When I participated in the latest meeting of Neuberger Berman’s Asset Allocation Committee (AAC), there was a great deal of discussion about low volatility and high valuations across markets. When it came to aggregating the Committee’s 12-month return outlooks for various asset classes, we bunched around “neutral,” unwilling to endorse strong directional views until a return to volatility created clearer opportunities.
Nonetheless, we did favour some alternative investments. Low-volatility hedged strategies fit the overall view comfortably: When market direction isn’t clear, eking out returns from market-neutral or relative-value strategies is often a good approach. But we also upgraded our view on private equity, and that was a much less obvious call.
After all, none of us was arguing that private equity valuations are cheap.
Multiples and leverage, absolute and relative
The multiples being paid for private companies and the leverage being applied are both undeniably high. To make sense of our favourable view of the asset class, bear two things in mind. First, these metrics are always relative. And second, private equity has unique qualities that complicate the question of whether a high purchase price is too high.
It makes sense to look at private equity leverage relative to history. According to data from S&P Capital IQ, for the past four years, the average debt — to — Ebitda multiple for large leveraged buyout deals has held steady at around 5.8x. Although high, the multiple remains lower than the 6.2x level hit back in 2007. More importantly, the capital structures of private companies are, on average, sounder than 10 years ago. Interest rates are very low; interest rate coverage is also robust at 2.4x versus the 1.6x it fell to in 2007 for large corporate LBOs; debt generally has more flexibility because of few or no covenants; and the average equity contribution to deals is at 40 per cent through the first half of the year.
When it comes to valuations, they need to be considered relative to the public equity markets. The valuation for the Russell 2000 Index in the first half of this year was 13.6x, while the average private company was purchased at 10.3x. Staying out of private equity because of valuations while still holding listed equities is difficult to justify.
Some unique qualities of private equity
What about those unique qualities of private equity? How do they support our case?
There is the illiquidity premium, of course — but it’s about more than that.
There is generally one driving thesis for buying one exchange-listed public stock rather than another: That stock is mispriced and available for less than it is really worth. Pricing is important in the private markets, too, but it is much less important for the simple reason that a private owner will tend to hold a controlling interest in its companies.
That control brings the opportunity for operational or financial improvements, or changes to strategy that can potentially increase a company’s value. What’s more, those improvements may be related to specific industry knowledge or skills that the private equity owner’s team has, which are not widely shared. That influence is much more difficult to effect in the public markets. It results in much greater potential divergence of opinion on what the “right” price is for a private asset.
That diversity of opinion — and business potential — is compounded by the fact that, in the US, for example, the number of public companies has decreased over time, while the opportunity set for investments in private companies has increased. Today, the public markets spurn companies with volatile earnings, even when that volatility is a symptom of activity that can ultimately benefit the company, such as rapid growth, investments in new markets and products, acquisitions or strategic reorientation. But these are precisely the opportunities that long-term private equity investors seek out — and create.
Impact of timing in PE investments
An investor in the S&P 500 Index at its pre-crisis peak, in October 2007, took almost six years to get back in the black. If they’d invested in a median-performing private equity fund in 2007, they’d have enjoyed an 8.5 per cent net return, according to the Cambridge Associates Global Private Equity Index. That wasn’t the best you could hope for from private equity, but it was pretty good on a relative basis — and it was good partly because the capital committed in 2007 was actually invested as market prices declined from the peak, and partly because of all the added value that private owners created in their portfolio companies.
And that, in summary, is why the AAC recently upgraded its 12-month view on private equity relative to many other asset classes. There are points in the cycle when listed equities can appear more attractive than private equity, but the point at which prices appear high is not one of them — and that’s because private equity brings a set of tools to an investment that make the market purchase price much less of a determinant of the ultimate outcome.
— Anthony D. Tutrone, Global Head of Alternatives, Neuberger Berman
