3 hot sectors in private equity right now

How do higher for longer rates and sticky inflation impact your outlook for the private equity market?

Gabriel Ng: I think it's been a challenge because if you look back at the last seven to 10 years, a lot of the returns have been fuelled by attractive borrowing rates. And we don't expect that contributor of return to persist going forward, at least in a meaningful way. It's also been a challenge where the broadly syndicated loan markets have retreated, and we've seen that in a meaningful way throughout 2022 and some parts of 2023. 

That has given rise to the opportunity for private credit funds to step in to fill the void that the banks have left behind. So, we do see private credit funds providing the financing to enable some of these transactions to materialise and take place. And we do see the banks actually coming back, so we see a bit of a recovery in the broadly syndicated loan market. So, hopefully, that bodes well going forward, but as sponsors think about underwriting transactions, they need to look at other levers to drive returns besides financial leverage.

How is private equity underwriting their transactions right now?

That's a great segue into this question. I would broadly break down the contributors of returns into three different buckets. Number one, it's really revenue growth and profit increase. Number two, it would be multiple expansion. So, if a general partner or fund buys into a company, at a certain multiple, they would aim to reposition the business and sell it at a higher multiple. And the third contributor of return would really be debt or financial leverage. Our observation is the latter two are going to play a smaller part in driving the returns on a go-forward basis simply because of the higher rates environment, as well as the trickier exit market.

So, it's really back to basics. It's back to revenue and profit growth really driving the returns that private equity funds are underwriting to, and we see that from a very practical perspective. And just to give an example, in the last 10 co-investments or the last 10 direct deals that we've done, as we broke down that bridge or returns decomposition, the vast majority of the returns that GPs were underwriting came from revenue and profit growth. So, we're still underwriting to the same returns, but the breakdown has changed from where it was seven to 10 years ago when rates were low and macro was a bit more accommodative.

With all that in mind, which sectors are private equity firms turning towards?

I would say that there has been a pivot towards more resilient and defensive sectors. And the good news is that there are multiple of them and a large opportunity to go after. So, just to mention a few sectors that we like - we like the software space. These are software providers providing mission-critical products to companies, and these are typically on a subscription basis. There's very high visibility of revenue and cash flows and the asset-like business and very cash-generative. So, software and technology is a space that we like. 

The second area is healthcare. I think the COVID pandemic has really emphasised the importance of healthcare and wellness, and a lot of consumers out there are paying a lot more attention. And particularly in some markets where public healthcare systems have been stressed, there is a great reliance on the private healthcare system to step in to fill the gaps, and that's where we see private capital coming in to make some investments in that space. 

To mention another example, I think we like the consumer non-discretionary space. So, an all-weather type product that continues to sell, whether it's in a bull market or bear market. So, we like these defensive products that are highly resilient. So, some of these sectors are the typical ones that GPs have been investing in and where we are seeing deal flow in more recent months.

And on the other side of that, which sectors are not receiving a lot of capital right now?

I think some sectors that we tend to avoid, not to say that they're good or bad, but I think it's just how to underwrite those risks. So, we tend to shy away from energy, commodity, and oil and gas type sectors simply because there are many market elements that are beyond the control of the general partner to influence. So, we've typically shied away from that. We've also stayed away from CapEx intensive, as well as highly cyclical sectors like consumer discretionary when in softer macro environments, consumers tend to pull back on spending in those areas and those businesses tend to disproportionately suffer. So, these are just some sectors that we aren't avoiding completely, but just keeping a very high bar.

Technology and healthcare are typically the more expensive industries. What trends are you seeing in terms of valuation multiples in private equity?

Yes, I would say that the public market multiples have come down more meaningfully. Private market valuations have remained quite sticky, and I think it's for two reasons. Number one, sponsors or general partners are still paying up for premium assets. So, there has been a bit of a flight to quality. So, I think they're more willing to pay for a market-leading scale and dominant market leader. One of the tools that you have in the toolkit is to pay a full multiple but blend down the entry price by doing these target accretive acquisitions during the investment holding period.

And I would say a more nuanced reason behind some of these valuations holding up strong in the private market space has got to do with the bid-ask spread. Taking 2023 as an example, there have been a lot of sellers who still expect buyers to pay multiples that were reflective of 2021 time periods, and as a result, they choose not to transact. So, those transactions did not happen, but we do believe that as the bid spread narrows, as sellers come back to the table, hopefully, we see some further normalisation. But in this current market environment, I would say that market-leading premium assets still command a full valuation.

What would a catalyst be for sellers to come back to the table?

I would see it from two different angles. I think if we look at the private equity seller, so a private equity fund that has a portfolio of companies, they're managing these vehicles that have a finite fund life. So, if a vehicle comes to the end of its fund life, I think that's a good catalyst for a sponsor to come to the table as a seller and divest those assets, so that is one key catalyst. 

The second angle that I see this from is from a company's perspective. I guess as we navigate a high inflation, more uncertain macro environment, some of these corporates might have to divest non-core assets or non-core subsidiaries, and that's when they would come back to the table. Those divestments need to be made and they need to free up cash to find other parts of the business. So, I would see these as two broad catalysts for sellers to come back to the table and hopefully, there could be a meeting of minds on valuation.

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