QD View: The future of private equity

I was recently asked about the outlook for listed private equity funds and whether it was likely to improve along with the more optimistic macroeconomic environment – by Matthew Read

 
Despite having a strong track record of achieving strong realisations and the private funds generally reporting good operational performance from their underlying holdings, the sector seems to struggle to grab investors’ attention, with the listed private equity funds trading at significant discounts to NAV. The question is, how did we get here and is there an opportunity?
 

We have long argued that private equity discounts are too wide

 
Regular readers of our research and news will know that, at QuotedData, we have long thought that the discounts to NAV that are prevailing within the private equity sector are overdone and we can see a number of reasons for this. First, as signs that the economic outlook was becoming more challenging started to emerge, a small but vocal group of investors started to question whether the NAVs of listed private equity funds were still valid. They observed that these weren’t falling as fast as those for listed equities. However, they failed to appreciate that private equity valuations do move with listed equity valuations, but this occurs with a lag.
 

Private managers have no incentive to inflate carrying values

 
A frequently cited and important misconception is that managers of private equity funds benefit from inflating the carrying value of the assets in their portfolios, but this simply is not true. Private equity managers are rewarded based on the amount of money that is initially committed to their funds and profits on realisations – not valuations – so there is absolutely no incentive to do this.

Once you understand this, it comes as no surprise that private equity valuations tend to be conservative, with an uplift often recorded versus the last valuation when a sale occurs. Some of these uplifts can be substantial too. Most limited partnership (LP) funds and direct private equity investments will have some latent value embedded in them, implying that NAVs are understated.
 

Private equity has been hit by the cost disclosure problem more than most sectors

 
Second, private equity funds have been particularly affected by the cost-disclosure problem that affects the investment companies sector more generally. Many of these vehicles are structured as fund-of-funds – the listed private equity fund investing in private equity via LP funds. Experience in recent years is that wealth managers have been shying away from investment companies more generally because they are required to include the management costs of these funds in their own expense ratios (despite this already being baked into the share price and not needing to do so for an equivalent UCITS fund). This has driven selling of investment trusts more generally, pushing out discounts out across the sector. Private equity funds-of-funds have another layer of fees and so have been even more affected.

As an example, Patria Private Equity Trust (PPET), which offers a diversified exposure to the European mid-market segment, is a well-managed fund that has suffered more than most because of this. Despite generating internal rates of return of 16%,20% and 20% on primary, secondary and co-investments respectively, it languishes on a 24% discount to NAV today.
 

Major hangover from the GFC….

 
Third, private equity continues to suffer from negative sentiment based on historical experience that is now out-of-touch with reality. Post the GFC, private equity was deeply out of favour. Some LPs had over-committed at the top of the market and suffered as they were not able to meet their obligations. In some instances, there were fire sales of assets to try and meet their commitments that eroded a lot of value for certain funds. While this did not apply to many of the LPs that survived, many funds were tarred with the same brush and the listed private equity funds that owned them were left trading on hefty discounts and there is still a hangover from this today, despite the backdrop having changed significantly.
 

….but private equity has moved on dramatically

 
Today, private equity is altogether different and overwhelmingly focused on developing and growing businesses (we think Oakley Capital Investments is a good example of this), rather than financial engineering, but the market’s perception seems little changed. By and large, private equity managers are focused on businesses with cashflows to support their debt and so we are unlikely to see a repeat of the previous problems. Furthermore, banks are now far more cautious when lending and, even if they and their LP backers wanted to, private companies cannot borrow extensively unless they have the cash flows to support the debt.

To give this some context, PPET says that the median leverage multiple on its top 50 underlying companies was a pretty conservative 3.9x EBITDA as at 31 March 2024. At the same time, its median valuation multiple is 14.4x EBITDA, while average EBITDA growth over the previous 12 months was 22.4%.
 

We think the outlook for private equity is strong

 
Despite the sizeable discounts, we think the outlook for the private equity sector is strong. Although often overlooked, a key reason that investors should consider having some exposure to private equity is that, over the long term, returns from private markets have tended to outpace those of listed markets. There could be a number of reasons for this, but it is often argued that there is less distraction from short term considerations of hitting quarterly earnings numbers and that management can focus on driving growth over the longer term. In addition, the more tightly held nature of private assets leads to better alignment between owners and managers, resulting in stronger corporate governance.

It is worth remembering that, post the GFC, a dearth of capital allowed private equity managers to secure deals at very competitive prices, which laid the foundations for exceptional outperformance in the years to come. It looks like history is repeating itself here, particularly once you take into account that private equity managers are generally continuing to report good if not strong operational performance of the companies within the underlying portfolios. This suggests that we should see decent NAV growth as interest rates continue to recede and economies recover, which should also stimulate discount narrowing.

Resolution of the cost-disclosure issue suffered a setback with Rishi Sunak calling the snap general election but there appears to be both recognition of the problem and support across political parties and so a resolution should come eventually. This should be an extra fillip for the sector.