Introducing the Back to the Future strategy, a dynamic approach to private equity investing focusing on underdeveloped markets throughout Southeast...
Seeking Alpha: A Deep-Dive into Private Equity’s Extended Outperformance
A high-risk tolerance and the ability to handle significant illiquidity are necessary to participate successfully in private equity markets
Private equity is a source of investment capital from high-net-worth individuals and institutional investors, defined as a managed pool of raised or borrowed funds used to obtain an equity ownership position in an entity that is not listed or traded publicly.
Undoubtedly, a high-risk tolerance and the ability to handle significant illiquidity are necessary to participate successfully in private equity markets. However, for the past two decades or more, private equity has enjoyed a long winning streak – the US Private Equity Index from Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20-year period ended 30 June 2020. Over the same period, the Russell 2000 Index, a performance tracking metric for small companies, averaged 6.69% per year, while the S&P 500 Index returned 5.91%1.
Similarly, JPMorgan Asset Management data revealed that private equity funds since 2009 have delivered between 1% and 5% in excess annualised returns (net of all fees) over the S&P 500 Index2.
In the aftermath of the bursting of the internet bubble (2Q 2000 to 1Q 2003), private equity investments outperformed public markets by 6% in North America and 20% in Europe on an annualised basis, while during the financial crisis from 3Q 2007 to 1Q 2009, private equity investments beat public market indexes by 19% in both North America and Europe on an annualised basis, data from Partners Group showed3.
Extended Trend of Outperformance
Looking ahead: private equity as an asset class is expected to continue outperforming the public markets, driven by valuations, ability to structure investments, usage of debt, long investment timelines and the liquidity premiums between a public company and private company valuation multiples.
First and foremost, purchase price multiples in private markets are usually more disciplined and subjected less to the hubris of public markets. Public market valuations can sometimes be skewed to extremes due to varying factors that include sentiment, algorithmic trading, forced selling from margin calls and the growth of passive asset allocation strategies, such as ETFs. On the other hand, private markets, while less liquid, focus on bilateral negotiations involving more sophisticated investors who are typically less emotional, and value assets after a detailed due diligence process and valuation analysis.
Next, private equity has greater room for the use of debt as a tool as compared to public companies, thanks to reduced regulatory and investor scrutiny. This results in higher leveraged returns since the cost of debt is lower than the cost of equity. Interest cost from debt financing is also tax-deductible, as it can be treated as an expense in the accounts.
Private companies also have the benefit of being able to resolve their problems privately, out of the public realm. There is the added advantage of being able to manage their stakeholders more effectively, and in most cases, by circumventing bureaucratic red tape and being out of the public eye.
Yet another boon is the extended investment horizon of up to 10 years in private equity markets, which allows company management to take a longer-term view of the company’s strategy, not only for investments but also for capital expenditure. In comparison, public equities are marked-to-market every day, spurring company management often to focus on short-to-medium-term strategies that drive stock prices.
These longer time horizons also mean private equity fund managers have more control over the sale of the investment by targeting the most attractive means of exit (IPO, trade sale or secondary sale) based on market conditions. They can structure exits at the most opportune time, unlike investments in public equities, where assets are priced by market forces daily.
Access to Broader Investment Opportunities
Companies that fall below certain thresholds in size and profitability are often excluded from public market listings and can only be accessed through private equity. These companies, usually in the early and growth stages, do not qualify for minimum market capitalisation requirements that stock exchanges have, are unable to afford listing fees, or generally do not presently view a public market listing as a strategic move.
Nonetheless, among them are some that possess strong qualities of a valuable company to invest in robust business models, favourable steady-state unit economics, large and growing addressable markets and management teams with proven ability to execute.
With access to these businesses made available through the private equity asset class, addressable investment opportunities and the potential for portfolio diversification are expanded, providing room for enhanced risk-adjusted returns.
Value Creation in Private Equity
While larger publicly listed firms can employ the expertise needed to pursue growth, private equity-backed companies have the added advantage of leveraging their sponsors’ networks, operational expertise, and in some instances brand equity, to seek out additional avenues for growth. These sponsors, by virtue of their vested interests, are fully motivated and aligned towards driving maximum value creation and are a powerful supporting act to company management.
Coupled with the investment periods typical of private equity, long-term strategic decisions aimed at magnifying company value can be executed in partnership with and support from private equity sponsors.
Illiquidity Discount vs. Liquidity Premium
Private equity investors also benefit from being able to buy private companies with an illiquidity discount, compared with public market investors who pay a liquidity premium. This multiple arbitrages between private and public company valuation multiples can be a major contributor to returns for private equity investors, outside of the company’s revenue and earnings growth.
For example, if you purchase a company for US$100 million and it makes earnings before interest, tax, depreciation, and amortisation (EBITDA) of US$12.5 million, this is equivalent to an 8x EV/EBITDA multiple. If over the next five years, EBITDA grows to US$25 million and you sell it at the same multiple of 8x (assuming zero dividends and no leverage), the internal rate of return per annum is 15%. However, if the company is listed at a 12x EBITDA multiple due to public company liquidity premiums, even without accounting for the uplift from the excess cash generated by the business over this period, the internal rate of return jumps to 25% per annum.
Not surprisingly, the outlook for private equity markets over the next few years remains buoyant – especially for Asia, which now makes up more than a quarter of the global private equity market. In particular, the Southeast Asian private equity market staged one of its most impressive runs in history in 2021, with overall deal value reaching an all-time high of US$25 billion, more than double 2020 levels4.
No doubt, private equity is still relatively nascent in Southeast Asia, given the historical dominance of family conglomerates in the region that owns large swathes of each individual country’s economy, but the sector remains primed for an exciting decade ahead, as the market continues to evolve and grow.
At Aura Group, key factors that have driven robust returns for our private equity investments include a market-leading position in a sizeable total addressable market, consistent strong financial performance, and most importantly, a passionate management team.
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