Creating value in an overheated market
Are private equity returns doomed? Andrea Auerbach, Managing Director and Head of Global Private Investment Research at Cambridge Associates, started the session off with the aim to answer this question.
There were certainly things to be gloomy about, said Andrea. Private investment performance was not what it used to be. Long gone were the heady days of the 90s when IRR could exceed 40%.
Purchase price multiples were at an all-time high while leverage levels had stayed the same, yet commitments kept on rising. The amount of dry powder waiting to be deployed was “off the chart” — the cumulative US private equity overhang, for example, was at an all-time high – $294bn as of the end of 2017.
“Buying low and selling high is proving very difficult,” said Andrea. “It’s now more a case of buy high, sell higher. The elevated purchase price multiple environment makes us as investors get concerned and that becomes quite a level of discussion with the managers we’re talking to.”
But it wasn’t all bad news.
Alternative investments outperform every other asset class, and that was going to be sustained, because the core essence of private markets hadn’t changed. “Those that master bringing a team of people together with a specific set of skills to execute a specific strategy can, and do, succeed wildly,” she said.
In this environment, choosing where to invest became ever harder.
“There was a time when investments were pretty simple and straightforward, you found a company that could be levered and executed a plain vanilla LBO,” she said. “If you wanted something edgy you would do some venture capital, growth-oriented companies, or on the other end, classic mezzanine or even distressed. This is how the market was in the 80s and 90s.”
But this no longer held true, she said. “The private investment universe is constantly evolving, you only have to listen to all the conversations going on here at SuperReturn about strategy to see that. Plain vanilla private equity is getting crushed; the returns aren’t there. Now you have this plethora of very focused spaces in which an LP can invest their money.”
There was one trend in particular that Cambridge Associates was paying attention to – operator/ executive-led private equity.
“Now what we’re seeing is operators hiring junior private equity professionals and doing the deals themselves. They are self-actualising, and it’s very interesting.” The challenge, said Andrea, is deciding which of these newer strategies would be sustainable.
It had become increasingly clear, she said, that sector focused funds outperformed generalists pursuing investments in the same sector. “At no point does the generalist beat the specialist at their own game.”
And don’t forget about the new kids on the block, she warned. Roughly 50% of US Buyout and Growth Equity funds are fund 1 or 2, another 30% are fund 3 or 4. “In the search for return, those investors who have ruled not to do first time might need to consider this. And these aren’t funds learning how to invest, these are usually spin-offs.”
In summary, the private markets were not doomed, concluded Andrea. “You just need to know where to look, have conviction and make sure you’re paying an appropriate amount of fees and carry for what you’re getting. The market will continue to evolve because the hunt for return is always on.”
Following Andrea’s insightful talk, a panel discussed their tips for portfolio construction in this environment.
Pamela Hendrickson, COO & Vice Chairman, Strategic Initiatives at The Riverside Company said they liked to avoid concentration risk. “I agree that sector specialisation is good, but you still have to have some diversification within the portfolio,” she said.
Pamela also felt that it was critical to have a clear growth strategy, and to go in and execute it fast – and relentlessly. “These days we move within the first 100 days”.
In Eileen Burbidge’s world as Partner at Passion Capital, sector focus was their strength – in this case, fintech. But she conceded that they too looked for diversification. “Around 30% is healthy enough to show we have expertise, but not so much that it might worry our LPs.”
Jennifer Dunstan, Partner, Head of Fund Investor Relations at 3i said that they were thematic investors. “What matters to us is what’ going on in the world. Digitalisation is having a huge impact across the board – we’re seeing it in the industrial space, in healthcare and so on.”
The other thing is sustainability, she said. “We all need to be thinking about how we are investing for the longer term to ensure we are not being too short-termist. This will help us have strong businesses in the future. The other key piece on value creation is really understanding what the business is that you are buying and taking an active approach operationally.”
But with the end of the cycle looming, it would be harder to avoid a short-term approach, thought Andrea. “It feels like everyone is playing the short game because the music is going to stop.”
Eileen said that in recent years their focus had shifted from 35% B2B to 65%. “We see a lot more sustainable longer-term value on the B2B side,” she explained. “We are thinking mostly about cyber security, AI, and a lot more selling picks and shovels to the people mining the gold as opposed to those seeking the gold.”
From a regional perspective, Eva Halvarsson, CEO at AP Fonden 2, thought that Africa was interesting, particularly given the demographics there.
Elaine, who was regionally led by their fintech focus, said South East Asia was extremely interesting.
Pamela added that the micro is sometimes more important than the macro. “We invested in a gelato company, because people will eat gelato whether there is a wall or whether there is Brexit.”
When thinking about what to look for in their partners, Eva said that she wanted to understand their values and, in particular, how they were developing their organisation for the future. “Leadership excellence is crucial, because I believe that culture and values are a very important thing if you are going into a long-term relationship.”
Being able to recruit the best talent was also important, she said, and that meant hiring a diverse team.
“Sometimes we have a GP that has the same staff, from the same business and educational background and that makes me wonder if these really are the people that will find the next investment opportunities, because they think so much alike. When I see very few or no women, I wonder why they haven’t been able to recruit or retain some of the best apprentices, because women outperform men at university.”
Jennifer agreed, adding that “If we want to keep investing well, the most diverse companies are the best performing. I think the industry has picked up on the issue, but it takes personal leadership and commitment, and everyone in the organisation has to take responsibility. And by the way, diversity is not just women and men.”
Eva said that she was the first to admit that it’s harder to lead a diverse team, “but in the long run, you get a better performance.”
Indeed, concluded Andrea, when we ask firms why they don’t have a more diverse workforce, “I can’t find any”, just isn’t an excuse any more.
Andrea Auerbach shares her thoughts on why often looking to the tails is a great way of finding new opportunities.
Eva Halvarsson discusses the importance of having different perspectives and what she looks for to determine if they are viable for the future.
Pamela Hendrickson explores how to build a robust portfolio and what PE firms should consider in the current economic conditions.