equity investors mustn’t be naïve or complacent in thinking their portfolios are insulated from the wider macro-economic forces.
Stephen O’Neill, Nest
A different picture
This cautious tone gives a small insight into the private equity picture going forward. Marks in the road indicate that for the future for the asset class may not be as rosy as in the past.
An obvious factor for private equity is the favourable financial conditions in which it has prospered, delivering top returns over the past decade and more, driven by constant ultra-low interest rates. But that is not the world in which we will inhabit going forward. In fact, the new world will be as far from it as you can get.
This could raise a big challenge to what PE can offer in an investment portfolio. Research by Bain found that – after outpacing public markets for a decade – the performance of private equity funds was the same last year as if the money had been put in the S&P500.
Getting sluggish
Looking further ahead, private equity is on track for sluggish growth during the next five years, according to investment data company Preqin. Institutional investors, a key source of capital for private equity funds, “are becoming more risk averse,” prompting some to shift money out of such funds and into real assets and private debt, which are viewed as safer bets, Preqin said in its analysis.
“Our forecasts suggest that the sweet spot that private equity markets have enjoyed over the past few years is likely over,” the report states.
This puts private equity in a different place entirely: one that is neither a megatrend nor a pyramid scheme, but instead, facing something of a new reality. So where does it leave private equity from an investor perspective?
There is still much to be positive about, says Andre Bourbonnais, global head of Blackrock’s long-term private capital. “We see that private equity multiples, which have increased, still remain attractive relative to the public markets,” he adds.
And investors are honing their approach to the asset class. “Investors are looking to see if there is value in participating earlier in a corporate lifecycle – such as growth – or investing in assets which bring together different sectors, such as energy and fibre delivery to homes,” Bourbonnais says. “Investors increasingly need to be multi-dimensional in order to identify and underwrite these opportunities.”
Global opportunities
Looking at geographic private equity opportunities, in the US, Bourbonnais is focused on strategies including corporate carveouts, family-run businesses, private investments in under-appreciated public companies and consolidation strategies.
Moving closer to home, there exist real private equity opportunities. “Europe is likely to follow a similar trajectory with elevated valuations and investment appetite, albeit with some dispersion across the region,” he adds. “In the UK, asset prices should continue to reflect the uncertainty in the economic outlook, with private equity funds continuing to find take-private opportunities among public companies they see as undervalued.”
Asia also offers opportunities. “We believe China continues to offer strong long-term opportunities, especially in technology, healthcare and consumer goods,” Bourbonnais adds.
Bermont-Penn picks out one particular asset class as attractive. “Venture capital, which typically targets companies at an earlier stage of growth than private equity, can be better isolated from macro conditions,” he says. “For example, WhatsApp, Airbnb, Uber and Zoopla – the latter of which Octopus backed – were founded and funded during the last downturn.”
Not insulated
But the new reality does, and will, impact on the investor outlook of the asset class. “Private equity investors mustn’t be naïve or complacent in thinking their portfolios are insulated from the wider macro-economic forces,” O’Neill says. “The fair value of an asset will be impacted by rising interest rates, inflation and labour shortages.”
Bermont-Penn does also offer a proviso about the potential risk involving PE. “Like all asset classes, private equity is not with- out risk, and by the nature of being a private market you are investing into a less liquid portfolio, which DB schemes in particular need to be conscious of, depending on where their funding ratio and timescales are.”
Nevertheless, Bermont-Penn notes that for DB and DC schemes, adding private equity to their portfolio, at the right stages, could be a method of improving growth, enhancing diversification and adding impact.
“In a world where ‘once in a generation’ events seem to be happening with increasing regularity – the dot-com crisis, the global financial crisis and Covid-19 among them, this asset class can be a useful addition in a pension fund’s tool kit.”
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