Faring well in a choppy market

If the volatility at the end of 2018 spooked public markets, those active in private equity, dare we say, welcomed it. In 2019, the asset class is looking at further outperformance relative to public markets along with plenty of opportunity to invest its mountain of dry powder.

Private debt continues to be reliant on private equity for dealflow, a trend that a source at an advisory firm says will likely continue this year. And the outlook for private equity is bright in several important aspects. While public equity markets have “been on a tear” in recent years, this source says, the potential for superior returns from private equity, relative to the shares of listed companies, may be attractive to investors.

PitchBook made a similar prediction in its 2019 private equity outlook. While the returns of public and private markets run in tandem in the long run, when rough patches in the economy pop up, private equity returns improve when compared with public markets, even if short-term returns for the asset class fall slightly.

Those private equity firms raising capital for mid-market buyouts may be in a particularly enviable position – almost three-quarters of institutional investors participating in a survey by placement agent Probitas Partners said they would be targeting the sub-strategy. And, of course, that is welcome news for direct lenders.

An eventual downturn this year would, in some ways, be a net positive for private equity firms, and the effects of December’s choppiness have already started to appear in the market.

Valuations have fallen and will likely continue to be in a range much more attractive to buyout shops, causing equity funds to deploy some of the uncalled capital sitting on the sidelines, the advisory source notes. On the credit side of the equation, there was a slowdown in covenant-lite loans in the fourth quarter, one credit manager said, adding that he expected it to continue.

FUNDRAISING DECLINE

One trade-off for private equity in a bear market, however, could be a fundraising slump. That would be the second year of a fundraising decline for the asset class, which raised a total of $352.3 billion, according to data from sister publication Private Equity International. Last year’s total was a drop of more than one-quarter from the $473.2 billion collected in 2017.

One other potential area where private equity firms might feel a little more pressure is loan documentation and covenants. In an overheated market, sponsors have been able to negotiate terms and definitions in credit agreements that once would have caused alternative lenders to stay awake at night. One credit manager notes there was a slowdown of covenant-lite deals done in December, a trend they expect to continue through the first quarter.

The few drawbacks would seem to largely be outweighed by the positives: increased returns in volatile times could convince investors to increase their allocations, and the dry powder sitting on the sidelines could mitigate any retreat in fundraising.