Private Equity: The Game That Ends With A Credit Crisis

Submitted by Saxo Bank’s Peter Garnry

Summary: Private equity is one of the worst asset classes during a liquidity and credit crisis. Private equity firms cannot adjust risk because they invest in illiquid assets and their high leverage amplifies returns both ways. The recent decline has reduced the annualised return to 5% since late 2003 significantly lower than the S&P 500 and with worse risk-adjusted metrics. Our view is that it will get worse before it gets better but in the rebound phase listed private equity offers fantastic returns. We provide some inspiration of where to look.

Instruments mentioned: iShares Listed Private Equity UCITS ETF IQQL:xetr, Hamilton Lane (HLNE:xnas) , 3i Group (III:xlon), Apollo Global Management (APO:xnys), Ares Capital (ARCC:xnas), Blackstone Group (BX:xnys)

Private equity has at the center of the lower interest rate environment the past 30 years. In the past 10 years many private equity firms have listed their shares giving the public access to private equity deal and returns. In 2008 private equity and real estate were two parts of the public equity markets that suffered the most. The S&P Listed Private Equity Index declined 80% from May 2007 to February 2009 as the credit crisis forced private equity firms to write down their assets and their holding companies reported lower operating earnings.

The current drawdown is 39% so if we see a repeat of 2008 then listed private equity could decline much further from here. The recent decline has revealed that private equity does not deliver good risk-adjusted returns for shareholders. The annualized return since November 2003 is 5% which is 2.7%-points lower than S&P 500 in the same period and with significantly higher average drawdowns.

The catalyst for these large drawdowns is high debt leverage and high valuation multiples, and the fact that private equity firms cannot adjust their portfolio risk when a liquidity and credit crisis is unfolding. We observe that private equity firms have been valued at a premium to the overall equity markets since 2013. Given the bad risk-adjusted returns we expect private equity valuation to fall below that of the market extending the drawdown from current levels. The financial market is experiencing one giant margin call and private equity firms will be hit as well.

However, when the market bottoms private equity firms will represent a leveraged high beta play. One of the best ways to get exposure to private equity is either through an ETF (IQQL:xetr) or some of the listed private equity firms with solid balance sheets and low default probability. Private equity firms such as Hamilton Lane, 3i Group, Apollo Global Management, Ares Capital and Blackstone group fit these characteristics as of today. But overall we believe more pain is ahead for private equity.