Selecting the winning themes in private equity

PE has form. It outperforms other alternatives, public equity and fixed income over almost any time period, from 12 months to 20 years.

There are two main reasons for the resilience of PE. The first is the active ownership of assets in PE. Agile management teams can drive growth, and the degree of flex and change means PE-owned companies can adapt quickly.

The second key factor in ensuring PE’s robust nature is the industry split. There has been a stronger focus through the pandemic on industries that performed well when lockdowns threw many others into turmoil - particularly healthcare and tech. Broadly speaking, PE tends to focus on less cyclical sectors, and instead backs innovative, disruptive models, further reducing dependency on economic strength.

Opportunities: think smaller, and emerging

Covid has accelerated change in many segments, sometimes moving companies and industries forward or backwards by 10 years. In 2022, we expect to see more of the same.

In particular, small- and mid-cap seem to offer great opportunities. As PE has matured and evolved, investors focus on increasingly specialist managers, in line with sustainability objectives as well as value creation through business and operational transformation. Finally, the pricing dynamics are more attractive and business owners of this scale are looking to grow their markets, not just returns.

Emerging markets (EM) are also enticing in the PE space, given the entrepreneurial spirit imbued in growth markets.

For many of them, the speed at which they are maturing is increasing. Demographic and GDP growth trends favour EM, and as many developing economies emerge from the pandemic, opportunities to meet funding and capacity gaps are growing. Many companies need growth capital and the entry multiples and valuations are attractive in the current environment.

The “GP-led” market is also increasingly interesting in terms of PE. GP-led transactions allow general partners (GPs) to retain control of star companies beyond the initial maturity of the fund. The pandemic pushed GPs to become active investors, and as GPs supported good companies through an unprecedented – but ultimately transitory – demand shock, the number of these transactions exploded.

Risks: overcoming pricing and people shortcomings

The most glaring issue, however, and one most investors continue to mull in both private and public markets, is valuations. As concerns mount around tapering, and how that might impact liquidity in the public markets, worries about valuations are growing more acute.

The truth is, bargains – if they exist in the market today – are few and far between. We have been concerned with the search for quality; the pandemic has been a reminder that it is not possible to know everything. Good models can be incredibly valuable, but the world is full of people, not models. The key, therefore, is to work with strong management who can change and evolve over time. 

It is also important to have the depth of resource and specialist skills to identify where the value is. Our added advantage, for example, is the experience and perspective of our equity experts in EM investing. Emerging or growth markets have always been considered riskier than developed markets. Over the last 20 years, our focus has been mitigating and managing certain risks, and ensuring risk and return potential are in line.

Successful investment in growth markets is contingent on local expertise, hence the majority of our investment team that invests in EM is located there. A robust risk management framework and structured investment process help us to manage this risk. The way we performed in the pandemic gives us a lot of comfort that our approach is sound.

Sustainability: making an impact

The market has clearly moved towards more sustainable investment and investing with positive impact. Capital is essential to addressing global challenges such as climate change and inequality. PE lends itself well to impact investing, given the greater proximity to assets and lower information barriers.

The focus now is on consistent, transparent, repeatable measurement. Despite the rise in profile of an “ESG approach”, sustainability is still seen with some scepticism over its impact on financial returns. But the negative effects of weaker ESG practices accumulate over time. Consistent measurement could avert problems developing. We see more managers coming to the market with more thematic offerings and a push towards data collection on impact and sustainability.

The question may well become “can you still achieve returns if you do not factor in impact?”.

Over the last two decades, investors have secured market rate returns while advancing important causes such as poverty alleviation or climate change adaptation and mitigation. There are ample opportunities in EM to choose a specific outcome, allowing us to be selective and select the right targets from both an impact and return perspective.

The future: democratisation of PE

Democratisation is also a captivating development, and likely to be formative for what we call “private assets 4.0” – the next phase of the private markets overall.

Most PE investors have historically been pension funds, insurance companies, banks and other institutions, based on the structures generally being 10-year limited partnerships. These still dominate the landscape because they are proven to work and most investors like them.

Recently, more liquid and semi-liquid structures have emerged, falling into one of two camps:

• Vehicles with monthly or quarterly subscriptions and redemptions
• Listed vehicles, such as investment trusts, where investor decisions to buy or sell holdings doesn’t prompt the trust to sell portfolio investments    

Notably, both structures make it easier for retail investors to invest in PE, where more traditional GP/LP structures would previously have prevented access.

Click here to learn more about private equity investment strategies at Schroders.

IMPORTANT INFORMATION
Investment involves risks. This material is issued by Schroder Investment Management (Hong Kong) Limited and has not been reviewed by the SFC.