Private assets' role in a diversified portfolio
Private assets are an increasingly important source of returns and diversification. Shaniel Ramjee, senior investment manager, Multi Asset, takes us through the opportunities private markets offer, as well as the risks they pose.
Written by
Shaniel Ramjee
Co-Head Multi Asset London
Q: What do you see as the defining features of private equity – both as companies and as investments?
A: There are many reasons why companies might choose to remain private. They might be family owned, or not want to be subject to the administrative burden of public listing, or to the short-termism imposed by quarterly reporting. Typically they are in a different part of their lifecycle – usually at an earlier stage – from publicly-traded firms. They might have just found their niche in the world of business and are starting to grow. It’s at a stage where a lot of exciting things happen to some of these companies. And where a bulk of their returns is often generated. So for investors to be able to access investments at this stage is particularly interesting.
Q: Does it make any difference being a Europe-based private equity investor?
A: Europe has a long history of private companies, many of which have been in existence for decades and controlled by a founding family. These companies are extreme specialists in what they do. And there are lots of them – there are 23 million small and medium-sized enterprises (SMEs) in Europe, employing two-thirds of the region’s workforce. But we see with increasing frequency in these companies that younger generations are less involved in the business, or indeed, a first round of professional managers have stepped into the business hoping to expand or grow it.
Private equity can be one of the ways in which they do that without relinquishing family control. So they're able to get financing through the private markets but still retain that ability to have that long term management style, long term vision in terms of where the company is going and how to grow it. They don't need to go to the public market. They can align themselves with private equity capital, which has a similar mindset to that long term investment style. Private debt becomes important here too – historically, these companies were much more dependent on bank loans, but these can be relatively inflexible compared to contracts that can be struck with private lenders. But for the most part private lenders have focused on larger companies, so it’s a wide open field for new entrants focused on SMEs.
Fig. 1 - Private trumps public
Performance of Private Equity Buyouts vs S&P 500, rebased Dec 2000 = 100
Q: Ultimately, is what makes private assets special the fact that they are illiquid and that investors expect to be paid a premium for holding illiquid assets?
A: The illiquidity premium in and of itself doesn't garner extra return. It's what you do with that illiquidity that matters. So, for example, private companies are able to set longer term objectives, longer term goals, which management can work hard to achieve without having to focus on the market’s quarterly reporting demands. We believe that illiquidity in itself doesn't generate the return, it’s the value creation it allows that does.
It’s also important for investors to really understand how much illiquidity they can manage in their portfolios. They need to realise the degree to which leverage was employed in private equity and to have a very clear understanding of what the value creation proposition was in private equity deals, especially now that interest rates have gone up.
Q: Have rising interest rates altered the landscape for private equity?
A: I think it's an important question because the frothiness of markets that we saw at the end of the last cycle, especially in growth markets, meant that price-to-earnings multiples in private equity also expanded quite substantially.
There was a lot of value creation through balance sheet optimisation – using cheap debt instead of more expensive equity. Now it’s important to understand how best to finance companies in a world where interest rates are higher as we have now. We believe that earnings multiples can still grow, but for different reasons, and one being the ability to build conglomerates of companies so companies that fit well together and are worth more than the sum of its parts. And that's an interesting evolution, we think, the next cycle for the private equity market will involve finding groups of companies to put together, that will create a much more interesting new company at the end of it. We think that value creation is going to have to come a lot more from how to get the best out of a company’s operations – such as through geographic expansion or integration of the value chain – rather than through financial structures.
Q: What do rising interest rates mean for private debt?
A: It’s certainly a challenging environment. And given the risks of volatility means it makes sense to focus on defensive sectors – healthcare, education, business services and software. These are naturally cash generative and have low correlations to the wider market. This makes it easier for them to generate profits even in uncertain times. It also becomes even more important to structure contracts with suitable covenants, particularly on interest cover and maximum leverage – and then assessing these metrics frequently.
Private assets in a multi asset portfolio
Alen Mattich, Senior Investment Writer discusses private assets with Shaniel Ramjee, Senior Investment Manager at Pictet Asset Management.
Source: Pictet Asset Management.
Q: Rising interest rates have clearly been a wider risk for the markets, but are there any risks that are specific to private assets?
A: Due diligence is crucial. We know that, on the face of it, these companies are slightly less transparent than those in the public markets. So what investors in private equity partnerships need to understand is how these due diligence processes are undertaken and the guiding philosophy of each private equity transaction that is undertaken. Meanwhile, private equity teams need to be able to source deals in a competitive landscape.
Vintage diversification – holding a spread of investments in private equity companies, coming due in different years – therefore, is extremely important because we know once we're invested, we are invested for quite a long time, we might be able to choose when we start investing, but when we start after that, there's very little we can do about the economic environment. So understanding how the thinking behind investments that are being made in various economic environments is extremely important in that risk management.
Exits are also important. When conditions for initial public offerings (IPOs) are robust, taking private companies public becomes more likely. But in some market environments this is more difficult. In those circumstances, expertise in trade sales becomes necessary, that’s to say selling companies to other parts of the value chain – mergers and acquisitions that build conglomerates that become worth more than the sum of their parts.
Q: What does that sort of concentration imply about the relationship between investors in private markets and the assets they hold?
A: In all private markets, the investor or the manager is very close to the companies in which they invest. It really is an active approach.
They're close to the boards. They often have seats and they are able to draw on not just their capital to fund the growth of these companies, but also their know-how, their expertise, their operational excellence to build these companies over time.
That’s not just private equity, but private debt and private real estate.
For example, in private debt, investors can write specific needs or objectives into the contracts they make with borrowers, in other words the terms and conditions of the loans.
These can be around key points of company performance or even something broader – think about sustainability of a company in terms of its environmental impact and goals around that. For example, if the company has a target of, let's say, reducing its carbon footprint over time, the contract could be written such that the coupon on its borrowings drops once the target is hit. Its borrowing costs drop. But the investor benefits because in hitting its targets, the company becomes more secure and its credit rating rises. Everyone wins. In a way, private markets offer a much more active role to investors.
In many cases, this develops into a very strong symbiotic relationship between the private equity or debt managers and the companies in which they invest. That is true active investing.
Q: As an asset manager, does it make a difference to you that the firm you work for is also privately held?
A: Absolutely. I think at Pictet we understand uniquely what strength private structure gives us: the ability to think long term; to invest long term; to be able to be contrarian at times; and to think about what truly matters in terms of growth. It is always about the quality of that growth, not just the quantity or the speed. And we appreciate that.
related articles
Demystifying multi-strategy hedge funds
A niche investment two decades ago, multi-strategy hedge funds have grown in popularity. As one of the pioneers of the approach, we look at its benefits and potential pitfalls.
May 2022
Why invest in real estate?
Many people already invest in real estate through owning a home. Investing in a real estate fund however can bring numerous benefits to your portfolio.
September 2022
The sweetspot in European direct lending
When it comes to European direct lending, we believe that small is beautiful. Here is why.
April 2023
Important legal information
This marketing material is issued by Pictet Asset Management (Europe) S.A.. It is neither directed to, nor intended for distribution or use by, any person or entity who is a citizen or resident of, or domiciled or located in, any locality, state, country or jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. The latest version of the fund‘s prospectus, Pre-Contractual Template (PCT) when applicable, Key Information Document (KID), annual and semi-annual reports must be read before investing. They are available free of charge in English on www.assetmanagement.pictet or in paper copy at Pictet Asset Management (Europe) S.A., 6B, rue du Fort Niedergruenewald, L-2226 Luxembourg, or at the office of the fund local agent, distributor or centralizing agent if any.
The KID is also available in the local language of each country where the compartment is registered. The prospectus, the PCT when applicable, and the annual and semi-annual reports may also be available in other languages, please refer to the website for other available languages. Only the latest version of these documents may be relied upon as the basis for investment decisions.
The summary of investor rights (in English and in the different languages of our website) is available here and at www.assetmanagement.pictet under the heading "Resources", at the bottom of the page.
The list of countries where the fund is registered can be obtained at all times from Pictet Asset Management (Europe) S.A., which may decide to terminate the arrangements made for the marketing of the fund or compartments of the fund in any given country.
The information and data presented in this document are not to be considered as an offer or solicitation to buy, sell or subscribe to any securities or financial instruments or services.
Information, opinions and estimates contained in this document reflect a judgment at the original date of publication and are subject to change without notice. The management company has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and this document is not to be relied upon in substitution for the exercise of independent judgment. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Before making any investment decision, investors are recommended to ascertain if this investment is suitable for them in light of their financial knowledge and experience, investment goals and financial situation, or to obtain specific advice from an industry professional.
The value and income of any of the securities or financial instruments mentioned in this document may fall as well as rise and, as a consequence, investors may receive back less than originally invested.
The investment guidelines are internal guidelines which are subject to change at any time and without any notice within the limits of the fund's prospectus. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a specific security is not a recommendation to buy or sell that security. Effective allocations are subject to change and may have changed since the date of the marketing material.
Past performance is not a guarantee or a reliable indicator of future performance. Performance data does not include the commissions and fees charged at the time of subscribing for or redeeming shares.
Any index data referenced herein remains the property of the Data Vendor. Data Vendor Disclaimers are available on assetmanagement.pictet in the “Resources” section of the footer. This document is a marketing communication issued by Pictet Asset Management and is not in scope for any MiFID II/MiFIR requirements specifically related to investment research. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any products or services offered or distributed by Pictet Asset Management.
Pictet AM has not acquired any rights or license to reproduce the trademarks, logos or images set out in this document except that it holds the rights to use any entity of the Pictet group trademarks. For illustrative purposes only.