Follow the deals: To thrive in private equity, back a good fund manager
The private equity market has been growing rapidly, driven by increasing accessibility that has opened the traditionally institutional asset class up to retail investors. Those seeking consistent returns should back strong managers and look for long-term secular growth trends, industry leaders said, while emphasising that caution is key.
Speaking at The Inside Network’s Alternatives Symposium in Melbourne, David Chan (pictured, centre), MLC’s head of Asia – private equity, and Federation Asset Management CEO Cameron Brownjohn (pictured, right) touted PE’s defensive characteristics – funds typically see higher returns in recessionary years. Private markets also feature information asymmetry that can create opportunities not available in public markets.
“People will allocate to the private equity class for a range of reasons, including relative performance and diversification,” Brownjohn said in a session called Private markets – the power of deal flow. “Particularly with where the macroeconomy is heading, a key reason is increasingly the safe-haven nature of the asset class.”
Systemic tailwinds are also driving the growth of private equity. Companies are staying private for longer, thereby amplifying opportunities in private equity, in what Chan and Brownjohn believe could be a decades-long shift in public-private market dynamics.
“We see this as a very important global market,” Chan said. “We see companies staying private longer and the number of listed companies declining as a secular trend for the long term.”
Avoid the one-hit wonder
Chan noted that the high level of dispersion in private equity makes manager selection critical. “Essentially, the difference between a top-quartile-performing fund and a bottom-quartile performer in private equity is up to 20 per cent IRR [internal rate of return].”
He recommended that, to generate consistent top-quartile returns, private equity investors should be backing individuals, not funds – those that have a demonstrated track record but are still motivated. Also crucial is having a “great alignment of interest” with a manager who has skin in the game.
“If you’ve got most of your personal wealth invested in your own fund or in your own idea, you are showing a lot more conviction than someone who’s getting rich off the management fee in private equity.”
Chan cautioned against backing a “one-hit wonder” private equity manager; instead, “you want an operationally focused toolkit”.
He noted that MLC has increasingly been partnering with specialist managers, particularly in technology, healthcare and other verticals the fund targets. “Historically, the market has been full of generalist managers,” he said. “Increasingly, we need to see that operational value-add – we’re looking for partners. But, ultimately, alignment of interest is what we look at.”
A sweet spot amid volatility
Discussing the lifecycle of private equity, from venture capital through to late-stage growth, Chan said MLC has refocussed its book on the mid-market buyout segment in light of the backdrop of rising interest rates and higher inflation.
“It’s not to say there isn’t money to be made on all bookends of the private equity spectrum,” he said. “But the venture capital end tends to be more illiquid and volatile – if you want to invest more heavily in that segment, it probably warrants a smaller allocation of your total portfolio, and you should think about having a longer hold period.”
At the other end of the spectrum, more mature companies are also generally subject to volatility because they have a higher degree of financial leverage, Chan said. “In the mid-market, you’re taking more of an operational risk to transform the business with a lower level of debt.”
Mid-caps, with market capitalisation between $1.5 billion and $2 billion, are the “sweet spot”, he said. “Some of these companies have developed a sustainable mode: they’re profitable now, out of the venture-capital and early-growth stage, but not so big that it’s hard to double or triple the size of the company or find strategic partners when you want to exit the company.”
According to Brownjohn, areas of strength in the domestic private equity marketplace include sectors that focus on the changing demographic and healthcare needs of Australia. He noted that one advantage of private markets over public is the ability to obtain negotiated outcomes for investors.
Nonetheless, due to the “nontrivial risk of an inflation-driven recession or a low-growth and high-cost-of-capital environment”, Brownjohn said, “the way we’re underwriting opportunities at Federation is cautiously”. He noted the company invests in less than 1 per cent of the companies it considers.
“Caution and recession are okay when you invest through the private equity asset class,” Brownjohn added. “In fact, private equity funds that invest through recessionary periods have exceeded the investment returns achieved in non-recessionary periods.
“Frankly, we are cautious going in but excited about what opportunities we can find in the current environment.”