The weight of expectations brings Private Equity (“PE”) markets down

Consensus view: The past decade has been one of rip-roaring success for PE investments, with record capital not only raised and deployed, but also distributed back to investors. Indeed, total buyout value jumped 10% to $582 billion (including add-on deals) at the end
of 2018 globally, capping the strongest five-year run in the industry’s history. Last year figures will likely set another record. High double-digit returns (ca. 20% per annum) are where expectations are set for many.

What the consensus view is not pricing in: Low interest rates and steady GDP growth in the US and Europe have helped the industry, but the real juice in returns has come from selling assets acquired at cheap valuations in the years after the great financial crisis at much headier multiples now. This thunderous recent performance has diverted waves of new liquidity towards the asset class: a decade ago, a $1 billion fund raise would have been notable; today, some funds raise more than $100 billion. Dry powder, or capital which is raised but not yet spent, is above a record high of $2 trillion (December 2018, Bain & Co.) This has led to a transformed landscape: PE firms are forced to deploy ever more money not only at richer valuations, but also on increasingly speculative underlying investments. This is a dangerous convergence of factors.

Potential market reaction:

  • Macro: There are trillions invested in PE, but such “alternative investments” tend to be relatively small in the overall portfolios of most investors. They are often a larger proportion for family offices, or similar investors, who are comfortable with the illiquidity profile of such asset classes. Also, while investment banks are intimately connected in the process of buying and selling private companies and raising the capital to fund many of the transactions, the traditional banking system has fairly limited exposure given regulation mandating conservative balance sheets and appropriate risk-weighting. This means a disorderly wind-down of some large PE funds would not pose a systemic risk to global economies in the way the bust of mortgage-backed securities did in 2008, but there would still be a strong risk-off reaction.

  • High-yield debt: This is probably the most directly impacted asset class, since much high-yield debt is issued by companies owned by PE backers. One can expect spreads to widen and yields to double, even triple, from near historic lows now (ca. 5%).

  • Asset allocation: A fall in PE valuations would likely mirror a similar fall in valuations at publicly-traded companies; the two are correlated. A risk-off environment would lead to falling safe-haven bond yields and a jump in the price of gold.

Our positioning: As it says in every prospectus, investors should not be swayed by past returns. For PE, the next decade will be far more challenging than the previous one, and 2020 may well be the year the unravelling begins. In our flagship strategies, we have no direct exposure to PE, and remain vigilant to the valuations in publicly equity markets where we are invested. We continue to hold low-yielding safe-haven debt and gold precisely to protect against equity market downturns, which come unannounced. We do hold a modest allocation to high-yield debt but are cognisant of its risk profile and liquidity characteristics.