Private equity has enjoyed a remarkably strong run of performance1 and endured three major cycles of growth and recession over the past 40 years. Can it continue to deliver the returns that investors have come to expect?
2021 was a record year for the private equity industry in terms of new capital raised, public offerings of private-equity-backed companies and investors’ returns 2. But looking ahead, the outlook for the sector is changing as the world adjusts to sharply rising interest rates designed to combat inflation.
This has created a much tougher investment environment. However, our experience shows that some of the best private equity returns have been made from funds raised during recessions when entry pricing is under pressure and competition for new deals less fierce. It should also be noted that the success of private equity across cycles reflects the transformation that private equity has undergone since the 1980s, when deals such as KKR’s record-breaking buyout of RJR Nabisco in 1987 relied heavily on debt.
Rather than relying on leverage for returns, private equity managers now use a systematic approach (developed by KKR in the 1990s) based on thorough analysis of the businesses being targeted and a formula for operational improvement and strategic development of the companies they acquire. This approach, which is now ubiquitous among buyout firms, relies on highly capable company management who perform hands-on operational roles in underlying portfolio companies, and are able to act quickly to implement change. It is this that gives experienced private equity investors confidence in the asset class.
How will private equity fare as the growth cycle ends?
The decisive return of inflation for the first time in 35 years has forced central banks to raise interest rates aggressively in an attempt to contain it. This raises the risk of a low-growth, high-inflation economy, leading to diminished investment returns across asset classes. Private equity will not be immune: the declining stock market values that we have experienced this year will reduce the valuations of many private-equity-backed companies.
Private equity firms generally use a ‘valuation football field’ approach – a spread of techniques that creates a valuation consensus. Different weight is applied to different techniques, depending on the nature of the underlying business, but for most companies the public markets’ comparative price-to-earnings (P/E) ratio is a key valuation driver. If listed companies’ valuations decline, this will lead to lower private company valuations.
Our view is that private-equity-backed companies are unlikely to fail en masse, but neither will they be exited at valuations that generate the mid-teens IRR3 and two-times cost money multiple that investors are accustomed to.
Yes, valuations will decline, but businesses are likely to survive, provided they can cover their costs.
For investors considering investing in private equity for the first time this highlights the need to be extremely selective, to only invest with proven teams and to commit capital gradually.
A valuation is purely a snapshot of a company’s worth at a point in time and is unlikely to be what it will be realised for. Private equity managers will not sell until the price is right to generate the targeted required return, unless a company faces a liquidity crisis that they cannot refinance. This may lower the potential for an attractive return on exit, but it generally averts lost investments.
The banking system supported this strategy following the 2008 global financial crisis and regularly consented to amend and extend the terms of debt packages rather than force a default and risk the return of the loan principal. Debt has historically comprised approximately half the capital structure of a typical buyout investment but the majority of debt packages are borrower friendly and do not contain covenants that give the lender a right to control the business if the borrower defaults.
The advantages of private equity in challenging times
Private companies are unencumbered by the constraints and time pressures of public governance and investor reporting, and the cash drain of equity buybacks and dividends. This frees up private company management, with the support of private equity owners, to take rapid operational and strategic action that can enable businesses to thrive in good times and survive during recessions.
As an example, in 2013, Dell expected its annual PC shipments to drop 9% and its recent acquisitions were not bearing fruit. The company’s solution was to borrow US$18bn4, take itself private and implement an ambitious revival plan. The debt service cost of going private was considerably lower than the outflow of cash had been from dividends and buybacks in the public realm. Forbes magazine noted: “…unshackled by Wall Street’s 90-day attention span, Dell has boiled the priorities down to just two metrics: cash flow and growth”.5
Past experience gives us confidence that privately-owned entities can thrive in challenging times.
Prior to joining Sarasin, the Bread Street team invested directly in the Dell ‘take-private’ transaction6 and saw first-hand how a relentless focus on cash flow and execution of a clear growth plan turned a business around in a way that would be hard for a public company to achieve. Not all take-private and buyout scenarios succeed, but past experience gives us confidence that privately-owned entities can thrive in challenging times and – with the right financing, strong deal sponsors and smart incentivisation – remain attractive investments. Indeed, in periods of economic uncertainty and market volatility, private equity, with its long-term, committed capital funding model, is ideally placed to take advantage of investment opportunities.
Emerging value in the secondary market
Severe indigestion is the current order of the day in the leveraged loan and high yield bond markets. For example, Elon Musk’s acquisition of Twitter this year will add a further US$12.7bn of debt to the balance sheets of Morgan Stanley, Bank of America and Barclays that will need to be sold at a significant discount to par to provide the higher yields now demanded by debt investors.
They are not alone: other large global banks also have substantial acquisition debt underwritings on their balance sheets with similar mark-to-market losses. Our market conversations suggest that the higher cost of large debt facilities is already acting as a brake on buyout deal activity, as is the difficulty of negotiating acquisition pricing given increased uncertainty of future revenue and value growth.
By contrast, the private equity secondary market has been exceptionally active due to the emerging of attractive investment opportunities and a significant stock of uninvested capital available to be deployed into the market. Funds specialising in secondary fund investments and single-asset deals remain popular, with mega-pools of capital being raised by investors seeking seasoned fund investments at discounts from pension funds and institutional investors, many of whom are trimming private equity exposure in order to rebalance their portfolios following falls in public markets.
We estimate that the highest quality buyout funds with seasoned portfolios may now be available7 at discounts approaching 20% relative to their most recently available net asset values (NAVs), and that less seasoned and/or lesser quality funds will trade at much wider levels. We are also seeing more opportunities to invest in established venture funds, which are traditionally less liquid in the secondary market. We recently reviewed a high-quality portfolio of funds from a well-known venture manager being marketed with an aggregate discount considerably greater than the c20% being seen in buyout funds, though as most buyers right now would concur, that is only considered a starting point to a valuation discussion.
Following the collapse of crypto exchange FTX and the book value write-offs taken by its venture backers, the industry will be looking very closely at venture businesses’ governance models and the quality of venture houses’ oversight. It will take time for confidence in venture capital to be restored; in the meantime, we are likely to see further good opportunities to acquire venture holdings in the secondary market.
The secondary market is now pricing in expectations that underlying portfolio company exits will take longer to achieve and that distributions will be delayed. The slowdown in general private equity deal activity and a decline in performance will make new fund raisings more difficult.
However, once buyer and seller price expectations adjust and deal activity resumes, there will be more attractive entry pricing for new investments and, over time, more desirable returns on investment when the new crop of acquired businesses are ultimately exited.
1 Based on long-term private equity (PE) returns (IRR basis, 1980 to 2021), calculated by the BVCA, who estimate that during this period (to 12/2021) PE funds with various geographical exposure and vintages between 1980 and 2017 delivered an IRR of 14.9%. The BVCA fund universe numbers 155 funds spanning large and generalist PE to early-stage strategies. Source https://tinyurl.com/ytwwx3h7, see p.16. By comparison, the annualised total return from UK equities for the period 31.12.1979 to 31.12.21 is 11.1% (source: Sarasin and Partners LLP Compendium of Investment 2022). We choose UK equites given the significant UK fund exposure in BVCA data. PE IRRs vs long-term public equity index returns are not a like-for-like comparator and take no account of the additional returns available to PE investors who can invest undrawn capital in other risk-seeking strategies (including equities) prior to realising ahead of capital calls.
2 Bain & Company: “In 2021, global buyout deal value ended the year at US$1.1tn, double 2020’s total of US$577bn and shattering the old record of US$804bn set back in 2006…”. Chartered Alternative Investment Analyst Association: “…2021…produced an extraordinary 54% return for private equity, 12% better than the public stock markets.” https://caia.org/blog/2022/07/20/long-term-private-equity-performance-2000-2021
3 Internal rate of return, one of several private market performance metrics.
4 FT.com, Dell: the tricky maths of a reverse merger, 9/12/2018.
5 Forbes.com, Dell officially goes private, 30/10/2013.
6 Co-investment for Aberdeen Private Equity Fund Ltd, an LSE-listed investment company.
7 As at 30.11.22 and based on professional market counterparty conversations. September NAVs are not yet fully published.
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