Investors expect pandemic to create vintage private equity opportunities
Prior to the global financial crisis (GFC) of 2008, private banks began to highlight alternative assets, focusing on high risk hedge funds. Leading wealth managers including UBS were recommending wealthy families allocate 20 per cent of portfolios to less liquid investments.
The most vociferous proponents were Swiss private banks, including UBP and Banque Syz, basing their business models on promoting hedge funds. As some funds were gated and others crashed during the crisis, clients withdrew assets, leaving their banks battling for survival.
Today, we have another crisis – this time fuelled by the Covid-19 pandemic – coinciding with relentless promotion of a different alternative assets class, that of private equity (PE).
The very same protagonists, who so enthusiastically embraced hedge funds, are now putting their marketing muscle behind PE, betting on its likelihood of generating returns above those from volatile public markets.
Their belief is that many companies are shunning public markets and searching for sources of private capital to finance their growth. And they have a mountain of “dry powder” to tap. According to consultancy Bain & Company, an estimated $2.5tn of cash is waiting to be deployed in private equity strategies.
Low starting point
“The representation of private equity in private wealth portfolios is very low, often zero, and can only go up,” says Marc Syz, CEO at Syz Capital, hoping to generate 15 per cent returns across market cycles.
Along with other private banks preparing to ride this wave, Geneva’s Banque Syz has been gradually switching its clients’ emphasis to private equity, away from poorly performing hedge funds, marginalised by central banks’ liquidity injections, which favoured public equity.
The Syz family, like other entrepreneurial investors, is backing private markets to come into their own as a result of the pandemic. “Over the coming two to three years, we will keep a close eye on distressed investing and special situations, as over-levered companies sort out their balance sheets,” comments Mr Syz. “We expect this will create many opportunities.”
There are two reasons for this change of direction. Firstly, private banks have seen their wealthiest clients hire internal teams to source private equity investments (as described in PWM’s special issue on Global Families) and they want to preserve their own lucrative roles of presenting deals and conducting due diligence.
Secondly, they need to find a new panacea to satisfy investors, spooked by short-term market gymnastics and keen to buy into longer-term, private market stories. In the turbulent economic environment sparked by the onset of Covid-19, the vast majority of family offices surveyed by UBS (73 per cent), expected private equity to deliver higher returns than public markets, with many lauding its broader range of investment opportunities.
Thirdly, the top-tier clients of some banks, including UBS, have made “vast fortunes” from equity markets during the early days of the coronavirus crisis, and have since cashed in, with a view of shifting to less liquid, longer-term stories.
“Interest has definitively shifted towards PE at the expense of hedge funds since the GFC,” confirms family office adviser Didier Duret, expecting private equity to gain an even greater “strategic advantage” as Covid-19 highlights the entrepreneurial spirit behind real economy firms.
“As an investor category, PE represents a gigantic, post-Covid arbitrage force,” thriving in an environment of partial dislocation in the real economy, believes Mr Duret. Firms involved in life sciences, automation, new energy, new retail and digital transformation will all attract investor attention. But they will not be the only ones.
“A new opportunity set will be created by firms with profitable and sound business models, but in great need of cash as they face the ‘Death Valley’ of Covid-19,” says Mr Duret.
Incredible opportunity
There has been no shortage of financial services firms creating new products to anticipate the expected boom. A private equity fund of funds launched by Spanish insurer MAPFRE focuses predominantly on primary mid-market buyout funds in Europe and the US, plus some exposure to “special situations”, emerging market funds, secondary market opportunities and co-investments.
“This is probably the best timing in many years due to the correction we expect in many company valuations,” says Jose Luis Jimenez, chief investment officer at MAPFRE, who describes the firm as a “very cautious investor” with “a quite conservative approach to private equity”.
The economically damaging global lockdown may herald “incredible opportunities” for private equity. “We could be in one of the best vintages of PE in many, many years as long as we avoid the pitfalls,” says Mr Jimenez.
US wealth manager Northern Trust – one of the more sober and balanced voices – has a long-term return expectation of 8.9 per cent for global private equity, which can be further boosted by “robust manager selection”, compared to 6.1 per cent for global equity.
Among the more enthusiastic promoters of this currently in-vogue asset class, is French bank BNP Paribas, which claims private equity successes significantly outnumber failures.
Examples include the buy-and-build story of the world’s largest brewer, AB Inbev, developed from local Brazilian brewer Brama, into a powerhouse by private equity fund 3G Capital, through a series of mergers and acquisitions over three years.
Another has been Ceva Animal Santé, focused on animal vaccines, beginning its life as a spin-out from Sanofi in 1999, backed by PAI Partners. The company then embarked on a journey consolidating the sector and expanding internationally. It is currently a global market leader with operations in 42 countries and turnover exceeding €1.2bn ($1.37bn).
“Post-Covid, the firm is expected to continue to play a continued role in the fight against global pandemics,” repaying the faith of private equity backers from Europe and Asia, in addition to US pension funds, believes Richard Clarke-Jervoise, global head of private equity and private debt investments at BNP Paribas Wealth Management.
“Successive private equity owners have shown their ability not only to support growth but also to be receptive to the needs of company management, who have subsequently become the majority owners of the business,” he says.
The bank’s research shows PE has historically outperformed the stockmarket by at least 6 per cent each year. In downturns, like the GFC or the dotcom crash of 2000, PE’s outperformance of public markets was even greater. “We expect that this will be the case for the post-Covid environment,” adds Mr Clarke-Jervoise.
Given the lower volatility of the asset class compared with public markets, BNP Paribas’ clients have been comfortable to ramp up private equity investments since the onset of coranvirus. The bank’s research shows 32 per cent of high net worth individuals expect to increase their allocation to private equity and real estate (PERE) in the near future.
The French bank claims a 600 basis point “illiquidity premium” is the product of patient long-term approach, enhanced governance and a broader operating “toolkit” and targets returns as high as 20 per cent, depending on the strategies. But others, including family office adviser Mr Duret, believe any “illiquidity premium” could potentially be much higher.
“Investors should continue to demand returns between 15 and 30 per cent, to support the non-liquid nature, specific business and portfolio construction risks involved,” he says, suggesting ultra-wealthy families can mirror public equity exposure with private equity allocations of 20 to 40 per cent.
The BNP Paribas research shows allocations from today’s numerically larger, new, more entrepreneurial generation significantly exceeds the “old money” positions of five to 10 years ago. The highest, ‘ultra’ segment of entrepreneurs, especially those in Asia, have even bigger ambitions for private equity investments, expecting to double allocations from 10 per cent today to 20 per cent in 12 months’ time, as they chase unlisted opportunities
Millennial entrepreneurs and those from Generation X are much likelier to favour private equity than their baby boomer parents or grandparents, says the bank.
At UBS Wealth Management, Joe Stadler, head of global family office, says the wealthiest families have been busy taking advantage of market dislocations in stockmarkets during the onset of the coronavirus crisis and are now ready to cast their nets further afield.
“In some cases, vast fortunes have been made,” says Mr Stadler. “Now that public markets have come back, we’re seeing the return of the illiquidity premium. There are plenty of businesses that need fresh capital to restructure their operations or enter new markets. This year could be a very good vintage for private equity investments.”
Knowing this client base intimately, Mr Stadler confirms these investors are also prepared to take high risks, with losses factored into their business model. “For these types of entrepreneurs, the biggest headache is not from making a short-term loss, but from missing an opportunity.”
The case against
There are, however, many questions hanging over the current euphoria around private equity. Investors should be wary of “kneejerk reactions to volatility in listed markets”, says Charlotte Thorne, founding partner of Capital Generation Partners.
She also warns against a sometimes mistaken assumption that private equity is less volatile than public markets. “The same underlying volatility in valuation is there, you just don’t see it in real time,” she adds.
Complexity, access barriers and illiquidity can also be problems for many. “Private equity is packed with jargon, the return metrics are confusing at best and nonsensical at worst, and unless you’re an established player you can probably get access to some funds, but not the best ones,” says Ms Thorne.
Unlike investing in a public equity fund, “you are effectively giving someone a credit card, and they can pay you back in 10 or 12 years,” she says, describing the concept. “That’s very difficult to manage from a cashflow perspective, and for people who don’t navigate this asset class day-to-day, it can be a real headache. The last thing you want to do is sell down good assets because all of your managers have asked for capital at once.”
Many commentators are asking if the best returns have already been made, while others believe it is still too early for the next cycle.
“We came into this crisis at the end of a very long economic expansion. As such, many private equity companies will have engaged in late cycle, expensive projects and used a lot of debt to do so,” says Michael Sullivan, author of ‘The Levelling’ and former investment boss for private banking at Credit Suisse.
“Whilst the policy response to the crisis has been aggressive, my instinct is to wait for a downshift in valuations and the onset of a credit crunch. When this happens, it will churn up a lot of assets for sale, and will in time be a very attractive environment for private equity and private debt investors. I rather see this occurring in early 2021 than right now.”
While in theory, rising defaults in major economies will bring many distressed assets to the market, in practice, investing in private equity will not be plain sailing, believes asset and wealth management expert Amin Rajan, CEO of the CREATE financial research consultancy.
There are several warning signs clients need to look at. “First, data on PE returns suffer from the survivorship bias: only those companies doing well have the incentive to report the performance data,” advises Mr Rajan.
Second, PE is a high dispersion space for returns, meaning the difference between performance of the best and the rest is big. “So manager selection is absolutely critical.”
Third, PE firms are already carrying a mountain of “dry powder”, unallocated capital in search of buying opportunities. This is currently equivalent to more than a quarter of assets in the PE universe.
“So there is already too much money chasing too few opportunities,” says Mr Rajan. “The days of double digit returns are over, as good buying opportunities were already diminishing long before the corona crisis.”
