Perspective

Outlook 2020

Outlook 2020: Private equity

Low interest rates and elevated public market valuations have been widely touted as potential headwinds to traditional asset classes in 2020. The backdrop has contributed to the rise in interest in private equity. In addition, private equity is positively aligned with another prevalent investor issue – environmental, social and governance (ESG) risks – due to its longer holding periods and greater control over investments.

As a result, it comes as no surprise to us that investor interest in private equity is currently strong, and is set to remain so. According to private markets specialist Preqin, 79% of investors in private equity expect to increase their allocation to the asset class over the next five years.

However, while there is always some cyclicality in fund-raising activity, we also believe private equity is on a long-term growth trend, and there seems to be little that will stop it. Private equity has long been an important contributor to value creation in the real economy and for investors’ portfolios alike. It plays a key role in transforming businesses and creating new, fast-growing companies. Private equity can also smooth generational transitions; the successful transfer of a firm from a retiring generation to a younger one. It can also better align the interests of investors with portfolio managers, via capital commitments from the latter (which are rising). 

Beware high capital inflows and high valuations in some parts of the market

Despite our optimism, the increased interest in private equity has created a “frothy” environment. This creates challenges for investors. In the past, some periods with strong investor appetite led to capital overhangs that in turn have dampened returns for certain vintage years (such as 1999/2000 for venture capital and in 2006-2008 for buyouts). Today, there is a risk that these patterns repeat again. Large buyout fund raising is significantly above its long-term trend (although still to a lesser degree than in 2006-2008).

Furthermore, pre-IPO stage companies with $1 billion+ valuations - so called “unicorns” - have mushroomed in recent years. This has been driven by investments by non-traditional late-stage investors, such as the $100 billion Saudi Arabia-backed Softbank Vision fund, which is comfortably the largest private equity fund in history.

The private valuations of many of these companies have been driven so high that they have ultimately disappointed when an exit into public markets has been sought. Darlings of the private world are now trading below their IPO prices. Some also had to pull their IPOs entirely even at a cut-price level.

Generally, the private equity strategies most at risk from strong inflows of capital seem to be those that can accommodate large, single investments without investors hitting maximum ownership limits. These are typically larger funds.

Smaller end of the market less expensive

In contrast, market segments with high barriers to entry, in our view, show the healthiest market dynamics. Smaller deals represent a large investable universe, which can restrict access for some larger funds, as it is harder to deploy very large amounts of capital quickly.

For small/mid buyouts in the US and Europe, start-up investments globally and early growth investments in Asia, fund raising trends have been stable or even been declining. This is a positive indicator for vintage year return expectations. Moreover, the current low-rate environment has allowed some fund managers to “scale up” and to raise significantly larger funds, thereby exiting these smaller market segments. This helps to further stabilise market dynamics at the lower end of the market.

One consequence of these diverging fund-raising trends is that acquisition multiples for large buyouts have risen to historically expensive levels. By contrast, small buyouts have remained more reasonable. For 2020, we expect the lower end of the market (in terms of transaction sizes) to continue to provide the most attractive opportunities within private equity.

Smaller buyouts offer compelling value

20200115_hk_eng_chart_1.jpg

Source: Baird 2019, S&P 2019, Schroder Adveq, 2019

Investor emphasis on ESG related topics to further increase in 2020

We expect investor emphasis to rise next year on ESG characteristics and – to a lesser but increasing extent – “impact” investing, for private equity investment decisions. This is becoming especially important in Europe, where heightened awareness of climate change and the European Commission’s Sustainable Finance initiative are important drivers. We also expect ESG and impact investing to increase in importance in other world regions.

 

Important Information
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
This material, including the website, has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.