Private equity redux
As we approach the end of the year, economic projections abound for 2023. As they are very rarely validated, economic authors make directional forecasts with very little scrutiny. We will attempt the same by amalgamating data and the opinion of professionals. We make the case that private equity has been less relevant in recent months as capital market trades yield better risk adjusted returns than private equity, but make the case for their resurgence - albeit in a different guise - next year. But first, the outlook.
Goldman are seeing some festive glimmers of hope. Despite the high likelihood of a European wide recession due to rising energy prices and a sizeable slowing in energy intensive industries, they point to resilience in GDP, significant government support and a reduced risk of gas rationing. They now forecast that the economy in Euro area will contract by only 0.7% from 2022Q4 to 2023Q2 (vs 1.1% before). The rise in interest rates, after decades of precipitous declines, signals payback time for investors according to Nick Moakes, chief investment officer at the Wellcome Trust, “We’ve borrowed future returns, we’re going to pay them back now. Whereas in the last decade we delivered real returns of 11 to 12 per cent a year after inflation, delivering 1 per cent real returns a year after inflation over the next decade would not be an implausible outcome”.
The returns private equity generates, particularly in an environment of unprecedent low interest rates, were compelling. CalPERS for one, regrets putting its private equity (PE) programme on hold after the GFC after a deep dive into disappointing investment performance. “Taking a sharper look at the scheme’s private equity programme, the period between 2009 and 2018 was a period of time when we really stopped committing. The impact of us not deploying capital during that period of time is estimated anywhere to $11bn to $18bn.” CalPERS is now reflecting on its decision to favour global over domestic growth and building a portfolio to limit downside.
A study by Stephen L. Nesbitt, Chief Investment Officer of Cliffwater, using data provided in Annual Comprehensive Financial Reports, found that PE had produced stronger returns this century for 53 state pensions than public equity. From Q3 2000 to Q2 2021, PE performance in state pensions produced a 4.1% annualised excess return over a benchmark constructed from a weighted average of the Russell 3000 Index (70%) and the MSCI ACWI ex US Index (30%). The study also found no evidence of a reduction in excess returns over time and expected the out-performance to continue in future. Most state systems have a private equity objective to outperform public equity by around 3%, net of all fees to compensate for illiquidity and complexity associated with PE.
Plenty of capital has been deployed to PE however, prompting fears from Mikkel Svenstrup, chief investment officer at ATP, Denmark’s largest pension fund, that PE could potentially turn into a pyramid scheme, warning buyout groups are increasingly selling companies to themselves and to peers on a scale that “is not good business.” He noted that last year more than 80% of the sales of portfolio companies by the private equity funds that ATP has invested in were either to another buyout group or were “continuation fund” deals, where a PE group passes it between two different funds that it controls. Svenstrup also warned that potentially PE was going into an era of “low returns and high costs” and warned of tricks by PE in manipulating their IRRs through bridge financing and leveraged funds.
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Falling markets have resulted in many investors becoming overexposed to traditional PE strategies, Chief financial officer Curtis Buser of the Carlyle Group told the Financial Times. Carlyle raised just $1.9bn for its newest flagship buyout fund, compared with $3.2bn in the previous quarter. In 2021, PE firms closed on €87.9bn over 161 funds, in H1 2022, 40 vehicles have so far closed on only €27.9bn. Faced with limited scope for growth, PE firms have targeted private individuals. “All the big players are working on strategies to hit the retail market,” says Steffen Pauls, founder and chief executive of Berlin-based private equity platform Moonfare, set up to offer wider access to the sector. “In five or 10 years, PE will be for most people as common and as accessible as public markets.” “The big problem … is that retail money is seen as being easily led and not so canny,” says Claire Madden, managing partner at London-based alternative investment firm Connection Capital. “As an asset class, it should be opened out a lot more. But it should be to the appropriate sort of investor.” Tellingly, Blackstone knows how fickle retail investors can be, limiting withdrawals from its $125bn real estate investment fund following a surge in redemption requests. The withdrawal limit underscores the risks wealthy individuals have taken by investing in Blackstone’s mammoth private real estate fund, which owns $69bn in net assets.
Whilst many private equity funds have the ability to invest in public equities, which are preponderantly short-termism, their business model do pivot on private markets. In a general memo to clients, Oaktree identify three ingredients for success during good times, “aggressiveness, timing and skill”: if you have enough aggression at the right time, you don’t need that much skill. Superior PE returns may simply be down to having the most risk, beta and correlation. This view could certainly be applied to real estate in recent times according to Tom Leahy at MSCI with, good, income-producing property bought using almost free debt and then sold at a higher price to pension funds hungry for real estate because it yielded more than bonds. The next cycle looks to be very different: “low economic growth and high interest rates is not a great recipe for real estate investment.” Similar sentiments can be expressed for PE, it’s going to take a new strategy for private equity firms to profit from the dislocation set to affect the market, experts told Bisnow.
Credit Suisse also expect the environment for real estate to become more challenging in 2023 due to higher interest rates and weaker economic growth. They favour listed over direct real estate and still prefer sectors with strong secular demand drivers. Property Market Analysis expect prime-property yields to rise by an average of 100 bp and property values are expected to fall between 15% and 20% across all sectors by the end of 2023. Investment opportunities are not expected until 2024.
The view from DWS is that central banks will keep interest rates higher for longer than markets currently expect, reducing the yield advantage real estate investments have had over ten-year government bonds; “real estate valuations have come under pressure," said Jessica Hardman, Head of European Real Estate Portfolio Management. They still find promise in residential due to high demand from European residents for very limited supply.
M&G’s also favour alternatives such as residential and student housing in their end-of-year Global Real Estate Outlook report, offering relative resilience, underpinned by chronic supply/demand imbalances in many markets. In Europe, property yields are thought to need to expand by less to restore a healthy spread over bonds.
The 18th century English nobleman Baron Rothschild, said "Buy when there's blood in the streets, even if the blood is your own." Whilst existing portfolios have undoubtfully taken a hit, there are cyclical headwinds that will make some private real estate investments prosperous over the long term. Aggression, timing and skill may have seen real estate investors through the decade long era of ultra-low interest rates, but asset allocation and stock selection skills are going to differentiate performance in the coming era of less and more expensive debt.?