Private View Blog: Is private equity all it is cracked up to be?
While most private banks are proposing their clients load up portfolios with private equity, in the same way they pushed hedge funds prior to the global financial crisis, Michael O’Sullivan, who has recently authored a book, The Levelling, believes they could be making another big mistake.
As a former CIO of Credit Suisse in their private banking and wealth management division, Mr O’Sullivan believes his strong conviction that the world is turning away from globalisation, towards a multipolar order - shaped by interlocking forces of economics, politics, finance and geopolitics - should form the basis of future asset allocation decisions.
Like all short-term highs, the “financial morphine” of QE will eventually come to an end, as central banks agree to use it only in extraordinary, preset conditions of great stress. This would lead to proper repricing of economic and political risk, generating macro and market dislocation, suggests Mr O’Sullivan.
This new world order has huge implications for asset allocation. Core asset classes are likely to generate low returns and investors should consider having “radically smaller weight” to equities, bonds and ‘govies’. “Many assets prices are now more skewed from their long-term average than they have even been, so the risk of mean reversion is huge,” he warns, with a global recession less than two years away.
In this scenario, alternatives such as private equity and hedge funds will suffer and should be replaced by long-short credit, or distressed debt funds, recommends Mr O’Sullivan. These will benefit from debt-driven themes, including downturn in the credit cycle, general higher dispersion in credit risk and emergence of a proper debt market in China.
While private equity is the most favoured alternative investment at many private banks, Mr O’ Sullivan believes the sector is peaking, having attracted huge assets and used lots of leverage. “Outside the big and seasoned private equity companies, the range of attractive opportunities is shrinking relative to the size of the private equity industry.”
Also, private equity is an industry which is “politically, massively vulnerable”. He likens the sector to a “submarine”. Going along under water, it has not been on politicians’ radar so far, unlike big banks or other financial institutions.
Many private equity companies are now stepping into shadow banking and lending. A change of political tack in the US could leave the industry vulnerable. He points to White House hopeful Elisabeth Warren’s proposal of new regulation pitching constraints designed to end what she sees as “legalised looting” by investment firms that take over troubled companies. Far too often, “private equity firms are like vampires bleeding the company dry and walking away enriched, even as the company succumbs,” the Massachusetts democratic senator wrote in a recent post.
New safe haven assets will emerge. Investors’ focus should be on resilient countries, such as small, advanced economies, including Switzerland, Sweden, Ireland, Singapore and New Zealand, which Mr O’ Sullivan names “canaries in the coal mine of globalisation”. Sectors and industries resilient to political pressure and populist movements should also be prioritised in clients’ portfolios.
“I have been in the industry long enough to know that what really matters is when things go wrong, and you need to design a portfolio with that in mind,” says Mr O’Sullivan, who is looking to partner with an asset manager to launch a fund based on his views.
Not surprisingly, these views are not shared by his former employers. Like other competitors, Credit Suisse forecasts net returns in the “mid-teens” for private equity for the next few years, and has created new “vintage” multi manager programmes to channel clients’ assets into this asset class.
But investors, who have previously suffered from over-allocation to hedge funds, technology stocks and structured products, all on the recommendation of private banks, may choose to listen to a broader range of commentators before making decisions.
Elisa Trovato is deputy editor of Professional Wealth Management. Follow her on Twitter @elisa_trovato
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