Investor and Consultants’ Outlook for Private Markets Strategies

Valuations reminiscent of pre-crash era, but concerns are mitigated
Research presented by various consultants and investors project their view that the private equity market is fully priced, with valuations and purchase price multiples at record highs. In a presentation to Fresno City Retirement Systems in August 2017, StepStone highlighted data that acknowledged purchase price multiples are at a record high. Year-to-date data reports an average of 11.0x total enterprise value for “global/large companies,” compared to 10.9x in 2007. Consequently, there are concerns on the ability of private equity to maintain its level of returns.

However, some institutions are forecasting that even though returns may flatten, they will still outpace public markets in the long-term.

In a June 2017 meeting, CalPERS staff presented third-party research that posited “Private Equity is forecast to have a lower ten year forward return of 8.7% compared to the actual ten year return of 10.4%. The ten year forecasted returns for Global Equities and US Equities are respectively, 7.5% and 6.9%.”

The risks associated with high valuations and purchase price multiples are also believed by some consultants to be mitigated by the moderate use of leverage within the market: leverage multiples are currently below the levels present prior to the global financial crisis (equity contributions are reported to be around 40%), with the resulting view that capital structures are more durable.

In a private equity program review for Santa Barbara County Employees’ Retirement System, Hamilton Lane staff stated: “Prices are higher, but capital structures should be more durable as the equity contributions continue to remain at a healthier level than 2005-2007.”

With a generally positive outlook, consultants are recommending increases to some US public plans’ private equity allocations. For example, on the recommendation of their consultant Nebraska Investment Council may double their private equity allocation, from 5% to 10% of the portfolio, to meet their return targets.

Outlooks are generally positive, but high valuations and concerns of a late stage market prompt caution

Few US public plans have made significant increases to their real estate allocation in 2017, perhaps in response to research and comments from consultants that point towards parts of the real estate market reaching maturity.

In a client presentation in August, ORG Portfolio Management points towards the maturing of the real estate market cycle as some property types are already experiencing declining fundamentals, namely luxury condos and class B and C malls. NEPC also voices that valuations have appreciated to the extent where some view it as expensive on both a relative and absolute basis, and further growth may be capped by the threat of rising interest rates and supply increase.

This current valuation environment has also created challenges for fund managers and investors alike: managers are finding it difficult to deploy capital in an expensive market with year-on-year deal volume figures on a decline since 2016 – Q1 2017 deal volume totaled just $150bn, compared to nearly $200bn in Q1 2016 – and investors’ portfolios are also being impacted by downward pressure on cap rates.

To combat declining cap rates, consultants are recommending investors look towards value-add strategies to benefit from the income appreciation opportunities present. The effects of this have been felt among core strategies already, with a significant decrease in net capital inflows in 2016 and 2017 compared to previous years. 2016 saw under $1bn of net inflows, and 2017 YTD data is showing a small net outflow, compared to over $6bn net inflow in 2015. With institutions, such as City of Fresno Retirement Systems and Seattle City Employees’ Retirement System making large shifts towards non-core strategies, this trend is expected to continue.

Strong outlook for direct lending opportunities but lenders loosen covenants amidst competition.

The private debt space continues to gain the interest of investors and consultants. Demand for credit in the middle-market remains strong and regulation of the banking sector continues to limit these financial institutions’ direct lending capacity. Consequently, there is a wealth of opportunities for institutional investors to capitalize on. NEPC highlights that in 2007 bank-issued lending made up over 70% of all commercial loans and it is now below 20%. This is anticipated to drop even further with pending increases in the capital requirements of Basel III legislation being introduced through 2019.

While challenges do exist in the form of increased competition from an influx of first-time funds (NEPC reports that in Q3 2016, 36% of direct lending funds in the market were first time funds), uncertainty over continued economic growth and the potential impact of a Dodd-Frank repeal, the sentiment towards the asset class is generally positive.

One potential issue in the market is that issuance of covenant-lite loans has hit an all-time high when measured as a proportion of total institutional debt, well beyond pre-global financial crisis levels. As a percentage of all US institutional loans, cove-lite loans peaked at 29% of the market in 2007, and after a sharp dip during the GFC, have now grown through 2016 to be 70%.

However, consultants who have observed this trend are cognizant of the fact and consequently outline their desire to mitigate their clients’ risk from exposure to cove-lite loans.

Many US public pension plans are creating dedicated private debt targets for the first time at the recommendation of their consultants, with some aiming for significant exposure through a 5-10.5% portfolio allocation.