What about the past decade’s performance?
Looking back, over the past 10 years, Private Equity Buyout funds delivered strong returns and can be considered as one of the best performing asset classes. Looking more closely at the performance drivers, recent research shows that roughly half of the median deal’s performance was delivered by revenue growth with the other half attributed to multiple expansion, meaning selling an asset at a higher valuation multiple than initially paid for. In a higher interest rate environment, however, Private Equity managers, or so called GP’s, cannot necessarily rely on selling a company for a higher multiple as a performance contributor anymore.
This means that the past macroeconomic environment we knew was quite favorable to deliver attractive returns more easily, something that I doubt will be possible over the coming years.
Interestingly, focusing on the top quartile realized deals, the best performing deals, GP’s were, in addition to the two other performance drivers, able to improve margins at company level which consequently contributed positively to the overall result.
What about now?
The Private Equity Buyout model is characterized by funds using a portion of capital and a portion of debt to acquire target companies, hence the term leveraged buyout. Since central banks increased interest rates at a rapid pace, the cost of debt for those underlying companies increased as well and is impacting their profitability. Furthermore, banks have become more reluctant to finance those so-called LBO’s. Consequently, factors such as the higher cost of debt, the tight access to financing and the price discrepancies between buyers and sellers, with sellers still seeking “yesterday’s prices” and buyers needing to take into account the higher cost of capital, has led to a decrease in the number of deals and exits in the Private Equity space.
Where do we go from here?
In order for the activity to significantly rebound, either valuation need to adjust or interest rates have to decrease. We currently observe that pricings have indeed started to come down from their peak levels seen in 2021 and even though a lot of uncertainties remain around the future path of interest rates, it is likely that peak levels have been reached. Consequently, funds currently investing can take advantage from lower valuations when signing deals, with less risky capital structures, the share of debt being lower. “Historically speaking, private equity funds that invested during challenging macroeconomic environments were generally among the highest performing vintage years, making the current environment potentially a favorable one to allocate capital to Private Equity”, explains Jérôme Zahnen. In addition, dry powder levels, meaning the capital ready to be deployed at fund level, will support higher activity over the coming years.
Macroeconomic conditions are ever-changing and very difficult to predict, which is why it is important to diversify the portfolio across asset classes, sectors, company enterprise values and geographies. In addition to the concept of diversification, it is also important to allocate capital in line with various secular trends such as digitalization, demographic changes, deglobalization or decarbonization. Many GP’s have developed cutting-edge expertise in various themes, making investing in Private Equity an interesting tool to get exposure to such secular trends.
In addition to the concept of diversification, it is also important to allocate capital in line with various secular trends such as digitalization, demographic changes, deglobalization or decarbonization.
How to choose and access the right managers?
There is a huge dispersion in performance between fund managers in the Private Equity industry, making the selection process a crucial step in order to achieve the expected outcome. “In the current macroeconomic environment, top-tier managers able to select good companies with the potential to create value through operational improvements will likely be those that will still be able to deliver strong returns over the coming years”, highlights Jérôme Zahnen. However, for those who used to rely on multiple expansion to deliver strong returns, the story will likely be a different one. Institutional investors that allocate capital to private markets have the resources to conduct thorough due diligence, but for private individuals seeking to increase their allocations to Private Equity, selection and access can be a challenge. In order to bridge that gap, some Private Banks have created dedicated Private Markets teams that offer well-informed private individuals sound advice. “At Banque de Luxembourg, we established such expertise about a decade ago and as of today we have successfully launched several funds that give access to leading Private Equity firms,” says Jérôme Zahnen.
How to build a diversified Private Equity portfolio?
Building a diversified private equity portfolio is clearly a more complex exercise than building a traditional portfolio allocated to stocks and bonds and without the right advise and tools, reaching the target allocation over time can be challenging. Private Equity funds typically have an investment period of around 5 years, which means that investors subscribe a commitment, with capital being drawn over time, in line with the funds’ investments in the companies. Consequently, the allocation builds up progressively, and usually after a 4-to-6 year holding period, the target funds exit their stakes in the companies, which means that the allocation is decreasing again. In a traditional portfolio, the target allocation can be reached within days but in a Private Equity portfolio detailed analyses need to be conducted in order to establish a yearly commitment plan that allows for vintage year diversification and cash flow projections in order to achieve the target allocation over time.
“At Banque de Luxembourg, as part of our advisory solutions, we help clients with the adequate risk profile, knowledge and experience to determine their Private Equity target allocation and on demand we set up tailor-made commitment plans that support investors in their journey to increase their Private Equity allocation,” concludes Jérôme Zahnen.