Private Equity Performance Across the Cycle
In our June 2022 newsletter, we took a look at the multiyear deployment pace of private equity funds. As just 40% of the capital is deployed over the first three years, we encouraged investors to devise a sound and realistic long-term investment strategy.
We now focus on the performance of vintages across the cycle. Specifically, we look at the high-growth and low-inflation period of 2009-2018 and at the pre–Global Financial Crisis (GFC) years. These two periods contain valuable insights for our investment strategy going forward.
We find empirical evidence that investing through new commitments when the going gets tough and panic is highest, as in the post GFC years, delivers the strongest investment results.
In addition, global equity markets1 have declined 25% so far this year. The yields to maturity of sovereign issuers2 have shot up by about 2.5% and those of junk bonds have doubled.
Still, we must maintain the course with our private asset investment strategy. On the one hand, as we saw in our previous note, capital will be deployed gradually over the next six years. On the other hand, investment performance is strongest just after the darkest hours.
Valuation as of June 30th, 2022. North American and European companies in Altamar’s Primary Buyout Funds – primary deals only. Excludes companies in the Debt sector. The sample contains 4010 companies as of 30/06/2022.
MOIC, DPI, RVPI and Realized Capital Loss weighted by invested cost. Buyout multiple (EV/EBITDA), Debt multiple (Net Debt/EBITDA), both entry metrics and median values. Realized Capital Loss calculated as realized loss over total realized cost. 2019-22 Realized capital loss not meaningful (n.m.) given low divestment volume during the period.
Figures refer to the mature Altamar Private Equity, S.G.I.I.C., S.A.U. Commingled funds: ABE, ABG, Altamar V, Altamar VIII & Altamar X.
During the years preceding the GFC, both entry (EV/EBITDA) and leverage (Debt/EBITDA) multiples keep increasing and reached historically high levels. As the crisis hit portfolio companies, portfolio losses reached a staggering 29%. Still, funds3 managed to deliver a multiple on invested capital (MOIC) of 1.5x.
We can appreciate that both entry and leverage multiples settled at lower levels in the aftermath of the GFC. As economies recovered, portfolio losses declined to 8% and exit valuations reached multiples of 2.4x. As a result, private equity funds were able to deliver a MOIC of 2.2x. Capital gains increased by 140% from 0.5x capital gain in the pre-GFC period to 1.2x capital gain thereafter.
Vintages for the period 2015-2018 have been able to continue delivering strong multiples of 2.1x despite the impact of the COVID pandemia starting in early 2020. Exit multiples have averaged 2.4x and portfolio losses 11%.
What performance can private equity funds expect for the most recent vintages of 2019 to 2021?
On the one hand, entry multiples have again reached record highs as has also been the case with valuations across all major asset classes. On the other hand, leverage is lower than that reached in the pre-GFC years. In addition, interest rates were at rock bottom and covenants were light.
All in, in the context of a worsening macroeconomic environment, we can expect returns lower than in the recent growth years but higher than those delivered in the pre-GFC years. Considering that losses could reach 15 to 20%, we could see MOICs of 1.7x to 1.8x:
“Realised return” corresponds to realized investments excluding written-down investments. “Total return” corresponds to both realized and non-realised investments, including written-down investments.
- S&P500 performance to 26th September, 2022.
- 10y Treasury bond performance to 26th September, 2022
- Figures refer to the mature Altamar Private Equity, S.G.I.I.C., S.A.U. Commingled funds: ABE, ABG, Altamar V, Altamar VIII & Altamar X.
- For further information, see “Targeting Private Assets”, page 42.
The Operational Resilience of PE Firms
Private assets offer a safe harbor to today´s volatility in traditional 60/40 assets. The resilience of private equity in such environments is not a mirage due to mark-to-model valuations or a growth sector bias.
Private equity, thus, offers bottom-up operational resilience most valuable in the volatile and uncertain times that we face today.
“Altamar Funds” data sourced from AltamarCAM’s fund portfolio. “Private Equity, Venture Capital, Infra, Real Estate and Credit: includes all primary and secondary funds managed by Altamar Private Equity, SGIIC SAU for each asset class.
Source: Data for Stock Market Performance obtained from www.Investing.com;
LTM: 30/06/2021 to 30/06/2022; Last 24M: 30/06/2020 to 30/06/2022.
As we all know well by now, these performance 3 numbers are not directly comparable:
- On the one hand, private assets are valued on a discounted cash flow and / or comparable companies methods (mark-to-model) whereas their public benchmarks are valued on a mark-to-market basis. There is thus a material lag on the time it takes private asset valuations to reflect an adverse market shock. This lag creates a smoothing effect on private equity returns.
- On the other hand, the sector exposures of private and public assets differ considerably and their relative performance may be significantly different. To illustrate, during the 12 months to June, the USD FTSE World Technology index4 dropped 23%, Telecoms 18% and Health Care 6% whereas the Energy index surged by 14% and Utilities by 1%.
Could there be other fundamental bottom-up reasons as to why private assets outperform public benchmarks during adverse market conditions?
In a Winter 2021 Journal of Alternative Investments article, Private Equity and the Leverage Myth, Czasonis, Kinlaw, Kritzman, and Turkington 5 explore the theoretical and empirical relationship between volatility and leverage.
- Volatility should scale directly with the degree of leverage.
- Investors usually estimate the volatility of private equity buyouts by applying a leverage multiple to public equity volatility.
- Even though private equity firms have twice the leverage of public equity, their observed volatility, even after adjusting for smoothing, is no greater than that of public equities.
- Leverage has, thus, no apparent effect on private equity volatility. There is no evidence that volatility scales with leverage.
We face a conundrum that would possibly challenge even Greenspan himself.
Czasonis et al undertook to understand the lack of statistical relationship between leverage and private equity metrics. After conducting time-series analyses and reviewing the financial conditions of several companies, they find that leverage is often stable for long periods of time, whereas volatility is highly time-varying, and companies have several sources of implicit leverage.
All in, Czasonis et al reach the stubborn conclusion that private equity volatility is similar to public equity volatility despite its higher leverage. As they explore why this is the case, they posit that “it could be that buyout fund managers prefer to invest in companies whose underlying business activities are inherently less risky and can therefore bear higher leverage, which increases profit”.
Consistent with Czasonis, J.P. Morgan has introduced this year, in its well-regarded Long-Term Capital Market Assumptions annual study, a novel approach to estimating private equity volatility reflecting the unique characteristics of private market assets – including the embedded operational optionality of private equity. This methodology leads to a dampening of estimated volatility:
1. Information obtained from funds managed by State Street Private Equity Index (page 23 of “Private Equity and the Leverage Myth”).
2. y 3. Past performance is not necessarily indicative of future results as current economic conditions are not comparable to past performance, which may not be repeated in the future. 4. Data sourced from FTSE All-World Index Series. Monthly review. June 2022
5. Megan Czasonis, William Kinlaw, Mark Kritzman y David Turkington
6. Long-Term Capital Market Assumptions (JP Morgan) & Private Equity and the Leverage Myth (Megan Czasonis, William Kinlaw, Mark Kritzman y David Turkington)
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