The asset class with plenty in the toolkit to navigate volatility

No investor has been immune to higher rates, high inflation and a slow macro environment. That said, some investors have a greater ability to navigate such periods than others. 

Gabriel Ng, managing director of Neuberger Berman Private Equity, believes those operating in the private equity landscape are especially well placed. 

"One thing I would say is that there are many tools in the toolkit that private equity general partners (GPs) have at their disposal to manage through that", says Ng.

Ng goes on to explain that the ability to seek new avenues of growth through expanding into new markets, rightsizing the cost structure, or even leveraging technology and automation to improve efficiencies and productivity are all levers that can be pulled. 

More importantly, Ng believes that the returns on offer in private equity remain compelling and achievable. 

"The bottom line is we're still seeking the same returns, but the path to getting there looks a bit different today versus where we were in a low rates environment seven to 10 years ago", says Ng

In the following episode of The Pitch, Ng shares how Neuberger is navigating the new regime, where they are finding opportunity right now, and the types of deals they are pursuing. 

Note: This episode was recorded on Thursday 12 September 2024.

EDITED TRANSCRIPT

Starting first with direct co-investments. So this is essentially an investment into a direct portfolio company alongside an elite private equity GP. And there are several reasons why the elite private equity GP would need co-investment capital from their LPs. Number one, it's really that the deal size is just too large for the fund to absorb or to undertake on its own. So it needs co-investors to come in to make up the difference in the equity check. And then the second reason as to why co-investments are required is really to fund certain strategic initiatives within the portfolio company. It could be to support and fund a strategic or accretive bolt-on, M&A, or to fund the company's expansion into a new market or new growth initiatives. 

Looking at secondaries, I would further dissect that into two categories. Number one, you have LP secondaries. Essentially this is the secondary investor providing liquidity to existing LPs in a fund who, for whatever reason, cannot wait until the end of the fund life to generate their liquidity. So they need to sell their LP interest typically midway through the fund life cycle. Secondary investors provide that liquidity option and basically buy into the fund at that point in time. So that's one variant of a secondary deal. 

The second would be what I call a GP-led secondary. As the name suggests, it's initiated by the GP essentially to move one or more of its existing assets from an existing fund to a new continuation vehicle that is, once again, capitalised by a new secondary investor, and hence provides liquidity to the investors in the existing fund. So those would be the main differences between those two underlying strategies.

Where is Neuberger Berman active in private equity markets?

That's a great question. We are active across the PE ecosystem. I think we want to continue to be value-added partners to our private equity GP relationships across the world, be it in primaries, co-investments, or secondaries, and still be able to generate good risk-adjusted returns. 

So, on the primary side, we continue to invest in funds that are being raised by cycle-tested, stable GPs that have a proven track record, and we do that across the globe in the co-investment space. That's where we're spending a lot of time - we're helping our GPs step up to transactions that would otherwise be too large for their funds to undertake. And more importantly, in a time when liquidity is limited, to come in with strategic capital solutions to help them perform accretive M&A transactions, or to fund certain growth initiatives. 

Last but not least, on the secondary side, we are a provider of liquidity - whether it is to LPs who wish to cash out on the LP positions or to lead some of these GP-led continuation funds, which we are seeing a lot of deal flow in.

Essentially we are active across the board. 

I would say that from a geographical perspective, our deepest markets are in North America, followed by Europe and Asia Pacific. It's not too different if you look at the respective depths of the PE markets in these regions. 

From a sectoral perspective, we're sector agnostic, but we're leaning into more resilient defensive sectors - for example, education, healthcare, software, business services - companies that have a very defensible clear moat and market positioning. So these are some of the opportunities that we're chasing at this point in time.

Is the defensive positioning a function of analysing each deal individually as it comes across your desk, or is it based on the way that you view the world right now?

We look at it from both a bottom up and a top-down approach. 

So from a top-down perspective, we'll need to like the secular tailwinds that the industry brings. We're certainly not going to be investing into CapEx heavy industries or industries that might be disproportionately impacted by a down cycle. 

From a bottom-up perspective, every investment has to stand on its own two feet. 

We have a large investment team around the globe that is very proficient in performing ground-up due diligence. This includes anything from the sector, the company, or the financial analysis. So I would say that it is both ways - top-down and bottom-up.

There's been a lot of talk about valuations - where are they now and how does that compare to historically?

Our observation is that the private market valuations have been relatively sticky. They haven't corrected as drastically as we might have seen in some sectors within public markets. The impact is different. 

As you look across different sectors, obviously early-stage, loss-making tech companies have corrected a lot more, whereas some of these other defensive businesses and resilient sectors haven't exactly corrected that much. The stickiness can be boiled down to two reasons. 

Number one, it's really that bid-ask spread. Sellers are still having the price expectations of 2020 and 2021, whereas buyers are a lot more cognizant of the current market environment and might not be able to match those pricing expectations. As a result, the sellers don't transact. You don't capture those lower multiples in the data, and that has, in part, led to a reduction in private equity volume over the last two years. 

The second reason - it's really for the deals that are getting done - I think there's been a bias towards quality. So I would say that private equity sponsors are not shying away from paying full valuations for very high-quality defensive businesses. So those valuation multiples are still stacking up if you look at high-quality assets.

Just how sensitive is private equity to changing macro conditions?

I would say that we're certainly not immune to higher rates, high inflation and a slow macro environment. But the one thing I would say is that there are many tools in the toolkit that private equity GPs have at their disposal to manage through that. 

For example, the ability to seek new avenues of growth through expanding into new markets, rightsizing the cost structure, or even leveraging technology and automation to improve efficiencies and productivity. So there are levers to be pulled. But the one thing I'll say is that in spite of the macro environment, we as a firm are still underwriting the standard private equity returns that we seek in every single transaction that we do. It's just the levers and how you get there.

If you look at the returns composition for the deals that we're underwriting in today's market, a lot of that value creation comes from fundamental revenue growth and EBITDA margin expansion or profit expansion.

And to a certain degree as well, the ability to execute creative bolt-ons and M&A deals. I see much less reliance on the impact of financial leverage or financial engineering, just given where rates are. And there's also less dependence on multiple expansion. In fact, we are actually incorporating multiple contraction in our own underwriting for some of these deals that we analyse. 

The bottom line is we're still seeking the same returns, but the path to getting there looks a bit different today versus where we were in a low rates environment seven to 10 years ago.

Can you give us an idea of the type of deals that Neuberger likes to pursue that highlight the opportunity in private equity?

Absolutely. Maybe I'll start first with co-investments. On the co-investment side, we're looking at a lot of co-underwritten transactions. So, this is a situation where the deal size is just simply too large for the sponsor to undertake at the point of the final bid. So, someone like us will come in for a sizable amount of the equity, and we join the due diligence process from the very start. 

We've had a lot of time to really build conviction on the opportunity and to work alongside the GP through the due diligence process. 

And at the end of the day, if we do prevail in these transactions alongside our GPs, it's a much larger equity ticket that we can write to a high-conviction opportunity. So we see an interesting and robust set of deal flow on the cowriting side of things. And there are several other players who have also retreated just because they might have been over-indexed on the private markets allocation, so they've stepped away. So I think we've been able to get a pretty good market share of the co-investment deal flow. 

The second deal type in the co-investment space is what I call a midlife. So, this is us investing into a portfolio company that a GP has owned for a certain number of years, and just given where liquidity situations are and capital constraints, they might not always be able to easily raise the capital for bolt-on M&A. That's where we come into the picture. We provide the capital for that portfolio company to execute an accretive acquisition, and we take a minority stake in the combined entity. So we are trying to create situations where we provide the capital solution, help the GPs, and get a good M&A deal done for one of the portfolio companies. So these are some of the deal archetypes that we're focusing on in the co-investment space.

On the secondary side, we continue to be very active on the LP secondaries. Investors, for various reasons, need liquidity. So we think that it's an interesting time to be buying into these LP positions. 

Importantly, for some of these GP-led continuation funds, with the IPO markets being shut, there's a more compelling need for GPs to seek ways to optimise the eventual exit outcomes. We're there providing capital for them to move high-performing, high-quality assets from one fund to a new continuation vehicle to give it a bit more runway. So, I hope that gives you a good sense of some of the types of deals that are keeping us busy.

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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Neuberger Berman Global Private Equity Access Fund (AUD)

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