The writer is CEO of Van Lanschot Kempen
The stock market has run out of exuberance, but private equity has not. That is causing some extreme distortions in the correlations between the public and private markets.
Stock markets are seeing big and fast declines as the largest single buyer of US financials, the Federal Reserve, switches to selling as it raises rates.
The world of private equity remains more isolated, still poised after years of fundraising booms with an abundance of “dry powder”: money not invested but available. Bain’s estimates the industry had its second-best fundraising year in its history, capping a five-year run that has generated $1.8 billion in new buyout capital.
But it is clear that investors should not see Private capital as a means of hiding from the economic cycle. Traditionally, there is a trickle-down effect in stock valuations between the public and private markets. This relationship can sometimes be distorted by factors such as the lack of liquidity of private investments, as well as the ability of purchasing groups to acquire more debt to pay more. But over time, the distortions should generally be reduced through arbitrage, at least through initial public offerings and delistings.
So when the dislocation between private and public capital becomes too great, the alarm bells should start sounding. The pain may be delayed, but eventually there is a reckoning.
Even if the drop in broader asset valuations is not reflected in the current estimated value of unlisted portfolios, eventually private equity groups have to exit their investment due to the finite holding periods set for them. The clock is ticking for the delivery of the internal rate of return, the industry earnings benchmark. According to PitchBook data, these slowed in the third quarter of last year to 6.8 percent compared to rates above 14 percent in the first two quarters.
While illiquidity provides the incentive to do the right homework and think long term, it also breeds complacency. Less immediate asset valuations can mask performance.
And there is an unfortunate congruence between fundraising and business cycles. When economies and markets are booming, private equity funds can more easily raise money. This means they are under pressure to allocate considerable funds for investments at valuation levels that risk being problematically high.
McKinsey estimates that by net asset value, the global private equity industry has grown by a factor of nearly 10 since 2000, outpacing growth in market capitalization in public stocks nearly three times over the same period
But this has led to huge amounts of capital chasing a limited number of deals, as well as an arms race in which companies with the lowest cost of capital win. There was a shift in the industry from asset performance to asset collection; a trend that could be less in the interest of end investors, or limited partners, and more in favor of the general partner, the managers of private equity funds.
If returns suffer, that could hit less experienced private equity investors particularly hard, many of whom have only recently been able to put money to work in the asset class as it has become democratized with greater retail access.
However, we still believe there is opportunity and real value in private equity. An example is funds that focus on small and medium-sized companies, where private equity owners have the opportunity to professionalize and internationalize or consolidate fragmented industries. These areas enjoy the double benefit of a larger pond of offerings to fish, with fewer anglers around. This reduces the risk of “overpaying”, while the idiosyncrasies of the portfolios reduce the dependence on the economic cycle.
Likewise, there will be good opportunities for funds that focus on megatrends such as the energy transition, digitization and urbanization. Real estate assets (real estate, infrastructure and land) are strong beneficiaries of these trends. This asset class is likely to increase its weighting under the umbrella of private markets.
One example is that to achieve climate goals, there is a critical need to upgrade existing buildings. This provides value-added opportunities for real estate managers who can make an impact while enjoying valuation improvements as their buildings’ energy labels improve.
These themes offer a practical way to invest responsibly and enjoy secular growth in a turbulent macroeconomic environment. They could also provide private equity investors with returns closer to those they have grown accustomed to.