Alternative investments
Alternative investments
Podcast
13.4.2023
International trouble spots, such as global supply bottlenecks and the war in Ukraine, caused severe market turbulence in 2022, affecting both equity markets and private markets.
While 2021 was an outstanding year for private equity investors, company valuations and the number of deals declined in 2022. The number of exits (sales) by buyout funds also fell significantly, with IPOs in particular coming to a virtual standstill. This picture has not changed much to date.
In addition, longer holding periods for portfolio companies are to be expected, which primarily affects the IRR (the average mean annual return on the investment) of investors. Investors will therefore have to be patient before they receive distributions from the funds.
While company valuations reached a global high of 13.0x across all sectors in 2021 and 17.4x in the IT sector (enterprise value / company profit*), they fell to 10.9x and 11.6x respectively in Q2 2022. The number and level of transactions in technology stocks in particular has fallen significantly. For investors, the changed investment environment may offer the most attractive entry opportunities in years. The opportunity lies in buying: private equity managers can take advantage of temporary market distortions to generate more attractive long-term returns.
A look at the venture capital market shows that exits have also fallen significantly this year and venture capital funds are acting more cautiously than before. In the late stage/growth financing phases in particular, there is a conflicting expectation gap between founders and investors.
This is not least due to the fact that founders are reluctant to enter into a new financing round due to the current low company valuations. This is offset by the expectations of investors, who are not prepared to pay the same high prices of the past in view of the changed market environment. A clear decline in company valuations can be observed in the transactions of recent months. Many founders have already arrived in the new reality and the expectation gap is increasingly closing. New investors are therefore also finding more attractive entry valuations here.
What at first reads like a gloomy forecast may actually offer investors the most attractive entry opportunities in years.
First of all, the direct comparison between private equity and equities speaks for itself. The figures underline the fact that private equity not only generates higher returns, but also performs more robustly than the stock market in times of crisis.
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In the more than 20 years since 2000, the return (IRR) on private equity funds (buyout) was 12.1% p.a., while US equities were at 7.2% p.a. and global equities at 6.0% p.a.. During the five biggest price falls, the risk of loss for private equity was also between 11 and 19 percentage points lower than for the equity market (cf. S&P 500 TR, MSCI World TR).
If we also look at private equity funds that were launched during a period of crisis, we see above-average performance potential (see chart below).
.png)
The funds launched during the 2008/09 financial crisis and subsequent years recorded a sharp rise in returns. However, new capital commitments by investors fell significantly compared to the pre-crisis period. As the chart shows, the private equity market has recorded an annual increase in capital commitments since 2010.
This scenario could repeat itself in the current environment. Annual capital commitments fell in 2020 due to the Covid pandemic, rose again in 2021 and fell slightly again in 2022. It should also be noted that fundraising has slowed down significantly.
For private equity investors, downturns therefore tend to represent an interesting opportunity in which they can deploy their capital at attractive valuation levels.
The opportunities for good performance lie on the one hand in purchasing, as fund managers can take advantage of temporary market distortions to buy companies more cheaply and thus achieve higher returns in the long term. In private equity, however, the performance differences between the best and worst managers are particularly high. Access to top managers is therefore crucial for investment success, especially in times of crisis.
In addition, compared to previous crises (such as the global financial crisis of 2008), private equity managers are now much better positioned and have dedicated expertise, increasingly with a geographical and sectoral focus. This in-depth expertise offers real added value for the portfolio companies. While the use of debt capital (leverage) used to be a key component of generating returns, operational value creation is becoming increasingly relevant nowadays. This approach is not only more sustainable for the portfolio companies, but also more crisis-resistant.
In volatile market phases, many private investors are guided by their emotions and act cautiously. In particular, the longer investment cycle appears to be a disadvantage of private equity from an investor's perspective. However, the exact opposite is the case here: especially in times of high inflation, the longer capital commitment can benefit investors.
Looking ahead, portfolios with diversified private equity allocations are also expected to generate higher returns than traditional portfolios that do not include this alternative asset class. From a strategic point of view, investors should therefore invest anti-cyclically right now and build up their portfolio on an ongoing basis. A good portfolio is characterized on the one hand by the selection of top managers and on the other hand by diversification across regions, strategies, financing levels and years of issue (vintages).
Alternative investments
13.4.2023
Fabian Richter
The challenging environment on both the capital markets and the private markets is putting many investors to the test. In such phases, private equity as an addition to the portfolio can help to generate higher return opportunities compared to the liquid capital market. The performance potential of private equity funds is particularly evident in times of crisis.
International trouble spots, such as global supply bottlenecks and the war in Ukraine, caused severe market turbulence in 2022, affecting both equity markets and private markets.
While 2021 was an outstanding year for private equity investors, company valuations and the number of deals declined in 2022. The number of exits (sales) by buyout funds also fell significantly, with IPOs in particular coming to a virtual standstill. This picture has not changed much to date.
In addition, longer holding periods for portfolio companies are to be expected, which primarily affects the IRR (the average mean annual return on the investment) of investors. Investors will therefore have to be patient before they receive distributions from the funds.
While company valuations reached a global high of 13.0x across all sectors in 2021 and 17.4x in the IT sector (enterprise value / company profit*), they fell to 10.9x and 11.6x respectively in Q2 2022. The number and level of transactions in technology stocks in particular has fallen significantly. For investors, the changed investment environment may offer the most attractive entry opportunities in years. The opportunity lies in buying: private equity managers can take advantage of temporary market distortions to generate more attractive long-term returns.
A look at the venture capital market shows that exits have also fallen significantly this year and venture capital funds are acting more cautiously than before. In the late stage/growth financing phases in particular, there is a conflicting expectation gap between founders and investors.
This is not least due to the fact that founders are reluctant to enter into a new financing round due to the current low company valuations. This is offset by the expectations of investors, who are not prepared to pay the same high prices of the past in view of the changed market environment. A clear decline in company valuations can be observed in the transactions of recent months. Many founders have already arrived in the new reality and the expectation gap is increasingly closing. New investors are therefore also finding more attractive entry valuations here.
What at first reads like a gloomy forecast may actually offer investors the most attractive entry opportunities in years.
First of all, the direct comparison between private equity and equities speaks for itself. The figures underline the fact that private equity not only generates higher returns, but also performs more robustly than the stock market in times of crisis.
In the more than 20 years since 2000, the return (IRR) on private equity funds (buyout) was 12.1% p.a., while US equities were at 7.2% p.a. and global equities at 6.0% p.a.. During the five biggest price falls, the risk of loss for private equity was also between 11 and 19 percentage points lower than for the equity market (cf. S&P 500 TR, MSCI World TR).
If we also look at private equity funds that were launched during a period of crisis, we see above-average performance potential (see chart below).
The funds launched during the 2008/09 financial crisis and subsequent years recorded a sharp rise in returns. However, new capital commitments by investors fell significantly compared to the pre-crisis period. As the chart shows, the private equity market has recorded an annual increase in capital commitments since 2010.
This scenario could repeat itself in the current environment. Annual capital commitments fell in 2020 due to the Covid pandemic, rose again in 2021 and fell slightly again in 2022. It should also be noted that fundraising has slowed down significantly.
For private equity investors, downturns therefore tend to represent an interesting opportunity in which they can deploy their capital at attractive valuation levels.
The opportunities for good performance lie on the one hand in purchasing, as fund managers can take advantage of temporary market distortions to buy companies more cheaply and thus achieve higher returns in the long term. In private equity, however, the performance differences between the best and worst managers are particularly high. Access to top managers is therefore crucial for investment success, especially in times of crisis.
In addition, compared to previous crises (such as the global financial crisis of 2008), private equity managers are now much better positioned and have dedicated expertise, increasingly with a geographical and sectoral focus. This in-depth expertise offers real added value for the portfolio companies. While the use of debt capital (leverage) used to be a key component of generating returns, operational value creation is becoming increasingly relevant nowadays. This approach is not only more sustainable for the portfolio companies, but also more crisis-resistant.
In volatile market phases, many private investors are guided by their emotions and act cautiously. In particular, the longer investment cycle appears to be a disadvantage of private equity from an investor's perspective. However, the exact opposite is the case here: especially in times of high inflation, the longer capital commitment can benefit investors.
Looking ahead, portfolios with diversified private equity allocations are also expected to generate higher returns than traditional portfolios that do not include this alternative asset class. From a strategic point of view, investors should therefore invest anti-cyclically right now and build up their portfolio on an ongoing basis. A good portfolio is characterized on the one hand by the selection of top managers and on the other hand by diversification across regions, strategies, financing levels and years of issue (vintages).
About the author
Fabian Richter
Fabian Richter works as an analyst in the Alternative Investments division and is responsible for the selection and review of investment managers.
Fabian Richter holds a Bachelor's degree in Business Administration from CBS, Cologne, and a Master's degree in Corporate Finance and Financial Engineering from the University of Hong Kong. Mr. Richter also holds the title of Chartered Financial Analyst (CFA®). In addition to his studies, Mr. Richter gained his first practical experience through numerous internships at private equity firms and asset managers.
He began his professional career at HQ Trust, the multi-family office of the Harald Quandt family. As an Associate Partner, he was most recently responsible for portfolio construction and manager selection in the areas of private equity and private debt.
