Private equity not insulated from macro risks, but asset class has shown resilience: Azalea

PRIVATE equity (PE) investments are not insulated from the risks in the macroeconomic environment, but the asset class has still shown resilience compared to public markets in recent years, according to Azalea Investment Management, which is behind the Astrea PE bonds

Azalea’s chief investment officer, Chue En Yaw, said on Tuesday (Feb 21) that 2022 was a year with “heightened risk” – including disruptions to global supply chains, high inflation and rising interest rates – and these risks could cause further disruptions in 2023.

“Today, we see that these risk factors remain and continue to create a highly uncertain macroeconomic environment in 2023, with increased risk of recession,” he said to investors during the Astrea Investor Day webinar.

Chue noted that underlying PE investee companies could face rising costs of raw materials and energy from high inflation, while elevated interest rates also make it more expensive for companies to borrow money to operate.

“Such a rise in costs could lower profit margins and projected earnings growth, especially if they are not able to pass on the higher costs to consumers. Therefore, PE funds may experience valuation markdowns in the near term,” he said.

Investee companies may also take longer to achieve targeted growth levels, which may also result in PE funds delaying their exits. Some funds may also exit portfolio companies at lower valuations.

“While PE is not insulated against the risk brought about by the macro environment, if we look back at the recent years, PE has proven to be a resilient asset class,” Chue said.

During recent market downturns in early 2020 and through 2022, PE returns have held up better than public markets.

Azalea noted that total returns from the S&P 500 fell some 24 per cent between the fourth quarter of 2021 and Q3 2022, but Preqin’s private equity index showed that PE was down just 3 per cent.

Chue said that private market valuation multiples have typically been lower compared to public market, which provides a buffer when listed stock valuations decline. He added that well-established PE fund managers also have strong operating capabilities that can help create value in investee companies regardless of the market environment.

Investors have also continued to allocate to the asset class. Global private markets fundraising in 2022 was above pre-pandemic levels, despite dipping slightly from 2021’s record performance.

“For PE managers, it provides capital to navigate and tide them through the market uncertainties in the coming years and hopefully emerge stronger,” Chue said.

Azalea’s chief executive Margaret Lui noted that initial public offerings have slowed down globally, although there are still strategic sales among PE managers taking place.

“In general, there’s a slowdown in the monetisation of the Astrea underlying investments by the fund managers,” she said, but added that this highlights the importance of the over-collateralisation in the Astrea transactions.

“That would mitigate the risks of a situation like we have today when exits are slowed down, and yet there will be enough cash flows from a very diversified portfolio to fulfil the obligations of the Astrea transactions,” she said.

Astrea PE bonds are each backed by the cash flows from a portfolio of more than 30 PE funds, holding between 600 and 1,000 companies at launch. The bonds have been offered to retail investors by Temasek-backed Azalea since 2018.

The bonds are issued at a loan-to-value (LTV) ratio of under 50 per cent, with Azalea the sole equity investor in each issuance. The LTV ratio also provides a buffer against declines, with the equity holder bearing losses before bondholders are impacted.

Chue noted that there have been some markdowns across the portfolio, but there is still “ample cushion” in terms of the LTV ratio of each transaction.

The Astrea IV, V, and VI portfolios have achieved fair value gains since launch, and have generated cash distributions.

Meanwhile, Astrea 7 – the latest issuance from May 2022 – saw a slight decline in fair value of around USS$58 million, bringing its net asset value (NAV) to around US$1.6 billion.

However, Azalea noted that it has generated “very healthy cash distributions” of US$317 million so far – around 17 per cent of the starting portfolio NAV.

Lui noted that Astrea investors are investing in a bond, so capital gains or losses incurred by the underlying portfolio would not accrue to bondholders, but the equity holder.

Investors attending the webinar on Tuesday also sought information on whether Azalea would issue an equity product or new bonds for retail investors.

Lui said: “The next Astrea issuance really depends on the market conditions and other factors such as investor sentiment, whether they’re conducive for us as issuers as well as for our investors. As you would well know, we do issue Astrea (bonds) on a regular basis.”

Chue added that their aim has always been to make PE more accessible to a wider group of investors through a “phased approach”.

“For us to offer the equity portion to the retail investors, there are a few things that must happen: one is that our retail investors must be able to appreciate and know and understand more about the product and the risk, and two is of course our regulation must change”.

Selected Q&A during Astrea Investor Day:

Q: Once reserves are fully accumulated, does it mean guaranteed redemption in full?

Chue: The reserves are set aside every six months to build up a steady cash reserve for the principal repayment at a scheduled maturity date. So if it’s fully accumulated, this reserve that is segregated will then be used to fully repay the principal repayment. Astrea will redeem the bond at the scheduled redemption date, it doesn’t mean that we redeem it earlier.

Q: Is the current below-par value performance of Astrea V and VI a concern to Azalea? Are you planning to increase distributions for Astrea VI bonds with high interest rates?

Chue: The interest rates are fixed at issuance. When interest rates move, it has an inverse relationship with the trading price of the bonds. So as you can see when the interest rate environment move up, the price of the Astrea bonds will tend to move down. One thing to take note is that the bonds will be redeemed at par, meaning that the bonds will be redeemed at the original issuance price, and not based on the current trading price.

Q: Why does current regulation prohibit retail investors or non-accredited investors from accessing the Altrium PE fund?

Lui: Principally, Altrium is an equity product, and this equity product in this asset class is really investing for the long term. It takes quite a number of years for investors to be able to access whatever they have invested in. This is what we call illiquidity. The high degree of illiquidity is the one factor where most regulations prohibit retail investors from accessing this asset class.

Q: Given the current macroeconomic conditions, geopolitical tensions ... what could be the worst-case scenario for the Astrea bond investors?

Lui: Every time we come up with an IPO of the bonds, we have put in worst-case scenarios in the prospectus. And you could see even in very dire conditions like what we experienced during the global financial crisis in 2008-09, there are some scenarios that are stated in the prospectus for each of the Astrea transactions. Invariably, you would see that the bondholders may – under some circumstances – not be repaid on the fifth year, but invariably, they get repaid before the 10-year final maturity. That’s why we have this feature of the step-up interest rates.