Private equity - even better in bad years
It acts as a portfolio diversifier, generating strong historical returns at a time when traditional asset-class returns are on a downtrend.
THE past decade has been one of unprecedented growth for private equity (PE). The reason for this increased investor interest from institutional and high -net-worth (HNW) investors is simple: PE acts as a portfolio diversifier and has generated strong historical returns at a time when traditional asset-class returns are on a downtrend.
PE's consistent long-term outperformance against major public indices is well-documented, with the asset class outperforming by 597 basis points over a 20-year period and 489 basis points over a 15-year period versus the S&P 500. Assets managed by the industry have more than doubled since the global financial crisis (GFC), with firms now managing more than US$3.8 trillion in assets.
However, we are entering a new period where the outlook is especially uncertain. The pain and havoc wrought by the Covid-19 pandemic on lives and livelihoods is a global crisis where the human toll is yet to be fully understood, much less accounted for until a vaccine is available.This raises then the question for PE investors: To what extent are the lessons of previous downturns relevant? Let us look at the past performance of PE as a guide to what could be the outcome of this pandemic-led economic downturn.
A US study by Cliffwater LLC suggests that PE has outperformed public markets, and historical data demonstrates that PE outperformance has actually increased during distressed periods. The Cliffwater study examined PE-investment programmes at US state pension plans over the 16-year period ended June 2016 (encompassing two bear and two bull markets).
Due to the "private" nature of PE, performance has been less transparent. But with the US Freedom of Information Act, US pension plans are required to disclose the performance of their investments including PE, thus making it more transparent and the basis of the study. During this period, PE outperformed public equities by 440 basis points across the 21 pension plans studied.
It is interesting to observe that when the broader economy was stronger, PE outperformed by an average of 290 basis points; during weaker economic times, this increased to 660 basis points (strongest returns in recession years 2001, 2002 and 2009). It is worth noting that all 21 pension plans outperformed the public equity benchmark, with differences between pension plans performance the result of the different PE managers these pension plans selected.
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We would infer the following possible reasons for the outperformance:
A Harvard-backed study that focuses on the period around the GFC concluded that PE-backed companies are generally more resilient to downturns and can act as an economic stabiliser during a recession. PE-backed companies were found to be less likely to face financial constraints during the GFC, allowing them to grow and increase market share versus their peers. PE firms were also found to have been significantly more likely to assist portfolio companies with their operating problems and provide strategic guidance during the crisis.
In fact, PE-backed companies invested 6 per cent more and gained 8 per cent market share versus their non-PE-backed peers during the GFC. As a result, PE-backed companies were 30 per cent more likely to be acquired in the period post-crisis, with a greater potential for a profitable exit.
PE FIRMS TODAY VS GFC PERIOD
We believe that in general PE firms are better prepared today than they were a decade ago during the GFC:
With increased volatility in public markets, there is an opportunity for PE firms to come in and acquire high-quality companies at attractive valuations, eg as buyers of forced/distressed sales by owners and asset managers seeking liquidity. Opportunities to privatise public companies are also expected to increase as market corrections have made them more attractive targets. We would expect to see some increased investments in sectors below.
Immediate:
Distressed sectors such as travel, entertainment, traditional retail and energy sectors
Medium term:
1. Sectors benefiting from a shift in consumer preferences towards technology: eg e-commerce, online streaming media, and productivity applications (eg remote working tools and online education technology applications);
2. Healthcare & technology related to healthcare: remote consultation, remote surgeries, healthcare logistics, medical equipment, drug discovery & vaccine development (biotech and pharmaceuticals).
BNP Paribas Wealth Management has long advocated an exposure to the PE asset class. We believe that PE should play a role in the portfolios of most HNW clients (in general, between 10-15 per cent of the portfolio, depending on risk profile) as it offers diversification benefits, in addition to attractive risk-adjusted returns, that will complement existing public investment portfolios.
Our recommendation, as it always has been, is a two-pronged approach:
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