Wealth managers wondering where the next potential economic wobble-points could be are questioning whether private equity, which has boomed in recent years, could be vulnerable.
(An earlier version of this item appeared on WealthBriefing, sister news service to this one; the issues covered here are global, and of course particularly relevant to North America.)
History does not repeat itself exactly but it does rhyme, an old saying goes. And a decade on from the worst financial crisis since the 1930s, economists are checking where the next trouble might come from.
An area of business that has expanded rapidly over the past decades is private equity, and more widely, private capital markets in general. Today, there is more than $1.0 trillion of “dry powder” in the private equity space – that is money not yet put to work. And some wealth managers are starting to get nervous about what might happen, particularly if US interest rates keep rising or economic growth decelerates.
“One area that worries me tremendously is the amount of leverage accumulating in private equity investments,” Fahad Kamal, chief market strategist at Kleinwort Hambros, the British bank, told journalists at a recent briefing.
Low yields on listed equities and traditional bond markets – a situation caused to some degree by central bank money creation (aka quantitative easing) - has encouraged much of this inflow. As this publication has regularly chronicled, high net worth investors and family offices, for example, are increasingly loading up on the private equity asset class. As a subset of this, family offices’ direct investing has also become a hot talking point.
The past decade or more has seen private equity deliver double-digit internal rates of return – such as in the region of 15 to 20 per cent – but investors should not conclude that this will be repeated, Kamal continued.
“It’s much easier to get these sort of returns when you have got smaller funds in which to invest…they [investors] are deploying increasing amounts of capital to more expensively-valued funds,” he said.
However, Kamal did not say that the sector was dangerously overstretched. “If a few funds go bust it will hit the owners but this would not be contagious,” he said.
Michael Tiedemann, chief executive and chief investment officer of US-based Tiedemann Advisors, says that there remains a small liquidity premium that investors are paid to hold private equity, and added that there is a tremendous amount of money in the asset class, but he is not concerned that the sector will collapse. “I think it is doing a better job to protect investors,” he said. "It’s not possible to paint the sector with a broad brush," he cautioned.
Before the 2008 crack-up, private equity boomed, with buyouts driven by high levels of leverage that went sour when banks’ credit lines dried up.
So should investors be alarmed or have circumstances changed?
“Dry powder sitting at over $1 trillion may sound daunting, but it needs to be taken in the context of an industry that is still very much expanding. The private equity industry has seen huge growth in recent years, and there are more fund managers and more active vehicles today than ever before. As such, it’s not surprising that dry powder has grown,” Christopher Elvin, head of private equity at Preqin, the research firm tracking these sectors, told this publication.
“That said, the level of available capital to fund managers is contributing to a difficult deal-making environment. It’s certainly a seller’s market, with high asset valuations and competitive deal processes. Most fund managers, though, remain confident in their ability to find good investment opportunities, and we are not seeing the number of deals or deployment of capital slow significantly. In fact, the ratio of year-end dry powder to annual capital calls has fallen over the past 12 months – suggesting that while capital is building up faster than ever, it is also being put to work in greater quantities than ever,” Elvin said.
Elvin is relatively optimistic about the asset class in general, even with some caveats. “It is undeniable that asset valuations are high, and we are seeing some concern from fund managers and investors as to the impact of high valuations on long-term performance. However, valuations reflect the conditions across all asset classes in the current climate, so relative returns from private equity may still be favourable. The asset class has historically shown that it can outperform public equities in the long-term – we would expect that this would continue.”
Private equity firms remain on a roll. As noted two years ago - and not much appears to have changed since - there has been less downward pressure on the fees of private equity funds than with hedge funds; tepid performance by hedge funds has not helped. Even back in 2016, some figures began to wonder if the asset class would have an indigestion problem.
How well private equity continues to perform cannot be insulated from the economic situation more broadly. Growth forecasts for next year have been revised down for most of the world’s major economies. According to the Organisation for Economic Co-Operation and Development, global gross domestic product is now expected to expand by 3.5 per cent in 2019, compared with the 3.7 per cent forecast in last May’s OECD outlook, and by 3.5 per cent in 2020.
Private equity is still flying high, although the recent demise of PE-owned Toys “R” Us in the US (owned by Bain Capital and Kohlberg Kravis Roberts), for example, is a sign that these financial engineers can be wrong-footed.
Preqin is certainly confident that private equity will expand further. Such funds are predicted to overtake hedge funds to become the largest alternative asset class. They are projected to grow by 58 per cent, rising from their current AuM of $3.1 trillion to $4.9 trillion by 2023.
“Certainly, we are in an almost unprecedented period of low interest rates and inexpensive debt. This has contributed to leverage levels that probably wouldn’t be so prevalent in most other macroeconomic circumstances. On the other hand, government-mandated controls and guidelines on bank issuance of leverage means we have not returned to historic highs seen prior to previous downturns. In fact, high valuations have in many cases led fund managers to increase their equity offerings rather than loading up on debt,” Elvin added.