By Jim Strang and Tarang Katira
There are detractors aplenty for private equity. Some justified, some not. But how do the facts stack up? Let’s address the two rational factors of investment decision-making – returns and risk.
Firstly, returns. Long-term, private equity outperforms public markets significantly. Over the past 10 years (and despite an extended public bull market until 2014), the MSCI World Index returned 6.4% per annum compared to a solid 12.5% per year from private equity[1]. The difference is clearly substantial. Moreover, since 1986, private equity has outperformed public markets each year, without exception1.
How likely is it that private equity can replicate that magnitude of outperformance over the next 10 years? Detractors would argue that as the industry outperforms and attracts more capital, returns should come down. We are not so sure. Formal fundraising for each of 2012, 2013 and 2014 has been well below the 2006 level, let alone 2007 or 2008[2]. There is plenty of appetite for additional capital coming into the industry without diluting returns.
Another angle to look at is deal volumes. All years from 2008 to 2014 have had significantly lower deal volumes than pre-crisis. 2014, the most prolific post-crisis year by deal volume, registered $536bn of deal flow. This compares to around $771bn and $806bn in 2006 and 2007 respectively, indicating room for growth.
We often get asked whether the deal pricing environment today is worrying. For context: over the last four years, entry multiples for private equity deals have increased 14% in the US to 8.9×3. This is roughly around the 2007 peak, but over the same period, public market multiples have increased 34% to 12x! We would rather be in private markets[3].
So what are private equity managers most worried about? In a proprietary survey conducted by Hamilton Lane, the clear winner was: geopolitical events – a factor that impacts private and public markets alike. A clear number two, incidentally, was monetary tightening in the US – again, a factor whose impact is not limited to the private markets[4].
Is there a risk that the party stops as the Fed continues to raise rates? Data from 1999 and 2004 suggests that US buyouts outperform public markets[5], on average, by 15% in the year immediately following a rate hike[6]. Dynamic private equity allocation can potentially enhance these returns – investors who overweight distressed credit and mezzanine in periods of rate hikes tend to outperform those with pure play buyout exposure. Hamilton Lane helps clients set up and execute dynamic private equity portfolios.
Now the “risks”. To what extent are these returns driven by leverage? While transaction multiples have risen over the last 3 years, leverage multiples continue to be low around 3.7x and 3.8x EBITDA in the U.S. and Europe, respectively, compared to 4.7x and 5.9x in 2007[7]. Moreover, covenants today are significantly looser compared to pre-crisis, with “cov-lite” financing significantly reducing the chances of a private equity deal losing its shirt.
Liquidity risk? Sure it’s worth considering. Early on in a private equity programme, it’s not nearly as easy to trade in and out of positions as it is in the public markets. A secondary market exists, but it’s a fraction of the size of the public secondary market. What is less argued, however, is how strong the distributions are once a private equity programme is mature, with many of our client portfolios today being self-sustaining. For context, in 2014, private equity generated $537bn of distributions to its investors, accounting for 26% of outstanding NAV. In 2013, that same figure was 25%, while in 2012 it was 23%6. So liquidity does come to those who are patient.
Jim Strang is managing director and head of EMEA and Tarang Katira is vice president at Hamilton Lane
[1] Source: Hamilton Lane Find Investment Database (as of November 2015), MSCI World Net Total Return Index: The MSCI World Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets
[2] Source: Preqin (August 2015). Fundraising data includes real estate, secondary funds and funds-of-funds
[3] Source: Hamilton Lane Fund Investment Database, Bloomberg (September 2015)
[4] Source: Hamilton Lane GP Dashboard 2015
[5] See Public Market Equivalent Definition Below
[6] Source: Hamilton Lane Fund Investment Database (as of June 2015)
[7] Source: Hamilton Lane Fund Investment Database (August 2015)
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