Private Equity

The only thing we have to fear is… fear itself.

The first inauguration of Franklin D Roosevelt

Much is being written in 2021 about price inflation, debating its persistent or transient nature, and conveying a general worry over the impact of inflation on asset prices. With this note, we hope to explore the history of inflationary periods to determine how much inflation impacts fundamentals and how much market action is merely fear itself.

Investors with some age on them have been shaped by the period of elevated inflation in the 1970’s. As the graph below shows, most other inflationary periods have been associated with wars — with prices spiking from wartime shortages and then deflating when supply/demand conditions returned to balance. But the inflationary period of 1973-74 was different and not associated with wars but with monetary policy. Stock prices during this period declined by more than 45%, and bonds saw coupon interest undermined by declining principal value from rising rates.

Interestingly, the battle against inflation didn’t actually commence until after the Nixon Administration’s easy money policies had been abandoned and the Volcker Fed commenced a high interest rate regime to “break inflation’s back” in the early 1980’s.

Given the noise in the markets today, one would expect that this would have been a horrific period in which to be an investor. But despite persistent inflation during the ten years following the ’73-‘74 bear market, eight years were positive for equities. Bond returns were positive a similar percentage of the time. And shockingly, S&P500 returns (including dividends) averaged more than 15 percent per year during this decade. It would appear that inflation surprises are more important than inflation itself.

What does one make of this revelation, and how does it relate to private investments?

First, one must admit that market averages hide the volatility that affected many companies and sectors. Those bear market years were most difficult for high multiple growth stocks whose prices often declined by more than 80%. (Remember that Avon Products and Coca Cola were growth stocks of that era.)  Clearly, future earnings are worth far less in a high inflation environment. Similarly, lower quality names with high leverage were also decimated as the rising cost of leverage took its toll on free cash flow and solvency.

In the current era, the private equity industry has thrived in this period of lower cost leverage, allowing managers to widen their view of potential targets and buy at ever higher valuations. Assuming “real” rates of interest behave logically, then higher inflation would raise financing costs and put marginal deals out of reach. We would expect skilled managers to continue to succeed in such an environment, while those without an edge would eventually point their careers elsewhere. Investors without a coherent strategy may find this new paradigm less than accommodating.

The takeaway for private investments, therefore, is not that inflation is scary, or that it is benign. The observation is that low leverage strategies should endure. Skilled managers and sponsors in private equity can continue to add value. Enterprises with pricing power will better be able to navigate whatever environment exists. And certain real estate categories are clearly inflation hedges, with rents that adjust over short time periods. Conversely, highly leveraged strategies and overpaying for growth are risky endeavors when discount rates rise.

At Altera, we strive to identify strategies with real value-added as opposed to “prosperity through financial engineering”. We seek enterprises with pricing flexibility and modest leverage. We favor durable revenue streams, even at the expense of being a little dull. We are long term investors in long duration assets.

We can’t predict inflation rates, or whether or not the current spike will endure or prove to be transitory. But as history has shown (in the graph above), change IS the constant, and inflation rates are just as likely to surprise on the downside as the upside. This makes the entire inflation discussion (for long term investors in private securities, anyway) as much a media-driven phenomenon as it is a fundamental one.

When financial assets are strongly appreciating, diversification (to put it mildly) looks like a Fool’s Game. Speculative assets during such periods can hold unmistakable allure. Whether cryptocurrencies in 2020 or “dot com” stocks in 2000, investors ask, “Why didn’t my advisor diversify my portfolio like that?”

The corollary for investors in alternatives might be, “Why did I invest in this (sleepy) infrastructure fund, or in this yield-focused private credit vehicle?”

Altera recognizes that alternatives are unlikely to be a portfolio’s short-term “star”. It is easy to forget the investment case for, say, that infrastructure fund. That’s not to say that such investments don’t have clear appeal, tending to have a sizable income component and a chance at some appreciation, too. And as an illiquid asset, their value would be expected to change little over any short time period.

But stable income seems dull until markets become volatile. And future appreciation isn’t truly appreciated until it we actually see it.

In 2021, we might welcome a few assets with a lower correlation of returns with the public markets. Volatility has returned, and a vicious tug-of-war is occurring between richly priced growth stocks and the “value” shares that have underperformed since 2008. Some past winners have lost half their value from recent highs.

Meanwhile, today’s investors may be taking more risk, having allowed portfolios to drift to higher equity allocations. It is also well documented that investors’ “home bias” has continued to grow. And portfolio concentrations could possibly be higher than any time in recent memory. Five large cap tech stocks now account for 20% of the S&P500 and may comprise a significant part of many investor portfolios.

The question is this: Can volatility remind us to keep our eyes on the actual prize? Can it help us remember to play the long game of building wealth by compounding attractive long- term returns across a variety of less-correlated assets?

The challenge, of course, is in our basic human nature. Investors look at their portfolios and may not see concentrated risks across securities whose returns are driven by similar factors. Instead, they notice that some alternatives can take years to get fully invested or see the “J-curve” where initial periods show losses, not gains. Diversification requires patience in comparison with a robust market environment — especially when the sequence of returns for “alts” is weighed more to the future and less to the short term.

On the other hand, if those alternative investments can generate equity-like returns without equity market risk, then the long-term investor is the winner with a smoother ride and the returns that they need. Seven years in, that infrastructure investor may have gotten most of his or her capital back. And, by year eight and nine, portfolio exits may be occurring, with lumpy returns that make few headlines, but that can swell account values with little fanfare.

Human nature is unlikely to change, but with the mindset of a business owner, we can see the compounding at work (and not just the excitement of ups and downs) across our portfolio of “businesses”. Or, when we think like a pension fund manager, taking a truly long-term perspective, we can see how a balanced array of diverse return sources can make it more likely that we will achieve our financial goals.

In other words, we can be in tune with the actual workings of our portfolio. If volatility is what eventually gets us to have this mature look at our investments, then that not-so-gentle reminder is valuable indeed.

Of Expectations and Allocations

Each year, major investment firms make their assessments of the relative attractiveness of the main investment asset classes. They typically provide expected returns for the next decade. These numbers can be eye-opening when they deviate widely from historical results, while at the same time, the portfolio allocations recommended by such firms seldom reflects these expectations.

Some might refer to this as “talking out of both sides of your mouth”, but let’s be charitable and say that their recommended allocations reflect their short-term expectations. (It is also possible that low expected returns for both stocks and bonds cause them to arrive at the same allocations as before.)

That said, the logic behind the long-term return expectations of these firms is usually well supported. As with, say Vanguard, their ten-year US equity returns are based on currently elevated valuations and low dividend yields, delivering about a 5% expected return per annum through 2031.1 This is roughly half of the 10.6% average annual returns that investors have earned over the past 30 years.

If these returns turn out to be correct, then investors will need to seek other avenues for appreciation if they are to meet their asset growth objectives.

Looking Beyond Traditional Assets

Institutional investors have long sought to diversify their sources of returns, finding fertile ground in private equity, private credit, real estate, and venture capital. They may not have had lower S&P 500 return expectations in mind when they added private investments to their portfolios, but the 490bp return premium2 on private versus public equity over the past 20 years still provided ample motivation to make a shift.

It is important to note that the 20-year record of outperformance, referenced above, was driven to some degree by the elevated valuations of public equities in the year 2000. The so-called “lost decade” in the S&P 500 was a consequence of the elevated valuations of technology firms at the start of the period — and the more defensible appraisals at the end.

How similar is that environment to today’s lofty multiples?

As the chart at the right illustrates, an analysis of ten-year returns periods from private equity versus the S&P 500 shows two things: The rebound of public equities from that lost decade, and the far greater cyclicality of public market returns versus private. The most recent leadership of public equity versus private coincides precisely with elevated valuations on public shares. It can be argued that this performance advantage could therefore be temporary, completing the 20-year cycle.

Public Markets Benefited from Liquidity

In the COVID-19 environment, accommodative monetary policy has boosted money supply. McKinsey estimates that central banks have injected $9bn into financial assets worldwide in the current environment versus only about $2bn during the 2008-09 financial crisis.3 It is widely assumed that a large share of this money has made its way into the public equity markets. This, along with a larger pool of retail investors, has resulted in elevated valuations among US public equities.

Private equity acquisition multiples have also risen modestly over time, but then fell back during the pandemic while public equities continued to climb. The presence of low borrowing costs for private deals is clearly correlated with the low interest rate effect on public equity multiples. It is much harder to argue, however, that central bank liquidity has filtered into private equity flows. More than $2.5tn of dry powder held by buyout firms has been a fixture for several years and is not a recent phenomenon.

Can Private Equity Lead Again?

Investors can surmise that large buyout firms must do increasingly larger deals. Studies also show that higher entry multiples are directly related to lower fund returns.5 Taken together, the outlook for PE is tempered by the inevitable presence of mega deals and high valuations. It then follows that the lower and middle market segments should have less difficulty placing capital and may not be burdened by elevated entry multiples.

Altera’s focus on this segment, and primarily with funds that favor lower valuation multiples, leads us to expect a wind at the back of such funds. We see such skilled private capital allocators continuing to add value for firms positioning for a founder’s exit, seeking growth capital, or desiring financial and operational resources during a difficult environment.

Relative to overpriced public equity indexes, lower and middle market private equity has the potential to both diversify and enhance investor returns over the coming decade.

Altera Investments conducts due diligence on a wide array of private equity managers and sponsors in the middle and lower market. Our objective with this research is to create vehicles that allow investors to take advantage of specific niche strategies in areas that we have identified as attractive in the current environment.

Today, we are sharing a model success story of how managers can get things right, exiting a position at three and even four times their cost in just a few years. Private funds typically have strict confidentiality guidelines, but we can share generalities that are illustrative of industry best practices and how private equity “works”.

Creating Value to Deliver a “Win”

Altera begins by targeting investments that are consistent with our view of the macro environment at the time. For example, in 2020, the US was in the latter stages of the 10+ year bull market and economic expansion, so Altera chose to err on the side of caution, selecting funds with durable strategies, less leverage and strong “value” underpinnings.

PE managers have varied approaches to their craft, but Altera focuses on funds and strategies that address lower-to-middle market companies. In our view, more durable and successful funds work in this less-traveled segment and are particularly choosy about the valuation of their acquisition targets.

As we have recently seen, it is common for a PE manager to team up with other investors (and talent) to elevate their acquired companies to a higher level of competency and scale. Their objective in doing so is clear: Together, they can exploit an opportunity that seems just out of reach.

This team of investors brings in new management and additional capital with the clear objective of accelerating and scaling what is already present. They utilize some borrowed money to acquire the position more economically, without diluting their ownership, potentially multiplying their gains if successful.

Importantly, the target company’s original ownership group needs to agree that the addition of new resources could help it achieve more that would be possible on its own. In other words, by giving up some equity, two plus two could equal five. Or perhaps ten.

When their efforts start to bear fruit with accelerated growth, the portfolio company has the capacity to satisfy a larger clientele. If that new customer is thinking strategically, it may see an advantage in keeping its competitors from doing the same. The “win” is when this customer becomes a strategic investor, deciding to take a controlling stake in the company. And the portfolio company is now much larger, so its exit valuation should be several multiples of the PE firm’s cost.

In summary, the investor team identifies an opportunity and an ownership group that is receptive to some help. They have a clear “exit” mindset from the start and build a better and larger company to take advantage of the opportunity before them.

The Investor Experience

The investor “subscribes” to a private equity fund, committing a certain dollar amount of this investment. Their decision is likely based on the fund team’s past track record, quantitative and qualitative measures of competency, and on the positioning of the fund for the current and expected environment. They are hoping that the Internal Rates of Return (IRR’s) earned by this manager’s past funds would hold true again. But they may have to wait for eight years, or more, to fully earn those returns.

Occasionally, no money moves in the first months after this commitment (creating a bit of confusion on the part of some investors.) These early ownership months can be decidedly dull, as a fund methodically finds deals that meet their strict criteria. In fact, until cash flows accelerate from fund investments, the Net Asset Value (NAV) of the fund can decline (as shown below) in what is known as the “J-Curve”.

Periodic capital calls are evidence of the team’s activity, however. Within the first few years, a fund will have amassed stakes in a handful of companies, calling a significant portion of the capital.

Between the time of acquisition and the ultimate exit, PE managers will have to deal with a variety of issues, both general and those unique to their companies. In 2020, for instance, PE managers had “damage control” responsibilities, supporting portfolio companies, and making sure that the firms were taking the necessary steps to survive in the new COVID-19 environment.

In Altera’s case, choosing a private equity managers with an emphasis on resilient companies acquired with little debt was prescient. It was intended as a defense against a more difficult environment – not a pandemic. But this approach served its purpose in this new setting.

Winners and Losers

Private equity funds likely have anywhere from ten to thirty positions, and any one of them can produce returns of several hundred percent (typically referred to as “Multiples of Invested Capital”.) But, by the same token, companies can fail or deteriorate for any number of reasons. It is not unusual to look at the list of positions held by a PE fund and see some that are held at 0.2x their original cost. Diversification, therefore, is key.

Over time, fund managers have a deep incentive to build value: They get a portion of the profits. Part of any robust analysis is to scrutinize the fund’s the fee structure to make sure that incentives are well aligned between the manager and the Limited Partners. In fact, this is a high point of working with many of Altera’s chosen managers. Their fee structures need to be “LP friendly”, with a relatively high bar to be crossed before they earn any incentive compensation.

Investors receive distributions over the life of the fund as exits are consummated. But by the end of the fund’s target life span (7 – 10 years), some positions will likely still remain. It may take a while longer for the managers to find buyers for these remaining positions, but in all likelihood, these are a small part of the total value of the fund. And like the funds in question here today, investors should have earned the bulk of their returns on the other positions that have previously been sold.

In the end, we are hopeful that these General Partners of our funds get very rich. Because that means our investors will have built their wealth, too.

For many years, the default allocation for a large number of investors has been the “60/40 Portfolio” — an allocation so titled for its 60% portfolio weight in stocks and 40% allocation to bonds.

The conditions that made this allocation work so well, however, are no longer in place. In this article, we outline other options that should help investors to meet their financial goals without taking on large amounts of additional market or credit risk.

THE 60/40, AND A NEW APPROACH

The simplicity of this allocation was part of its strength. Over the years, its ability to mitigate volatility without a big reduction in performance made it valuable to investors who wished not to endure the full volatility of the equity markets. To use a badly worded metaphor: One could have their cake and eat it, too.

This attractive mix was possible thanks to two factors that no longer exist: Relatively high interest rates and fair valuations on stocks. A 40-year decline in inflation and interest rates created a wind at the back of both stocks and bonds, pumping up the returns of both. And now, bond yields are in the very low single digits and stock valuations are approaching all-time highs.

What is an investor to do when the wind that was once at one’s back is no longer blowing?

To make the 60/40 work in the current environment, investors need to take on different portfolio exposures and different risks. Low yielding bonds need to be replaced by, or at least supplemented with, higher yielding vehicles. Overvalued stocks need to similarly be paired with more attractively priced choices.

Put simply, investors should look at assets in the private markets. All things equal, private investment valuations should be below those of the equivalent investments in the public markets and yields commensurately higher, as compensation for the lack of trading liquidity.

But what if this lack of liquidity was a benefit, not a drawback? By definition, an asset that is priced monthly, or quarterly, will have less volatility than one whose price updates every second. That does not reduce the chance of principal loss in a private investment, of course, but it does mean that such vehicles in a portfolio could create a smoother ride for the investor.

Both affluent investors and institutions have liquidity needs that need to be carefully monitored. But those same investors likely have a portion of their portfolios that will remain invested for years or even decades to come, with no need for funds to be distributed. Investors who create a budget for illiquid investments can harvest the returns associated with that lack of trading liquidity.

PRIVATE CREDIT

The opportunity in private credit was created, in part, by the increased scrutiny of bank lending activity. Higher capital costs associated with loans to mid-sized firms effectively forced banks into to the larger end of the lending market, creating an opportunity for private lenders to fill the void.

For bond-like investments of similar credit risk, a private credit vehicle will typically post yields higher than those of the public market equivalent. A study by TIAA Global Asset Management found that private loans carried an “illiquidity premium” of 100-200 basis points (1-2%) versus syndicated loans, despite a lower default rate.

Middle market lending has even higher interest rates than one finds in the public or large corporate market, on top of the illiquidity premium. In fact, it is not unusual to find private lending vehicles yielding upwards of 9%. It is also important to note that private loans could be based on floating rates, reducing the interest rate risk of the instrument to the investor should rates rise.

There are many different segments of the private lending market, with varying risk and return characteristics. Investors are wise to carefully consider the characteristics of each one. The bottom line is that this segment is decent place to look for possible portfolio yield enhancement.

PRIVATE EQUITY

The catch-all term of “private equity” is used here to include private investments across a wide array of categories from private real estate to infrastructure to venture capital.

The characteristics of such investments will vary greatly, of course, but a common theme across many of them is higher cash flows to investors versus publicly traded securities. It is not unusual to see private investments with cash flow yields between 5 and 7 percent. In the public equity markets, the S&P500 has a current dividend yield of less than 1.6%.

The attraction to these asset classes has been their historic return premium over listed equities. Cambridge Associates estimated this return premium to be 500bp per year over the 25 years through 2016. Similarly, retirement fund CalPERS (in the graphic below) showed a 500bp return advantage for their private equity investments over their public ones over a 20-year period.

Investors are cautioned that averages can be deceiving. The so-called “vintage year” of a private fund is among the most important factors in determining whether a particular fund does better or worse than the average. Years following recessions have typically been among the better vintages for both venture and private equity funds.

Niche-focused lower and middle market strategies often overlooked by large, mainstream investors and purveyors of mega-sized private funds. These strategies are difficult to execute at a $1bn scale. And they often rely more on micro-level strategy execution than macro-level valuation upgrades. Their “alpha”, therefore, is dependent on different drivers than those that impact the broader market, making them potentially better portfolio diversifiers.

CONCLUSIONS

Investors can draw conclusions from the relative success of other investors who have walked a similar path. Cambridge Associates tracks hundreds of institutional investors with varying allocations to alternatives. Their simple conclusion (in the chart below) was that the most successful of these investors were the ones who allocate more than 15% to alternative investments, averaging more than a 1.8% return advantage over those who allocate just 5%.

In the current environment of low interest rates and richly valued stocks, these lessons can be liberally applied to the 60/40 portfolio. Individual investors and small institutions have the added benefit of being able to execute niche alternative strategies to potentially enhance their long-term returns.