This year, we expect a continuation of many of the same themes we’ve seen in private markets this year. The global macroeconomic environment remains weak, and central banks continue to pursue accommodative monetary policy. Top line growth is still hard to come by – both for companies and for the US economy.
Investors are looking for private market yield more than ever. So alternative investments continue to be popular among institutional investors as their comfort level in traditional assets of listed equity and fixed income is tested. Fixed income looks fully valued to many as interest rates can only go up from here and investors wait for the negative consequence of central bank intervention and negative rates to materialize. Long range forecasts for public market equities among major institutional investors are as low as 4%-5%, which is far below their actuarial assumptions for the growth of their liabilities. So where else can investors turn?
We think the biggest change just may be among investors themselves. When the world is becoming compartmentalized, investors feel crowded. Everyone is following the same themes and feeling the same pressures. Investors are looking for new opportunities and ways to optimize their exposure through a “best ideas,” unconstrained portfolio of private assets, whether it be in emerging markets or developed markets.
Finding opportunities
We’re seeing large buyouts in private markets, purchased at over 10 times (x) a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) using 6x leverage for larger deals. In the general secondaries market, pricing is also becoming fully valued because more people are looking for truncated J curves and a visible portfolio that has growth potential. (The J curve shows a private equity fund’s tendency during its life to deliver negative returns and cash flows early on and investment gains and positive cash flows later on as companies mature and are sold off.)
We think investors should go where most of them aren’t – that is, areas of the market with less capital formation. It may be harder to do the work to generate returns, but it may actually be a lower-risk strategy than following the path of least resistance that many other investors follow. In particular, we are focused on opportunities in the small and midmarket segments of the private market, along with private credit. We believe that investors should focus on smaller companies and/or funds to pursue alpha, while keeping in mind that these segments require greater expertise and selectivity.
A small midmarket business will generally trade at a lower multiple than a large market business. Among the same types of companies, just different sizes, investors can pay 7x EBITDA for the smaller company but 9x for the larger one. Why? Because the leverage is easier to come by for the larger company. The bigger the fund, the more pressure to put money to work. Of course, small midmarket transactions are hardly cheap, but it’s a relative value proposition as opposed to an absolute value one.
There’s another advantage to small and midmarket deals. Not only can investors get the benefit of higher growth, but once the company gets to a certain size, investors may get the benefit of an expanded multiple such that the next investor uses more leverage to buy the company. Investors should never use the expanded multiple as the main justification, in our view – they should look for growth, operational efficiency, and good bottom lines – but an expanded multiple can be a bonus.
Be mindful of risks
Of course, investors need to be aware of the risks and special skills involved in the private equity markets. Investors should do the proper due diligence to make sure the managers they pick are able to execute on the type of mandate they’ve been given. This execution risk is even broader in cases where an investor is looking for a manager to provide a “best ideas” portfolio. In the past, investors needed only to ensure that the manager was capable within a constrained or compartmentalized context. Now, managers need to demonstrate the breadth and depth of their capabilities in several areas or markets.
Another risk in the private markets is that portfolios cannot react as quickly to market developments or uncertainty as compared with more traditional asset classes like listed equities and fixed income. The ship turns much more slowly in private markets, and a level of uncertainty can slow things down. If an adverse event were to cause corporates to step back from markets, liquidity will become constrained for private equity. Exit trends have been favorable over the past three years as low interest rates have caused corporations to become more acquisitive. However, we expect the number of exits to moderate into 2017 and 2018. Exit trends have the potential to revert to the mean over the next 12-18 months because of the continued uncertainty over the global macroeconomic picture and investors’ nervousness about what central banks will do. On top of that is growing political risk, particularly in Europe and other developed markets.
Currency movements have had a huge impact on returns for international investments. EM currency performance relative to developed market currencies and even within Europe (for example, the euro versus the pound) has been dramatic. Most investment professionals believe volatility will still be the name of the game going forward, so general partners (GPs) of funds should be cognizant of currency effects. Many investors in the UK and continental Europe did not expect the pound and euro to move so dramatically. GPs should think about hedging within their funds versus telling their clients to manage it themselves, in our view.
Finally, it’s worth repeating that something that looks low risk can come at a high price. Investors can end up paying too much because debt is readily available. Paying up for an asset and then putting leverage on it makes something once solid and straightforward become more risky because of high purchase price multiples and high debt use.
One size will not fit all
The search for yield is becoming a catalyst for change in the private markets as investors now focus on determining the right strategy. Many are turning to alternative investments because of their ability to generate yield when there is little to be found in the traditional markets. Growth opportunities may also be more readily available in the private markets.
However, investors must remember that it’s not easy. As interest in these opportunities grows, assets become more expensive. And as competition for yield grows, returns are moderated. While there are many obstacles, we believe there is still more opportunity for skilled investors to generate yield and growth.
Steven Costabile is the Global Head of PineBridge’s Private Funds Group (PFG).
This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.
