Why private equity, why now?
Private equity falls into the private assets basket – which are investments that are typically not publicly listed or traded. Because of this, they can have lower volatility than their public counterparts and can offer diversification benefits, often alongside returns uncorrelated with market indices.
As an alternative source of return, private assets can help to diversify investment portfolios and can offer a revenue stream or potential capital growth to help meet long-term goals.
Private assets take in a broad range of investment types and opportunities. These asset classes offer the potential for attractive income or capital growth but may be difficult to access through traditional approaches. Two well-known private asset options are infrastructure financing and private equity, both of which typically cannot be accessed in the more traditional way of investing in listed markets.
Investing in private equity, in particular, opens up investment opportunities in a broader universe of companies than those listed on public stock exchanges. Many early stage and growth-orientated companies can only be accessed through private equity, given the high cost and governance requirements associated with public listings. Because of this, private equity investments may provide attractive returns and they generally have a low correlation to major stockmarkets.
STRATEGY SELECTION
Private equity investment strategies are typically structured around one of four strategies:
- Venture strategies focus on providing funding to start-up or early stage companies. These are companies at the beginning of their journey, and the funding provided helps them to commercialise their products and services;
- Growth strategies focus on investment in companies that are more advanced in the commercialisation of their products and services but that still require high levels of investment to achieve their full potential;
- Buy-out strategies that implement a change in the ownership of an established company, usually to facilitate a change in management, a new strategic direction, a change in capital structure or to drive improved operational performance; or
- A turnaround strategy involves investing in companies that have run into operating difficulties, and usually aims to implement significant changes to management and corporate structure in order for the operations to become profitable.
There are a number of potential benefits to private equity investing. Firstly, private ownership – as opposed to public ownership – is usually accompanied by a board or even management position in the company, permitting a greater influence on management and the direction of a company to ensure investor objectives are met.
The long-term nature of investment also helps to ensure better alignment of interests between investors and management. Management are given the ability to focus on long-term goals, without being distracted by daily share price movements and quarterly reporting requirements, as they could be in a publicly listed environment. Private equity also offers the potential for increased investment returns over the long-term, which is an attractive trade-off for investing in less liquid assets.
PRIVATE EQUITY OPPORTUNITY SET
It is our view that the most compelling global private equity investments are focused on small-mid cap specialist opportunities across the US and Europe, as well as Asian growth companies. This segment has historically shown a very favourable risk/return profile because of lower entry prices for companies and lower levels of leverage employed relative to larger companies.
The current opportunity set in the private equity space takes in primary investments, secondary investments and co-investments, and they have differing outlooks in the current environment.
Primary investments may benefit from more favourable entry valuations due to the current COVID-19 pandemic. There is also an opportunity in late primaries where experienced fund managers that have already begun investing require further capital and pockets of value may be found where managers have made initial investments that aren’t expected to be adversely affected by the pandemic.
The short-term opportunities in the secondary market may be limited, as we believe valuations do not yet reflect the full impact of COVID-19 and this may take multiple quarters to flow through to valuations. In the meantime, there will be opportunities to participate in select secondary transactions, as well as top-up funds and structured rescue financings that have some secondary-like characteristics.
The advantage of co-investment is that under the current crisis they may benefit from less competition for deals leading to more favourable entry valuations. We see direct/co-investments as the most immediate opportunity in new market environment.
WHY CONSIDER PRIVATE EQUITY NOW?
Private equity investment can help to strengthen portfolios by providing greater diversification and lower volatility. In addition, private equity returns can outperform other markets because of the illiquidity premium found with private markets.
In the wake of COVID-19, private equity market valuations are currently lower than have been seen in recent years, which makes it potentially an attractive time to invest.
In addition, historically private equity has performed strongly after market downturns like the one we are experiencing now. Compared to listed investments, private equity is well positioned to deal with shocks for a number of reasons. Private equity vintages that follow times of stress have historically been the best performing vintages.
As well, there are a variety of ways to access private equity (including primary, secondaries and co-investment) which gives investment managers a higher degree of flexibility when selecting investments. Because private equity investors are active managers, this means private equity managers can intervene in the operations of their portfolio companies in times of crises, rather than being passive stakeholders.
Additionally, managers of private equity investments during economic turbulence are often more able to negotiate favourable terms. Finally, private equity allows for flexibility with regards to type and timing of company exits – which is not a feature of the public market.
A COVID-19 LENS
In the wake of COVID-19 private equity investors are in uncharted territory, but history can offer some lessons that may prove a useful guide in deciding the most prudent next steps.
In addition to the humanitarian crisis, efforts to contain and mitigate the COVID-19 outbreak have resulted in a historic stock market correction and seem to be leading the world into a global recession. Implications for financial markets are wide ranging, and variables numerous, so that many investors do not even know which questions to ask, let alone what the answers they need might be.
The first and second order effects and the timeline of the crisis remain highly uncertain. However, the experience of the two previous major financial crises – 2000-03 and 2008/09 – offers some insight on the risk and liquidity management issues investors may encounter in the coming months and can help them to navigate through this crisis.
When searching for historic events that resemble the current crisis, 2008/09 seems to be a closer comparison than 2000-03. Both now and in 2008/09, entire industries required a bailout. Banks, auto manufacturing and insurance firms required government intervention in 2008/09. Travel, mobility and hospitality firms (amongst others) are vulnerable today and will rely on government interventions. In addition, fair market value accounting and mark-to-market rules (such as SFAS 157 in the US) were already largely in place for private equity during the 2008/09 crisis, but not yet in 2000-03. Additionally, both in 2008 and in 2019, large buyout valuations and leverage levels were at high levels and fundraising was robust.
Private equity valuations will likely correct less than stockmarkets in the coming months for most private equity strategies. In 2008/09, private equity valuations overall experienced a value correction between two-thirds and half the level experienced by listed equities. The tendency for buyout valuations to not fully track public valuations is because of valuation practices that tend to smooth valuations. These practices include using an average from a collection of relevant listed companies and comparable transactions (which are less affected by short term stock market volatility). In addition, it is not uncommon for the valuation of a buyout investment to utilise normalised EBITDA figures over several historical quarters to further smooth valuations and limit the downside impact.
In contrast, venture capital investments, in particular early stage investments, will have the tendency to rely on the valuation from the most recent financing round to base valuations, particularly if the company has not experienced a material degradation of its business prospects. This also contributes to a smoothing of valuations.
Furthermore, as early stage companies often have no or little revenues and can grow very strongly, often there is no direct impact on company financials from a degradation of general economic conditions.
Late stage and growth financings are expected to experience greater valuation volatility compared to early stage companies, as these companies tend to be valued on a multiple of revenue. In this risk-off environment, the momentum propelling late stage valuation metrics is expected to quickly contract yet with some of the same smoothing elements as for buyout investments, but with a revenue focus.
DIVERSIFICATION
In a climate of lower interest rates and elevated valuations, you may be looking for a new way to generate returns for your clients, while providing diversification away from traditional listed equity and fixed income markets.
Private equity offers investors with a suitable risk tolerance the potential for enhanced overall returns and diversification to help meet longer-term investment goals. It provides access to a broader universe of companies than those listed on public exchanges, including many early stage and growth-orientated companies.
In addition, it may provide comparative stability during times of market turbulence versus some other asset classes, such as equities and fixed income. This makes private equity relatively well positioned for market shocks or downturns, and worth considering in the current environment.
Claire Smith is alternatives director, private assets at Schroders.
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