Why investors should look again at private equity

In the first quarter of this year, average early-stage valuations in Europe fell 23% on the same period last year, while late-stage valuations slumped as much as 77%, according to capital market data company PitchBook. Current ructions in the financial markets have clearly made many investors fearful, yet it is hard to think of a better time to buy.

The route into this market is via private equity. This type of investment strategy typically involves the acquisition of a stake in private companies that are not (yet) publicly traded on stock exchanges. While private equity investment is normally at a later stage after private companies have proved themselves, venture capital investment is on the ground floor. Investors tend to take an active role in a firm’s management for three to five years before they look to exit, often via a trade sale, to a venture capital firm or a stock market flotation.

It is not too difficult to find the reasons why the market has slowed down.

Back in 2021, interest rates were either very low or in some cases negative which made private equity attractive. The jump in interest rates in many parts of the world over the past year means investors can now easily find stable returns of 4% to 5% from corporate bonds.

Then, of course, there are other reservations in the macro environment. Nobody knows what is going to happen in the war between Russia and Ukraine and, more to the point, the speed of China’s recovery remains uncertain.

Given that returns from almost every asset class fell last year, it’s no wonder that investors are a little bit more cautious. Even traditional safe-haven assets like government bonds have turned out not to be that risk-free, all of which has resulted in lower fundraising in general for private equity firms. Last year, global private equity deal volume fell 26% to $2.4 trillion and deal count fell 15% to just under 60,000, according to consultants McKinsey.

Investors might be more guarded right now, but many institutions like endowments, insurance companies, and asset managers in general currently have a very low proportion of their funds invested into alternative assets. There is still money that could flow into the asset class.

Valuations are low

Still, this dynamic has hit valuations.

With valuations as low as they are now – in other words when you look at the stock price of private equity companies and compare that to the portfolio valuations or their net assets – there is currently a discount of between 25% and 30%.

Over the past 30 years, this has always been a buying signal.

Take a look at Britain’s largest listed private equity firm 3i Group, for example.

It took a majority stake in Zwaagdijk-Oost-headquartered Action in June 2011. The fastest-growing non-food discounter in Europe, Action has more than 2,300 stores across the Netherlands, Belgium, France, Germany, Luxembourg, Austria, Poland, the Czech Republic, Italy, Spain, and Slovakia.

There is considerable market positivity around Action, encouraging cash flow, and the company’s valuation is very high. Earlier this year, Action was ranked first in EY-Parthenon’s annual study of France’s retail landscape, and in the year to January, it reported a 30% jump in revenues of €8.9 billion.

But even though Action makes up just over 60% of 3i’s portfolio, the private equity firm had a price/earnings (P/E) ratio of only 4.5 in mid-June. Calculated by dividing the share price by its earnings per share, a high P/E ratio means that investors are willing to pay a premium for the stock while a low P/E ratio often means that the stock is undervalued. In comparison, at the same time, the UK FTSE All-Share index had a P/E ratio of 14.4, which suggests that 3i has been trading at a significant discount to the main index.

Similar valuations were seen in 2012 during the euro crisis and the discounts were even higher after the great financial crisis of 2009. But the major difference is that the leverage ratios – the extent to which a company uses debt to finance its operations – were much higher then.

The bottom of the market

It is true, of course, that investors can look to established corporates to get access to emerging businesses as they often invest in startups within their own field. Investors could, for example, buy into Volkswagen or Novartis to get exposure to the automotive or healthcare sectors. But the capabilities of a corporate manager that is looking after those companies are completely different from those of a private equity manager. The latter does nothing all day except search out the next big companies. If they buy a company, it is for no other reason than they think it is a good deal.

Above all, private equity is the only asset class that can profit both from bull and bear markets. According to the LPX50 NAV Index which measures the returns of Private Equity valuations, it returned 8.34% in the decade to June 2020.

It benefits from a recession because then it’s a good time to buy companies, while during times of expansion, private equity can boom because it is easier to achieve higher valuations and make trade deals for the companies within their portfolios.

There are, of course, risks to private equity and it should be noted that these are higher than traditional public market investments. There are inherent operational risks that can be amplified by market conditions. Investors should also take into account the managerial risks of both of the companies in which private equity companies invest, as well as the private equity firms themselves. And above all, there is a capital concentration risk. As noted above, Action makes up 60 of 3i’s portfolio. Were the retailer to underperform or face challenges, then 3i itself would be disproportionately affected. Nonetheless, since 2009, leverage ratios have come down bringing a greater sense of rationality to market performance and highlighting investment opportunities. But this does mean that the valuation discounts that are currently available are unlikely to go on forever.

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Article first published on I by IMD. 

Authors: 

- Michel Degosciu, Managing Partner at LPX AG
- Karl Schmedders, Professor of Finance at IMD
- Maximilian Werner, Associate Director at IMD’s Venture Asset Management Initiative