Carraighill’s research is focussed on understanding investment opportunities across a range of areas including banks, private equity, asset management, payments, gold companies and the real estate sector.
As we review an investment idea, we aim to fully understand the ecosystem within which the company operates. Our systems based research concentrates on the key long term (structural) and short term (cyclical) drivers of the top and bottom line of each sector, within each country. This is an exhaustive activity that distils billions of data points into clear logical insight and trends. This work allows us to better understand the drivers and the risks in each investment opportunity, above what is stated in company accounts.
Within the Private Equity (PE) sector, we have observed several trends over the last number of years.
PE industry trends:
The PE industry has been one of the major beneficiaries of low interest rates as it is primarily a leveraged long only product offering. In addition, as governments increasingly guarantee the debt of the corporate sector, this lowers both the corporate debt and equity risk premia. This should benefit the equity return, as debt costs fall, and the potential for improved exit multiples rise. In addition, the elimination of the risk premium ensures a persistent favourable fund-raising environment. In particular:
Substantial growth in AuM delivered and expected:
According to McKinsey, global private market AUM now totals $6.5 trillion, almost 2.7x more than in 2010. In fact, global PE net asset values has multiplied 8x since 2000, almost three times as fast as public market capitalisation, which has grown approximately 2.8x over the same period. Most consultants, including PwC (below) estimated that global private market AUM will grow at a 10% compound annual growth rate to 2025 (pre COVID-19).
Underweight exposure driving expectation for increased flows:
The growth in AUM appears to be structural as allocations to private markets still tend to account for only 5% – 15% of institutional investors’ portfolios, with many funds underweight relative to their target PE allocations (below). Closing this gap would require more than $500bn in additional capital commitments—as much as the global amount raised for PE in 2019.
Disproportionate flows to largest firms:
The economics of the largest global players have also been improving in recent years, with capital going to fewer (larger) firms. Between 2016 and 2018, the proportion of capital raised by the top 20 private equity firms increased from 26% to 36% of amounts raised.
Strong returns are being linearly extrapolated:
The industry has established a best-in-class track record: private equity buyout funds have outperformed public market funds in both the US and Europe on a 1-, 5-, 10-, and 20-year investment horizon. This has led to the linear expectation of increased dramatic outperformance in years to come. In a world where equity markets have continued to outperform, this is not a surprise, as PE is essentially leveraged equity.
High valuations underpinned by the scale of uncalled capital:
Dry powder is high, which has been suggested should support market drawdowns and higher valuations. However, we believe this uncalled capital stack is reflective of how popular the asset class has become and has helped contribute to intense competition for deals, which has pushed valuations of transactions to record highs.
Recent Impacts of Covid-19
Some of the recent cyclical trends post Covid-19 include:
- Exits have slowed in 2020 and holding periods extend (sellers wait for the private markets to recover).
- New fund raising has been surprisingly buoyant as investors have adapted to an online process.
- Cash calls for existing portfolio companies increased, but in general were not significant.
- Further declines in interest rates globally are a continued tailwind to the industry.
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