Private equity – fallen back to Earth(?!)

The investment climate has gotten rougher this year and investors’ hunger for returns has moderated, not just on public stock markets, but also in the world of private equity. The private equity asset class is still in robust shape, but the rising interest-rate level is bound to lead to a valuation rerating on private markets, just like it has on public markets. However, this new reality doesn’t necessarily augur something bad for investors. On the contrary, it also presents an opportunity.

 

Inevitable return to normal

Private equity managers were still living in the best of all worlds last year – cheap capital was available in abundance, economic activity was humming, the deal carousel was spinning at high speed, and (book) gains and returns hit possible record-breaking highs. But in mid-2022, investors in private markets find themselves faced with the same new reality that public equity markets are confronted with – a reality marked by heightened geopolitical uncertainty, an emergent question about when the next recession will hit, rampant inflation and, last but not least, rapidly tightening monetary policy. Although private equity appears destined to hold up better than public stock markets again this time in the face of this challenging environment and continues to exhibit defensive qualities on the whole as it has in the past, investors nonetheless should dial down their return expectations for this asset class as well for the quarters ahead.

How well has private equity performed so far this year? In contrast to public markets, for which up-to-the-second price information is available practically in real time, the data situation on private markets is harder to keep track of (and is less up to date). However, quarterly reports from exchange-listed private equity firms like Blackstone, KKR, Apollo and Carlyle provide clues about how they did in the first quarter. Those companies reported a gross performance ranging between –5% (KKR) and +8% (Apollo) for their private equity strategies for Q1. It seems quite realistic to assume a flat 0% aggregate performance for the entire private equity sector for the first three months of this year. This would mean, though, that this asset class held up much better than the MSCI World (–5%), S&P 500 (–5%) and Nasdaq (–9%) indices did over the same period. Private equity returns have a general tendency to follow the performance trend on public markets, but with a time lag of six to nine months. The second quarter could thus now bring forth significantly negative returns also for classic private equity (buyout) funds, but especially in the private equity categories “growth equity” and “venture capital”.

 

Higher interest rates = lower valuations

As is the case on public markets, the most important driver of this trend is the rapidly changing interest-rate regime. Rising short-term market interest rates make the (partial) debt financing commonly used to fund typical buyouts more expensive. Private equity managers therefore won’t be able to employ as much leverage in the future, which is bound to lower returns a bit. However, since the good managers boost the value of their portfolio companies these days through operational improvements much more than by means of financial engineering compared to 20 or 30 years ago, the resulting adverse impact of rising interest rates is likely to stay within reasonable limits on the whole. But in light of the new interest-rate reality, managers contemplating new deals will pay closer attention to a company’s price and will look for the cheapest possible entry point. This will tend to compress the valuation level a bit.

Meanwhile, privately held growth companies are in even greater need of valuation adjustments. Their revenue and earnings lie far ahead in the future and theoretically now would have to be discounted with a higher interest rate in view of the sharp increase in (long-term) yields on the fixed-income markets over the past year. Over the last 16 months this adjustment has already been applied on a massive scale to publicly traded growth companies. This period has seen speculative (disruptive) hypergrowth companies (such as those represented by the ARK Innovation ETF) and companies recently gone public at sky-high valuations register share-price nosedives of 60% to 70% and even much more in some cases. With a time lag, we are now seeing corresponding valuation reratings also being applied to privately held growth and venture companies. One example of this phenomenon is Klarna, Europe’s biggest unicorn. Back in June 2021, the Sweden-based fintech company was valued at EUR 46 billion, but in its current financing round underway, Klarna was initially seeking funding at a reduced valuation of “just” a good EUR 30 billion, and lately there have even been rumors about a much deeper price discount to just EUR 15 billion now. And it isn’t just that book gains in the growth segment are melting away. Those gains that remain are also harder to cash in on in the current climate – they at least have become harder to monetize through an exit via an initial public offering because the IPO market has frozen up at present. While there were 347 IPOs on US stock exchanges in Q1 2021, there were only 31 in the three months through May of this year.

 

What goes up, must come down | Privately held companies are also in need of a valuation adjustment

Comparison of growth indices

Sources: Bloomberg, Kaiser Partner Privatbank

 

An environment full of opportunities

But private equity managers (general partners (GPs)) and their investors (limited partners (LPs)) are not faced solely with a phase of lower valuations. Alongside that, there are other trends and challenges in the private equity sector that definitely present opportunities for investors, which thus means also for individual investors.

Secondary market transactions: Many LPs are likely faced with a problem at the moment. Big private equity gains have accrued in the wake of the very good run in recent quarters, but at the same time, the percentage of liquid shares has shrunk significantly since the start of this year. As a result, the private-markets allocation in portfolios has increased sharply, and many LPs are thus now likely overallocated in this asset class. Some of them probably will solve this problem simply by raising their strategic allocation to private equity. Many LPs, though, probably want to sell existing positions to dodge expected valuation declines and to create room for new investments. This means that many interesting opportunities look set to emerge on the secondary market in the second half of this year. Private equity funds specialized in secondaries can particularly profit in this environment.

The private equity asset class remains chock-full of opportunities despite the more turbulent environment these days.

Co-investments: GPs’ appetites for investment capital are unsatiated and continue to increase. Driven by good performance and by mounting investor interest in “alternatives,” GPs are not only launching ever larger private equity funds, but are also creating more and more specialized vehicles (such as funds with a focus on growth, impact or specific sectors). The voracious and still increasing demand for capital contrasts with just a limitedly growing supply of capital from institutional investors. They have already continually raised their allocations to private equity in the past and now tend to be confronted with an overallocation, as described above. If GPs do not have enough “dry powder” of their own to engage in new transactions, they will increasingly go on the lookout for co-investors. So, there will probably continue to be plenty of good opportunities in the future also in the area of private equity co-investments (and corresponding specialized funds), which generally entail lower performance fees.

Evergreen funds: GPs already have an answer to the liquidity problem cited above: in the future they want to raise new capital also from wealthy private clients. Open-end investment vehicles called evergreen funds are a particularly suitable way to do that. Blackstone, Apollo and other private equity managers have already successfully brought such instruments onto the market, and many more are in the pipeline. Evergreens offer advantages for both sides. Investors in evergreen funds are fully invested right from the outset and do not have to service unpredictable capital calls, unlike with traditional private equity structures. Private equity managers, for their part, enjoy a stable capital base on which they can earn reliable management fees. For individual investors, this competition for their capital means an even wider selection of evergreens in the future and (potentially) even cheaper fees in the medium term.

 

The party is over (for the time being) | Management fees are becoming more important

Exchange-listed private equity managers

Sources: Bloomberg, Kaiser Partner Privatbank

 

The private equity asset class thus remains chock-full of opportunities despite the more turbulent environment these days. But in order to profit from its benefits, sufficient diversification across vintage years, geographies, investment styles and managers is necessary. The complexity involved in achieving adequate diversification is not insignificant and necessitates corresponding expertise. Kaiser Partner Privatbank has developed a dedicated private markets mandate specifically tailored to the needs of individual investors. Please feel free to contact us to learn more about this discretionary mandate.

 

Oliver Hackel, CFA Senior Investment Strategist

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