3 tangible opportunities in this US$1.5 trillion asset class
Data sourced from Investopedia proves that looking beyond public equity markets can pay off handsomely. The Cambridge Associates US Private Equity Index returned an average of 10.48% between 2000 and 2020, roughly double that of the S&P 500 over that same time frame. Looking beyond the US pays even more, with the Developed Markets ex-US equivalent index returning 13.8% over the last 25 years.
And while past performance is not always an indicator of future performance, the tailwinds behind private equity are indisputable.
One person who knows the growth and the opportunity set very well is Gabriel Ng, Managing Director at Neuberger Berman. Ng has covered private equity since 2010 and says the thirst for higher returns for less volatility has fuelled its growth.
"The growth of the private equity market comes down to investors seeking higher returns, so you have more capital that's coming into the asset class. The second key reason is also to do with the number of private companies there are in the market. An increasing number of companies are choosing to remain private so that has led to a larger investable universe," Ng told me.
That investable universe is now worth US$1.5 trillion, according to Ng. But where are the opportunities within this huge space? Find out in this episode of The Pitch.
Note: This episode was taped on Thursday 12 September 2024.
EDITED TRANSCRIPT
Why should investors consider private equity as an alternative to traditional equities?
Ng: Well, that's the golden question, right?
I would say that I'll break it down to the two main reasons. Number one, it's really driven by the higher returns that the asset class has managed to deliver over time. And we're not just looking at one, two, or five-year data. This is data going back 5, 10, 15, 20 years. So over the longer term horizons, private equity has delivered outperformance versus public markets, and that is a very practical reason why investors want the asset class in a portfolio.
The second reason, it really comes down to volatility. The private equity asset class is generally less volatile if you compare that to the public markets, and this is because the valuations are performed on more of an intrinsic basis every quarter. So with private equity, you see fewer swings in a portfolio as you compare that to the public market investments.
That being said, private equity does come with a high level of risk. Investors might access it to a different degree within the portfolio. So whether it's 5, 10, 15 or 20% allocation, that really depends on the underlying investors' appetite for liquidity and risk.
But we do believe that it has a role to play in investors' portfolio construction, and that's becoming more evident as we see it. Right. I think we see a lot more interest in the alternatives and the private markets asset class, and that's something that we're encouraged by.
What are some of the trends behind that growth?
Ng: The growth of the private equity market comes down to investors seeking higher returns, so you have more capital that's coming into the asset class. The second key reason is also to do with the number of private companies there are in the market. We do see, directionally, an increasing number of companies choosing to remain private. So that has led to a larger investible universe, and there are several reasons why companies choose to remain private.
I think number one, you just don't have that monthly or quarterly EPS or share price pressures that you need to manage. You're able to take on longer-term strategic growth initiatives without the scrutiny of the public investor base. So that allows you to create more value over the long term. So with more companies choosing to remain private, I think that has given more opportunities for the private equity asset class to invest into.
Last but not least, I would say that I think companies and founders are also more receptive to taking on capital from private equity investors because they can see the value add that these private equity GPs [general partners] can bring to the table in helping their companies scale to a different level or to grow and to ultimately increase in valuation.
Instead of tapping the public markets for capital funding, they're now more open to taking private capital to find the next of growth for these companies.
How big is the market and where is Neuberger Berman finding the most compelling opportunities?
Ng: If we look at it from a transaction value or transaction volumes perspective in 2023, it's about a US$1.5 trillion market, and that is already 30% down from the highs of 2021. But we do believe that it's more in line with the longer-term average transaction volume. So it's still a very large market.
Where are we seeing opportunities? I think we are a diversified private equity investor. We have multiple strategies that we operate. So, on the primary investing side, where we see some opportunities now are in what we call funded primaries because the fundraising cycle is just taking a lot longer for GPs to raise their funds. Oftentimes, we're able to come into a portfolio that's partially funded. When we're committing to a fund, it might already have two to three underlying investments that account for 15-20% of the portfolio constructed so there's a bit more visibility. That's what we call a funded primary. So we're seeing some opportunities in that space.
On the co-investment side, just given the liquidity constraints and banks pulling back from lending, there's been a lot more need for co-investment capital. We see multiple opportunities on other forms of transactions within co-investments and also these mid-life transactions, which require a more bespoke solution or capital solution that we were able to provide to our GPs to help the companies take on creative M&A deals or to fund expansion opportunities into a new market.
In the secondary space, there's been a lot of talk about GP-led continuation funds just because the exit markets have been tough, but sponsors see the ability to continue to grow very high-performing companies for another four to five years and to continue to compound on that growth. So we're providers of liquidity to move some of these high-performing assets from one fund to a new continuation fund. And that has seen a lot of interesting opportunities come up on our radar screen in the last six to 12 months. So it's keeping us busy.
Do investors need to take on extra risk to add private equity to their portfolio?
Ng: Yes, and I think they're compensated with the higher level of returns that the asset class has generated. But if you look at risk, I think number one, there's leverage. Ultimately some of these deals or most of these deals have some form of leverage. So that's one area of risk that investors need to factor into. The second is illiquidity. Every individual investment is held anywhere from five to seven years, but that's where the value creation comes in. You need that amount of time to grow the earnings to reposition a company, but once again, that's additional illiquidity that investors have to live with. And last but not least, it's execution risk. I think a lot of the time, private equity sponsors are trying to drive a step change in a business. They might not always get it right, but most of the time they do. But there's a level of execution risk when you embark on such initiatives. But at the end of the day, I think the returns will have to stack up for that additional risk that investors are taking on for this asset class.
How has access to private equity changed over the years?
Ng: This is a big topic, and I think it's been talked about a lot, this whole democratisation of private equity. If we look back, it's been an asset class that has only been accessible to very large institutional investors, but we're encouraged that there are solutions out there that provide exposure to this asset class to other investors. And they typically come in the form of semi-liquid fund structures where the underlying strategy is private equity.
I think the goal here is to solve a lot of the pain points that other investors might face, namely smaller ticket sizes to access. We're solving for that with single capital calls, monthly subscriptions and redemptions. So I think overall it does lead to greater access to the private equity asset class. But there are also different forms and different underlying versions of these evergreen structures.
I think some of them might be single GP-type, semi-liquid offerings. Some of them might be a bit more diversified across different GPs. Some of them might do a bit more primaries, and secondaries, some are more weighted towards clone vests and secondaries. For the investors out there, education is very important. I think you need to know what you're stepping into and to be comfortable that it's the right risk profile that you are willing to undertake.
For operators of these semi-liquid funds, I think having the right infrastructure to manage a large investor base to be able to manage the liquidity, I think all that is very important in addition to, of course, the core business of generating returns. So yeah, I think it is a good development and I think it's only going to continue to grow going forward.
Unique characteristics mean unique opportunity
At a time when investors are cautious about the return outlook for traditional public markets, private equity offers important long-term advantages, including strong historical returns and diversification benefits. Find out more.
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