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QD view – Discounted opportunity – Not all private equity is exuberant growth plays

If investors listened to the headlines, they would be understandably nervous about the prospects for private equity. Vincent Mortier, chief investment officer of Amundi, the largest asset manager in Europe, described parts of the industry as a “Ponzi scheme”[1], while former Pimco chief Mohamed El-Erian also raised concerns about the sector, notably its claims to be immune to volatility in public markets[2]. They suggest a ‘smell the coffee’ moment for the sector.

This has hurt private equity investment trusts. Half of the sector sits at a discount to net asset value of 30% or more and half has yields of over 3%. This includes some well-established and popular names, such as HarbourVest, Pantheon International and abrdn Private Equity Opportunities. For most of the trusts, it is their widest discount in over a decade.

A perception problem

Alan Gauld, lead manager on the abrdn Private Equity Opportunities trust, suggests private equity trusts may be suffering from a perception problem. Private equity has been subject to the same value-growth phenomenon as public markets. The low cost of capital has sent investors hunting for high growth private companies in areas such as ecommerce, software or digitalisation.

Valuations have also been inflated by vast venture capital groups such as SoftBank and Tiger Global. With $100bn at its disposal, Softbank has created bidding pressure on deals. Finally, says Gauld, the government’s response to Covid brought new rounds of quantitative easing, creating additional capital that needed to find a home.

This unquestionably inflated values for certain parts of the market. A recent private equity report showed growth and venture assets under management have expanded at about 2x the rate of traditional buyout assets under management over the past 10 years[3]. Gauld says: “This phenomenon has sent valuations significantly higher for these cash burn, unprofitable but high growth businesses that are disruptors and innovators.”

These are the valuations that have been extremely hard hit as higher rates, rising inflation and a weakening economy have prompted a drastic reappraisal. Buy-now-pay-later group Klarna is a good example of this change of heart. The group’s latest funding round suggests a valuation of around a third of its peak[4]. Gauld says: “This is a good company and a real disruptor, but the consumer is being squeezed and the environment has fundamentally changed.”

Most private equity investments trusts has not been subject to exuberance

However, most investment trusts are not in these areas. There is a whole other world of private equity that hasn’t been subject to this exuberance. In the buyout market, for example, valuations are holding up well with companies still exhibiting strong revenue growth and profitability. These areas are not as vulnerable to rising rates and sliding valuations. In most cases, the NAVs have been stable – HarbourVest, for example, has seen its NAV rise 10% over the past six months, Pantheon is up 6.2% (source: Trustnet, to 20 June 2022).

Valuations look conservative

Should investors expect NAVs to drop? If anything, says Gauld, valuations look conservative. Transaction comparisons, which form part of the valuation for private equity businesses, tend to be more stable and are usually at a discount to public market comparables. He points out that private equity businesses are almost always sold at an uplift to carrying value: “There’s a perception that private equity is just levered listed equity. It’s not. The valuation is typically longer term-based and more conservative.”

That is not to say that there aren’t difficulties looming for this part of the market too. The IPO and M&A markets may be less buoyant as inflation, higher interest rates and weakening economic growth bite. These are smaller companies and not immune to the mounting economic problems. This may start to be reflected in earnings over the next few months.

However, while Gauld expects the remainder of the year to be tough, he says the discounts to NAV look overdone. “There is an expectation that NAVs could fall 20-30%. However, that has only happened in the Global Financial Crisis when all banks were shut and these businesses couldn’t get funding. This seems quite extreme.”

Private equity has learned lessons from the GFC

He says that private equity learned a lot of lessons from the financial crisis about the kind of businesses it should be targeting: “Private equity has been focused on buying A-plus assets in structurally growing markets. Private equity used to love the restaurant roll-out, for example, but it doesn’t do that anymore. Its focus is on areas such as mission critical software, healthcare, business services or fintech.” He also sees greater specialism across the sector, leaving investors with a ‘trade buyer’ level of knowledge.

The other mistake for private equity funds during the financial crisis was to overcommit themselves, promising ongoing funding to limited partnership funds, which tend to operate on 10-year cycles. They were hit hard when they could not meet those commitments and this saw discounts widen out and NAVs slide. Private equity managers are unlikely to repeat this error.

In the longer-term – and private equity should always be considered as a longer-term investment – this may prove a fertile time for private equity, as the dislocation in public markets throws up opportunities for them to buy companies at lower valuations. In the meantime, there may be tougher times ahead, but valuations more than reflect any potential weakness.

[1] https://www.ft.com/content/4e0f1691-368d-4d02-a373-69fdf661b0b7

[2] https://www.ft.com/content/109a8d88-2c56-4cc0-bd90-1d3a9dff2966

[3] https://www.bain.com/insights/topics/global-private-equity-report/

[4] https://www.cityam.com/klarna-looks-to-raise-cash-at-slashed-valuation-of-15bn/

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