Private Equity Performance Shows Its Stickiness
Two practitioners discuss private equity’s ongoing appeal with investors.
22 November 2019
As Private Equity Wire noted recently, The Carlyle Group hopes to have raised around USD 110 billion by year-end, as large private equity (PE) groups continue to evolve their product offering to cater to an ever wider and deeper pool of institutional investors. Having raised USD 5.7 billion in Q3 alone this year and USD 23.2 billion over the last 12 months, Carlyle’s firmwide AUM has ballooned to USD 221.8 billion.
Mega-funds continue to dominate new launch activity. As investors scramble to allocate to PE, part of the reason for explaining the asset class’s ongoing appeal is that it continues to deliver on long-term performance.
As the SS&C Intralinks 2020 LP Survey, produced in partnership with Private Equity, revealed, while 50 percent of LPs felt that their overall alternative allocations were in line with return objectives, private equity emerged as the clear winner, cited by 45 percent of LPs.
“I think the private equity portfolio has delivered on plan, even if we see slightly fewer deals, slightly fewer distributions,” says Jean-Francois Le Ruyet, partner at Quilvest Private Equity, which has been investing in the asset class since 1972 and manages approximately USD 5 billion in AUM. “Overall, we have not been disappointed at all with the performance of the portfolio in 2019.”
Not that private equity is ubiquitous in its ability to generate solid performance. A recent McKinsey & Company study showed that there is a wide dispersion of returns from first quartile to fourth quartile U.S. private equity funds, suggesting that LPs still have to do their homework before allocating to GPs.
In Le Ruyet’s view, this task is easier within PE than it is within hedge funds because, conceptually, it is an easier asset class to understand. Some hedge funds are very complex, black box-type investment strategies, whereas PE strategies are simple: you buy companies, you sell them.
“In the aftermath of the ’08 financial crash, some hedge fund strategies that were labeled as ‘all weather’ strategies were nothing of the sort; it rained and their performance was poor,” comments Le Ruyet. He thinks this is still negatively impacting the view of investors on the asset class.
"What we see in this environment are three things: a focus on increase in diversification for those who have earlier portfolios; a keen eye on more niche strategies where there is perceived better relative value for those investors with a more mature allocation to the segment; and by all investors, an increasingly more stringent focus on manager/company-level due diligence." – Sweta Chattopadhya, director, private equity at bfinance
“On the contrary, private equity has shown its stickiness and ability to turn things around over time because managers do not have to sell and over time can recover notional losses, which one does not see with hedge funds,” he adds.
This is an interesting observation which mirrors a clear year-on-year fall in sentiment among the LPs surveyed by SS&C Intralinks. It found that whereas, in 2018, 26 percent of investors cited hedge funds as the asset class they were most happy with, this year that figure fell to 12 percent.
Sweta Chattopadhyay is director in the private markets team at global investment consultancy, bfinance, where she heads up private equity advisory.
She is not surprised that LPs singled out private equity as the best performing asset class for risk-adjusted returns. “Private equity tends to be highest on the risk/return spectrum amongst other private market asset classes, generally speaking. In arguably top cycle macro environments where there is a somewhat ‘risk-off’ attitude amongst investors, the sentiment is not surprising.
“What we see in this environment are three things: a focus on increase in diversification for those who have earlier portfolios; a keen eye on more niche strategies where there is perceived better relative value for those investors with a more mature allocation to the segment; and by all investors, an increasingly more stringent focus on manager/company-level due diligence.”
At Quilvest, the focus is on growth and buyout funds in the middle and lower middle markets. By using a large global team, it scouts the marketplace to seek out GPs that it feels are well placed to deliver strong performance. This is no easy task, of course, especially because the volatility of PE fund performance in the lower mid-market tends to be more pronounced than in the large-cap fund space.
“We spend time doing deep due diligence on managers, which allows us to find very good risk-adjusted returns. Although I was slightly surprised by the survey results for infrastructure and real estate, over the last 11 or 12 years I would say investors have realized that PE can really perform,” says Le Ruyet.
One of the key questions that investors now face in respect to PE is how they assess future returns over the coming decade, given that we are now in such a highly valued marketplace. Ultimately, can they expect to still enjoy attractive risk-adjusted returns? Or are we coming to an inflection point where new fund vintages (2018, 2019) could, if not adroitly managed by GPs, hit the skids?
In the U.S. mid-market, the perception is that there remains a huge wealth of private companies to tap into that are still attractively priced. In Le Ruyet’s view, founders of family-owned companies are finding more comfort selling to the right type of private equity group.
Le Ruyet says, “There is enough statistical evidence that often families are well served by selling to PE groups and partnering with them. That said, future performance won’t happen using old style playbooks (e.g., financial engineering). It’s going to come from GPs rolling up their sleeves and working hard to improve the fortunes of assets. It is becoming more complicated as managers seek to institutionalize companies, do bolt-on acquisitions, and help them become transnational. Not to mention, help them operate in a digital economy.”
"You can’t be a ‘Jack of all trades, master of none,’ especially in the U.S., where the middle market is so competitive. In Europe we are more cautious about country-specific generalists than in the past, and we are increasingly reviewing opportunities around sector specialists, at the regional or pan-European level." – Jean-François Le Ruyet, partner at Quilvest Private Equity
Asked if he feels if there is still spare capacity for private equity to continue to deliver outperformance over the coming years, Le Ruyet succinctly responds: “Cautiously, yes.”
He says that in terms of sector preferences, technology and healthcare are two verticals that the portfolio allocates to “but they are slightly expensive,” confirming that consumer goods – which was cited as a preferred sector by less than 10 percent of survey respondents – “is currently a sector we are slightly overweight on.”
Le Ruyet confirms, “We see significant outperformance in our best healthcare and technology funds.”
Recurring revenues, low operational leverage and their non-cyclical nature make these sectors more recession resistant, according to Chattopadhyay, “so they are popular with LPs at the moment. It is worth bearing in mind, however, that PE is invested 10-plus years at least, so there may be merits to not focusing on any one particular sector across an economic cycle.”
As LPs evolve their PE allocations, they are also looking to access specialist managers rather than generalists.
“You can’t be a ‘Jack of all trades, master of none,’ especially in the U.S., where the middle market is so competitive. In Europe we are more cautious about country-specific generalists than in the past, and we are increasingly reviewing opportunities around sector specialists, at the regional or pan-European level,” concludes Le Ruyet.
Investors remain buoyed by the performance on offer in private equity; but if market economics waver in the coming years, it’ll be interesting to see how good their GP selection skills prove to be. And if their faith endures.