The counter-cyclical asset that pays in a downturn

How do high inflation and rising interest rates impact markets? For many, the answer would be some combination of greater risk and lower returns from traditional asset classes.

In one market, however, these conditions represent a great opportunity for returns, without taking on undue risk, according to Credit Suisse Private Banking Australia CIO and Managing Director, Andrew McAuley.

"That may sound like bad news, but it's actually good news for private equity because it opens up more opportunities. There will be companies requiring cash flow. There will be startups that have lower valuations. And so that opens up opportunities," said McAuley

In this Expert Insights interview, he explains how to identify opportunities available in private equity at the moment, as well as how to best open a position in the space. 

McAuley also discusses the emerging trends he has noticed in private equity and outlines how these should inform a sound investment strategy.

Edited Transcript:

What does the current environment of high inflation and rising interest rates mean for private equity markets in the coming year?

I think there's good news and bad news. The good news is that as a result of high inflation, interest rates are rising, and central banks are raising rates, which means the global economy will slow. 

That may sound like bad news, but it's actually good news for private equity because it opens up more opportunities. There will be companies requiring cash flow. There will be startups that have lower valuations. And so that opens up opportunities.

The bad news is probably more for existing investors in private equity. There always tends to be a lag in valuations for private equity. What's happening in listed markets should, normally, overflow into the valuations in private equity. So after the wonderful returns that have been reported for the end of June, there may be some giveback. 

Undoubtedly, however, history shows that if you pick the right managers over the long term, private equity adds value, provides good returns, and reduces the volatility of portfolios.

How would a potential slowdown affect the private equity markets?

There are pros and cons for the private equity market. If it's a hard landing, it will open up opportunities. And that will benefit those private equity firms that are putting money to work now, and those that have already raised the money, haven't invested it, and are about to put it to work. 

If it's a soft landing, again, there will be opportunities, but not the same as in a hard landing. What it does mean is that existing businesses where private equity is already invested will be under pressure.

Now, what does that mean? Are those businesses cash-flow-positive? If not, they have to raise funds. And what valuation will be implied when those funds are raised? So it's a bit of a tricky environment for private equity.

The ideal situation in my view, regardless of a hard or soft landing, is for a brand new fund that is about to put money to work.

Do you see the concentration of private market flow changing in the future?

I don't see it changing. I think that the private equity market in the U.S. is broad and deep, and is very well-established. If you look at the big investors in the states, for example, endowments like Yale, and Harvard, their proportion of unlisted illiquid investments in their portfolios are more than 50% and growing. 

So there's a ready-made investor base there, and the private equity managers have had the benefit of that, as well as the intellectual property as a result of operating for many years.

The U.S. economy, it's the largest in the world. It still is the last time I looked, although that may change. At the moment, it is a deep technology base, which is very creative. Silicon Valley, for instance, is the home of technological innovation, and that's only one sector. 

The U.S. has many benefits, but that's not to say there are no opportunities elsewhere. For example at Credit Suisse, healthcare private equity has been a theme of ours for the last few years.

So how do you take advantage of that? We've provided the opportunity for our clients to invest in an Israeli private equity firm that invests in healthcare technology stocks and up-and-coming companies. That opportunity has performed very well. Another example is an Indian healthcare provider, not actually technology-based, but more around providing healthcare for the growing middle class in India and Southeast Asia, and again, that's been very good. So outside of the major markets in the United States and Europe, there are opportunities, and I don't see that changing.

What emerging trends are you seeing in the private equity space?

I think the big trend is that the definition of what private equity is has expanded. It's not just investing in early-stage companies with ideally positive cash flow. It could be infrastructure. It could be anything that may have an annuity-style of revenue. It could be forestry, which used to be its own standalone type of investment. 

Private equity is a broad umbrella, so what can be private equity? And now when we talk about private equity, there is also private debt. So they tend to be used interchangeably and are mixed in together.

So we've seen a big increase in the number and quality of issues on the private credit side, particularly related to real estate, but not just real estate. And again, the U.S. market is very deep and very broad in terms of private credit. So there are some really good opportunities over there. The definition is expanding.

What is driving the increase in private equity opportunities in real estate?

I think that historically, just talking very simplistically, historically the returns from real estate in most developed markets have been very good. Of course, it's cyclical like everything. 

At the moment, with rates rising, there is concern around the valuation for real estate and if it has washed through yet. The short answer is it probably hasn't washed through yet because the central banks have only just started raising rates. So I think that's key.

Real estate has a utility. It has a use that there's always going to be some sort of demand for. So real estate really just comes down to what price, what rent you're going to charge. If you've got a well-established property portfolio that is well-tenanted and has a long WALE, a weighted average lease expiry, then the credit metrics around that are very attractive. 

You can look at them with some reliability. If it's unlisted real estate the valuations are created by the manager and checked by a third party, so they do tend to be smoother than what you see for listed real estate. And that's attractive to investors with a very long-term outlook.

What tips do you have for investors in private equity?

Well, I think the first thing would be to get a high-level understanding of exactly what you're investing in and understand that it comes with risk as it is early stage. Understand the nuances around when is a good time and when isn't to invest in private equity. 

I think the key is understanding or getting an understanding of who good managers are. Our research shows that the top managers, those that produce returns in the top 20%, stay there. That's very notable, even more so than in listed markets with active managers. It's very strong empirical evidence that supports that quality.

So if you're investing for the first time, you want to make sure that you're getting a good manager. That's very difficult for someone who may not have our history or the expertise we have. So if it's someone starting out, you would look at a diversified portfolio. So a fund made up of funds.

Now, a lot of people get worried about that because they think, oh, that's fees on fees. But if you get the right managers and good, double-digit returns that you would expect, the fee doesn't matter. 

As long as those managers are earning that fee, they're actually adding value, and it's in a diversified way. That way you have diversified managers across diversified sectors, whatever it is, healthcare, tech, industrial, property, then that's a good, lower-risk way to get a start.

And the final thing I would say is that you should think about investing over a few years, three or four years. Our clients in the last couple of years have become very interested in this and are putting their money to work. 

What we're saying to them is think about it as a three, four, or five-year program, work out how much you're going to invest and split it into five, and then invest over five years or four years. That's the best way to get into private equity.

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