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How can private equity funds deliver resilience?

Resilient Ferns Growing Through Rock

As low interest rates bite into returns, investors have increasingly poured money into private assets, partly driven by fears of an upcoming downturn market.

While latest inflows into equity funds point to a possible turn in sentiment, this is a recent phenomenon.

The interest of investors in private assets raises the question: how can the asset class deliver resilience?

A Last Word Research survey, published in Expert Investor Magazine in January, found that European fund selectors cited the potential of private assets to deliver superior return as the biggest reason for investing in the asset class (73%), while as many as 69% of those surveyed selected the asset class because of its low correlation to mainstream strategies.

Meanwhile, as the biggest concern regarding private assets, an overwhelming majority of European investors (74%) pointed to its limited liquidity; which could be linked to the recent scandal surrounding the equity fund of British fund manager Neil Woodford.

Resilience of PE funds during downturn markets

Brent Burnett, co-head of real assets investment committee at Hamilton Lane, told Expert Investor that its recent data suggests that private equity could specifically outperform in public equity markets during downturns.

 

Source: Hamilton Lane database

“Historically speaking, in the data that we have, the downside protection from private equity has been significantly better than from public equities,” he explains.

Burnett stresses, however, that the downside protection only exists for the “right” private market investments.

This, he says, means “diversification, conservative leverage structures, companies or assets where the buy-in valuation is compelling” and the ability to carry out “clear operating improvements” to the company.

“If those things aren’t in place, then I would say that the downside risk to private equity is very similar to public equities.

“In very strong public equity markets, it’s going to be difficult for private equity to outperform,” he adds.

Factors that bring private equity into “trouble”, Burnett explains, are if companies overleverage their balance sheet, operate in sectors with high GDP sensitivity and cyclicality or overpay for assets lacking the ability to implement clear operating improvements.

Resilience of small and mid-cap PE funds

In its 2020 outlook on private equity, British asset manager Schroders also points to outperformance by small and mid-caps over large caps in private equity funds.

In the past, strong investor appetite led to capital overhangs and lower returns for certain vintage years of larger buyout funds, a risk that could repeat, Schroders says.

The firm also flagged the risk of high capital inflows and high valuations for larger funds.

Meanwhile, Schroders sees the “healthiest market dynamics” and less expensive deals being in the smaller end of the market, which has high barriers to entry.

“Smaller deals represent a large investable universe, which can restrict access for some larger funds, as it is harder to deploy very large amounts of capital quickly,” the outlook notes.

Observers agree that small and mid-caps can provide more opportunities for return.

Burnett explains that the competition in the public market dampens returns for large caps.

One advantage of small and mid-caps is their ability to utilise inefficiencies better.

“There are some potential risks to larger funds underperforming the small to mid-size funds simply because the assets or the companies that they are buying tend to trade in more efficient markets,” he says.

Resilience of private debt investments

Mikael Huldt, head of alternative investments at Swedish AFA Insurance, explained to Expert Investor that investors could expect more resilience from renewable energy and infrastructure investments through private debt rather than private equity investments.

He said that large cap, private equity fund investments have a higher correlation with the public market.

“They buy companies from the stock exchange. They typically employ quite a bit of leverage, which inherently makes those companies quite vulnerable to downturns, and when they sell or exit, they sell via an IPO.

“Now, for those strategies, I wouldn’t expect those to be much more resilient than listed equities, because they share a lot of common risks and value drivers,” he explains.

However, private debt investments have, depending on their strategy, an ability to reduce risk.

“You typically have a project finance leverage, which is leverage where you don’t take interest rate risk, because you typically hedge out and you don’t take refinancing risk. You typically have a loan, which matches the overall length of the project, which could be 15 or 20 years,” he says.

Another advantage of private debt strategies is that investors could expect stable cash flows.

The income streams would allow investors to retrieve the principal after just a couple of years, Huldt continues.

Supported by the global energy transition, he also notes that long-term and sustainable energy sources have “materially different” value drivers in the private compared to the public market.

Source: Private asset sentiments by pan-European fund selectors, produced by Last Word Research

 

 

Elena Johansson

Senior Reporter

Part of the Bonhill Group.