(Katrina King, The Australian Financial Review)
The withdrawal of post-GFC central bank liquidity in 2018, a dovish shift among central bankers globally and high asset values help paint the picture of a late-cycle market.
However, as addressed before in this column, “late cycle” can extend a long time and the opportunity cost from moving to cash can be expensive. While I might usually address fixed income matters, it’s timely to address the fact that late-cycle private equity (PE) investing may offer compelling opportunity in an otherwise nervous market.
In terms of long-term investing to maximise returns, PE offers some clear advantages over public equity markets. PE outperforms public market equity on average 5 to 10 per cent a year over time. What is even more interesting is this outperformance is cyclical. PE returns tend to lag during expanding markets, but outperform listed equities more than average in late-cycle environments. Thus PE offers attractive return diversification over the cycle.
Compared to its importance to investment portfolios offshore, PE is still a very small part of the Australian investment landscape, comprising less than 5 per cent of the 10 largest superannuation funds’ investments. Compare this to about 10 per cent for US pension funds and 23 per cent for US endowments.
A long-term focus, and the ability to fundamentally improve the performance of a business beyond the daily gyrations of markets adds to its compelling benefits.
There are always innovative opportunities and excellent commercial ideas that need capital – these appear, agnostic of where we are in the cycle. PE offers shelter from the radical price discovery of listed markets so great ideas can fully develop and commercialise.
By its nature the asset class is more illiquid. This helps overcome human nature’s tendency to be distracted by noise and sentiment, and to chase returns. Nobel laureates like Daniel Kahneman, Richard Thaler and Robert Shiller have shown our biases impact our judgment to the detriment of returns. PE’s long-term approach helps redress some of these biases.
The ‘Gordon Gekko’ model is out
PE today is a different beast from the levered model of old. Modern PE managers rely more on the model of purchasing assets with potential for great value improvement from great operational improvement. The old “Gordon Gekko” model of debt-funded acquisitions repackaged for listed markets is out.
Further, the huge advances we have seen in technology and data processing are now opportunity sets for the PE market. Managers that can harness and truly monetise data will be well rewarded in future.
But before you race off to sell down public exposures and dial-up PE, caution is advised, particularly at this late-cycle stage.
Care needs to be taken to ensure PE managers are operating in an area where they have proven expertise. New managers emerge late in the cycle, and some existing managers are tempted into new areas where they may have little experience.
Late in the cycle there can also be pressure to increase fund returns by raising money faster, lowering valuation hurdles, and loosening underwriting standards to get deals over the line. This is where experienced and established PE managers offer an advantage.
Experience tends to play out in PE performance. BCG research shows that on a sample of industry deals by experience, deal returns were higher for frequent acquirers (36.6 per cent internal rate of return per annum) than for medium-frequency (28.7 per cent), and low-frequency asset acquirers (27.3 per cent). Standalone deals returned 23.1 per cent IRR.
Another late-cycle trend can be in co-investment: either significant co-investment with first-time managers or managers pursuing larger deals to meet client demand for co-investment. For an investor, co-investment can look attractive as managers don’t usually change a fee for deal participation.
Some managers are exploiting this drive for fee-minimising co-investment by building funds simply on the basis of offering co-investment opportunities and, therefore, attracting investors not on the basis of net return, but on the basis of fee minimisation.
Investors need to carefully question why the manager is creating capacity for them – funding is a necessary but insufficient rationale. Pursuing a path of “growth by co-investment” and foregoing true selection skills can result in lower net returns.
Co-investing can work, but the fundamental nature and potential of underlying assets is crucial. Co-investment requires patience, clear asset discrimination, genuine alignment between the manager and investor, and an active two-way relationship.
PE has the potential to yield higher long-term risk adjusted returns. In the world of PE, an excellent business is excellent, no matter where we are in the cycle.
The key to success in PE is to focus on the quality of the assets, and the experience of the manager — with this, great PE assets will have space and time to perform free from the madness of listed markets.
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