Where are the opportunities in private equity?
It’s been a bumper period of performance - across the card - for private equity. Our experts explain why returns have been so strong and offer their views on what comes next.
Even amidst the turmoil of the global pandemic, private equity attracted capital inflows. Performance in 2020 was strong and 2021 is set to impress. Why, when so many challenges face investors, has private equity stayed so robust?
For starters, private equity has form. Over the long term private equity outperforms almost everything. Private Equity outperforms other alternatives, public equity and fixed income, and over almost any time period from one to twenty years.
Active ownership and sector bias
There are two main reasons for the resilience.
The first is that ownership of assets in private equity is very active. Agile management teams can drive growth, and the degree of flex and change means private equity-owned companies can adapt very quickly.
The second key reason for the resilience through the pandemic is the industry split. Private equity has a stronger focus on industries that performed well when lockdowns threw many others into turmoil - particularly healthcare and tech. Broadly speaking, private equity tends to focus on less cyclical industries, and backs innovative, disruptive models, that further reduces dependency on economic strength.
Where are the opportunities: think smaller, think emerging
Covid accelerated change in many segments, sometimes moving companies and industries forward or backwards by 10 years, in just the last year. Looking forward to 2022, we see more of the same.
In particular, we believe small and mid-cap offer great opportunities for next year. As private equity has matured and evolved, investors can now focus on increasingly specialist managers, allowing investors to target sustainability objectives, as well as value creation through business transformation and operational transformation. Finally, the pricing dynamics are more attractive, and business owners of this scale are looking to grow their markets, not just returns.
There are two other areas we would single out that, in our view, are generating a lot of opportunities. In addition to small and mid cap, emerging markets (EM) is enticing. Everyone who travels - or used to travel - in growth markets will have felt the incredible entrepreneurial spirit imbued there.
For many of these markets, the speed at which they are maturing is increasing. Demographic and GDP growth trends favour EM, and as many developing economies emerge from the pandemic, we are seeing opportunities to meet funding and capacity gaps. Many companies are in need of growth capital and the entry multiples and valuations are very attractive in the current environment.
The “GP-led” market is another interesting space that has emerged in private equity in the last few years. GP-led transactions allow general partners (GPs) to retain control of star companies beyond the initial maturity of the fund. The pandemic pushed GPs to become active investors. As GPs sought to support good companies through an unprecedented – but ultimately transitory – demand shock, the number of these transactions has exploded.
What are the risks?
The most glaring issue, the one that most investors have spent some time mulling in both private markets and public, is valuations. As concerns mount around tapering, and how that might impact liquidity in the public markets, the valuations worries are growing more acute.
The truth is, bargains – if they exist in the market today – are few and far between. We have been very concerned with the search for quality. The pandemic has been a reminder that it is not possible to know everything. Good models can be incredibly valuable, but the world is full of people, not models. Therefore you need to work with very strong management who can change and evolve over time.
It’s important to have the depth of resource and specialist skills to go where the value is. We have the added advantage – for example - of the experience and perspective of our equity experts in EM investing. Emerging or growth markets have always been considered more risky than developed markets. Over the last 20 years, we have been focused on mitigating and managing certain risks, and ensuring risk and return potential are in line.
We believe successful investment in growth markets is contingent on local expertise, hence the majority of our investment team that invests in EM are located there. We have a very robust risk management framework and structured investment process which helps us to manage this risk. The way we performed in the pandemic gives us a lot of comfort that our approach is sound.
Sustainability and impact
It goes without saying that the market has moved towards more sustainable investment, and investment with positive impact. Capital is essential to addressing global challenges such as climate change and inequality. Private equity lends itself especially well to impact investing, given the greater proximity to assets and lower information barriers.
The focus now is on consistent, transparent, repeatable measurement. Despite the rise in profile of an “ESG approach”, sustainability is still seen with some scepticism over the impact on financial returns. But the negative effects of weaker ESG practices accumulate over time. Consistent measurement could avert problems developing. We are seeing more managers coming to the market with more thematic offerings, and a push towards data collection on impact and sustainability.
The question may well be flipped soon. Will it be “can you still achieve returns if you do not factor in impact?”.
We can demonstrate that over the last two decades, investors have secured market rate returns while advancing important causes such as poverty alleviation or climate change adaptation and mitigation. There are ample opportunities in EM to choose a specific impact outcome, allowing us to be selective and select the right targets from both an impact and return perspective.
Democratisation of private equity
Democratisation is a captivating development, and likely to be formative for what we call “private assets 4.0” – the next phase of private asset markets overall.
Most investors in private equity have historically been pension funds, insurance companies, banks, and so on. The structures have generally been 10-year limited partnership structures. These still completely dominate the landscape because they are proven to work and most investors like them.
More recently though, we have seen more liquid and semi-liquid structures, which largely fall into one of two camps.
- The first is vehicles that have monthly or quarterly subscriptions and redemptions.
- The second are listed vehicles, such as investment trusts, where investor decisions to buy or sell their holdings doesn’t prompt the trust to sell portfolio investments.
Both structures mean it is easier for retail investors to invest in private equity, where more traditional GP/LP structures would have prevented gaining access.
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