This has been a golden decade for private equity. The financial conditions following 2008’s Global Financial Crisis were ideal for the asset class to flourish, with interest rates low and plenty of capital looking for higher growth assets. The question today is whether private equity can continue to thrive in the “new normal” that emerges from the Covid-19 crisis?
Over the past decade, private equity has seen a virtuous circle. Returns have been strong, encouraging new capital into the sector, which has allowed good companies to stay private for longer. While companies might have previously listed at an enterprise value of around $500m (e.g. Amazon), today, they have been able to raise the money to grow while remaining in private equity hands (e.g. Airbnb).
However, today, investors are questioning whether returns can be sustained at the levels we’ve seen for the last 10 years. Investors have assumed that this crisis will see private equity valuations weaken, as they did during the financial crisis. There have been media reports of some problems at private equity-owned companies, particularly in “at-risk” sectors such as leisure and travel.
Certainly, we saw a large decrease in valuations in March. Private equity companies will use public market valuations as a benchmark, so it was inevitable that the weakness in the major stock markets around the globe had an impact on the private equity sector. However, as valuation figures have come through over the summer, we have seen a significant uptick that almost fully offsets the drop in March.
Undoubtedly, there are still companies in there that are struggling, but the number of companies that have proved extremely resilient in challenging conditions is perhaps the greater surprise.
Part of this resilience was that private equity managers had recognized in advance that the market environment was likely to change. They knew this was the longest bull market they had seen and, in many cases, had prepared their portfolios. They were increasingly investing in resilient sectors such as technology, healthcare, and consumer staples. For the Standard Life Private Equity Trust, these sectors now represent around half of its net asset value (NAV).
Where private equity managers are invested in more cyclical sectors such as industrials, or consumer discretionary, they are focused on specialist areas. Typically, digitalization and the shift to online is a big part of the investment thesis. The Trust is an investor in Photobox, for example. While this is ostensibly a consumer discretionary company and should be vulnerable to weaker economic conditions, it has proved resilient in this crisis. People took the opportunity of lockdown to organize the photos on their phone, creating new albums and the company has posted record numbers. Similarly, Dr. Martens, the footwear brand, initially appeared to be vulnerable because of the closure of its physical stores during the lockdown, but its online channel has almost completely offset lost physical sales. Allegro, the Polish online marketplace, has also traded at record levels during 2020 and recently successfully listed on the Warsaw Stock Exchange during the second half of the year.
Merger, acquisition, and Initial Public Offering (IPO) activity hasn’t dried up as would be expected. Firms still have a lot of ‘dry powder’ – capital available to deploy – and a limited time frame to use it. As such, we have seen private equity firms continuing to sell to other private equity firms. Undoubtedly, there have been difficulties where it has been impossible to meet face to face, but it is not as bad as might have been anticipated in March.
To our mind, companies seem to be generally weathering the storm. Where businesses have experienced disruption to their business model, many have managed to cut costs, furlough staff, and raise additional capital. We estimate that only 9 of the Trust’s top 100 underlying companies by value have seen a severe negative impact from the pandemic and are likely to experience debt covenant and liquidity issues. The remaining 91 companies have only seen a temporary negative impact at worst, with several actually benefitting from the current situation.
Looking at the Trust’s performance, we saw the NAV drop in March, but at less than half the fall of wider equity markets. By June it had recovered almost all that loss (on a constant currency basis). It has undoubtedly been volatile, but the swing in public markets was far greater. Historical analysis shows that private equity has a lower-than-expected correlation with comparable listed markets and so we believe that it has diversification benefits in an overall portfolio.
While we have made some small adjustments to the portfolio, we are happy with the way it looks today. We recently extended the size of the Trust’s debt facility by £100 million, which gives us more firepower to deploy into new investments. We believe there may be some distressed sellers, particularly in the secondary market, so this cash can be used to pick up positions more cheaply.
In spite of some gloomy predictions at the outset of the pandemic, private equity has shown its resilience in the face of a challenging environment. To our mind, this reflects the changes seen in the sector over the past decade – including a focus on more resilient sectors and a greater operational involvement in underlying companies, including an increased focus on digitalization and environmental, social, and governance factors. We believe that private equity will continue to build from here as we move into the “new normal”.
