Highlights from the Private Markets Navigator: Outlook 2020

Offense is the new defense
Against a challenging backdrop of low growth and geopolitical uncertainty, we believe “offense is the new defense” in private markets investing. We seek opportunities to build resilience instead of buying it by focusing on assets with value creation potential in sub-sectors with above-average growth rates.

Private markets outlook
Looking back on what is now the longest (US) economic expansion since the 1930s, we note the unprecedented scale of accommodative monetary policy still driving progress. Although asset prices have rallied strongly, in most cases decoupling from fundamentals, GDP growth has remained modest and far from pre-2008 averages. Valuations for most assets are at the upper end of 20-year historical ranges, and, as the business cycle extends further, they will become more sensitive to underlying growth assumptions.

A pick up in volatility is a typical development for a mature stage in the cycle, and this materialized in the Q4 2018 market correction, which was uncharacteristic in speed but not excessive in scope for a late-cycle correction. Looking ahead, our base case macroeconomic scenario assumes the low growth environment will continue, predicated on the assumption that central banks will maintain loose monetary policies. We also expect valuations to come down slightly from their current frothy levels. However, any deviation from this balancing act of fragile top-down fundamentals, low discount rates, and inflated valuations could result in a more pronounced correction in asset prices.

While we believe the global business cycle has further to run on the back of robust private demand and continued monetary policy support, we have lowered our economic growth outlook to reflect the signs of a cyclical slowdown and increased geopolitical uncertainty, including ongoing trade tensions. Slowing capital expenditure and manufacturing activity were two key drivers behind the sharp decline in US and European corporate earnings. Hiring is coming down from strong levels. Growth in China and several other emerging markets has slowed.

Short term, we do not rule out the possibility of a more pronounced slowdown, particularly in parts of Europe, as already reflected in the data. This is driven by idiosyncratic developments (UK), on the one hand, and by the spillover effects of trade tensions, on the other, given the manufacturing industry’s relatively large share in select economies across the region. In particular, Germany is deeply ingrained in the global supply chain. For emerging markets, given the disparities in fundamental conditions and political risks, our investment approach relies on a case-by-case analysis. We are also weary of currency implications as trade tensions evolve.

Longer term, there are other factors that should keep global growth on a modest path only: overall productivity growth remains low, and record high leverage levels are putting an additional barrier on sustainable credit-led growth. Simultaneously, the advanced integration of emerging markets into global supply chains and structurally lower growth in China is dampening emerging markets growth.

In this late-cycle environment, investors would typically shift their focus toward increased defensiveness by investing in assets offering cash flow security and operating in less cyclical sectors, such as big brands, large-cap companies, and core assets with a bond-like payout structure. This time around, however, these assets come at a significant premium as yields are suppressed and valuations stretched.

Barring another decade of multiple expansion and falling rates, the expected returns for these assets are likely to be mediocre at best, and the vulnerability of their valuations is often high. Disruption risk adds to downside vulnerability, potentially even threatening established large-cap incumbents as consumer preferences and technological innovation evolve. Recent examples include Heinz Kraft, which has not been able to keep up with changing consumer tastes, and traditional car makers, which are being marginalized by electric vehicle innovations.

In our view, investing in what has traditionally been perceived as defensive no longer represents a cautious approach. Investors will need to think differently to generate attractive returns and protect capital. We argue that “offense is the new defense.” Our aim is to identify transformative trends generating higher growth rates across specific sub-sectors. Within these subsectors, we look for companies that enable us to actively build out cash flows and develop valuation resilience at the asset level through value creation and strong entrepreneurial governance. This approach is particularly well suited to private markets investments because the universe of assets operating in attractive sub-sectors is much broader compared to public markets, facilitating a direct exposure to the transformative trends identified.

Private equity
The private equity investment environment remains highly competitive, with valuations near the upper end of historical ranges. The pick-up in volatility in public markets at the end of 2018 and early 2019 had a temporary knock-on effect on private equity transaction volumes. Combined with a more challenging macroeconomic backdrop, this led to a gap between sellers’ high valuation expectations and buyers’ willingness to pay, which, ultimately, meant volumes declined by 30% year-on-year in H1 2019. Market weakness, however, was short-lived, and private equity volumes have since recovered, with high levels of dry powder and very strong competition in the market keeping valuations high.

The one trend that has persisted is the more pronounced bifurcation we see in the market. Stable, non-cyclical assets are trading at record multiples. Recently, we have witnessed several companies change hands at EV/EBITDA multiples in excess of 20x and, in some instances, even 25x. The companies fetching these prices tend to be technology enablers, supported by long-term demand drivers and a high share of recurring revenues. In our view, although these factors mitigate downside risk, they only partially justify exceptionally high valuations given these companies’ inherent sensitivity to changing fundamentals such as growth assumptions.

At the opposite end of the spectrum, we see an increasing number of failed auctions for lower quality assets and/or assets that are perceived as having exposure to cyclicality or disruption risk. Over the last year, within the scope of our investment activities alone, we saw over 100 failed auctions globally. This phenomenon is also driven by asset sales from a number of relatively young private equity portfolios. Given the absence of portfolio management pressures, general partners have the flexibility to stop sales processes if the bid price falls below their expectations.

As part of our “offense is the new defense” investment philosophy, more so than ever, identifying sub-sector trends that generate higher top-line growth and value creation opportunities at the asset level is vital for achieving attractive returns. This approach allows us to build more resilient valuations and, in turn, should enable companies to be more insulated from economic swings. Finally, we remain prudent in our underwriting by factoring in multiple contraction for potential investment opportunities.

Private real estate
Global real estate valuations remain high, supported by continued demand and low interest rates and notwithstanding softening GDP growth clouding the prospects for rental growth. After a strong investment year in 2018, we have seen a 9% drop in global real estate investment volumes in the first half of 2019 compared to the same period in 2018. We believe that this is due to a combination of economic growth concerns and the impact of political uncertainty. For instance, investment volumes in the UK have fallen by 35% year-on-year during the first six months of 2019.

Competition for core assets remains particularly high, and prime office yields are currently below 3% in key European locations such as Berlin, Frankfurt, and Paris. These low yields reflect investor sentiment that core assets offer defensive qualities supported by an element of income yield. However, at these valuations, core assets are particularly at risk should there be a change in the accommodative monetary policy adopted by central banks and should valuations revert to long-term averages.

Given strong competition in the market and the threat of an economic slowdown, we believe smart investing must combine both offensive and defensive thinking. This means we seek assets that provide both value creation potential and downside protection. To originate these assets, we continue to focus on strong locations that benefit from fundamental demand drivers, such as population and employment growth, and favorable real estate fundamentals, such as low vacancy rates and the limited threat of excessive new supply. We are prepared to pay market prices as long as we know the fundamentals will provide a tailwind from a relative value perspective. Conversely, we avoid seemingly attractively-priced properties in locations or segments that face headwinds and are not well positioned to withstand the cycle.

For office and residential assets, we look to identify gentrifying suburbs that offer live-work-play environments with plentiful amenities and good public transport connectivity that appeal to a growing millennial workforce. These locations also offer interesting opportunities for last-mile logistics assets, which facilitate the fast delivery of goods from logistics hubs to end users and which cater to rising e-commerce penetration rates.

Private debt
Despite signs of slowing global growth and rising volatility in capital markets, demand for private debt remains strong, with total assets under management at a record high. Although senior loan issuance has eased in 2019, the private debt market continues to be borrower-friendly. Loan documentation in many parts of the market is weak, with high shares of covenant-lite structures in the syndicated space. In this environment, underwriting discipline and access to attractive transactions remain key. This means having strong relationships with sponsors to help source transactions and the ability to provide comprehensive, tailor-made financing solutions at an appropriate risk-adjusted pricing.

Source: Partners Group (read full report)

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