When I participated in the latest meeting of Neuberger Berman’s Asset Allocation Committee (AAC), there was a great deal of discussion about low volatility and high valuations across markets. When it came to aggregating the Committee’s 12-month return outlooks for various asset classes, we bunched around “neutral,” unwilling to endorse strong directional views until a return to volatility created clearer opportunities.
Nonetheless, we did favor some alternative investments. Low-volatility hedged strategies fit the overall view comfortably: When market direction isn’t clear, eking out returns from market-neutral or relative-value strategies is often a good approach. But we also upgraded our view on private equity, and that was a much less obvious call.
After all, none of us was arguing that private equity valuations are cheap.
Multiples and Leverage, Absolute and Relative
The multiples being paid for private companies and the leverage being applied are both undeniably high. To make sense of our favorable view of the asset class, bear two things in mind. First, these metrics are always relative. And second, private equity has unique qualities that complicate the question of whether a high purchase price is too high.
It makes sense to look at private equity leverage relative to history. According to data from S&P Capital IQ, for the past four years, the average debt–to–EBITDA multiple for large leveraged buyout deals has held steady at around 5.8x. Although high, the multiple remains lower than the 6.2x level hit back in 2007. More importantly, the capital structures of private companies are, on average, sounder than 10 years ago. Interest rates are very low; interest rate coverage is also robust at 2.4x versus the 1.6x it fell to in 2007 for large corporate LBOs; debt generally has more flexibility because of few or no covenants; and the average equity contribution to deals is at 40% through the first half of the year.
When it comes to valuations, they need to be considered relative to the public equity markets. The valuation for the Russell 2000 Index in the first half of this year was 13.6x, while the average private company was purchased at 10.3x. Staying out of private equity because of valuations while still holding listed equities is difficult to justify.
Some Unique Qualities of Private Equity
What about those unique qualities of private equity? How do they support our case?
There is the illiquidity premium, of course—but it’s about more than that.
There is generally one driving thesis for buying one exchange-listed public stock rather than another: That stock is mispriced and available for less than it is really worth. Pricing is important in the private markets, too, but it is much less important for the simple reason that a private owner will tend to hold a controlling interest in its companies.
That control brings the opportunity for operational or financial improvements, or changes to strategy that can potentially increase a company’s value. What’s more, those improvements may be related to specific industry knowledge or skills that the private equity owner’s team has, which are not widely shared. That influence is much more difficult to effect in the public markets. It results in much greater potential divergence of opinion on what the “right” price is for a private asset.
That diversity of opinion—and business potential—is compounded by the fact that, in the U.S., for example, the number of public companies has decreased over time, while the opportunity set for investments in private companies has increased. Today, the public markets spurn companies with volatile earnings, even when that volatility is a symptom of activity that can ultimately benefit the company, such as rapid growth, investments in new markets and products, acquisitions or strategic reorientation. But these are precisely the opportunities that long-term private equity investors seek out—and create.
Impact of Timing in PE Investments
An investor in the S&P 500 Index at its pre-crisis peak, in October 2007, took almost six years to get back in the black. If they’d invested in a median-performing private equity fund in 2007, they’d have enjoyed an 8.5% net return, according to the Cambridge Associates Global Private Equity Index. That wasn’t the best you could hope for from private equity, but it was pretty good on a relative basis—and it was good partly because the capital committed in 2007 was actually invested as market prices declined from the peak, and partly because of all the added value that private owners created in their portfolio companies.
And that, in summary, is why the AAC recently upgraded its 12-month view on private equity relative to many other asset classes. There are points in the cycle when listed equities can appear more attractive than private equity, but the point at which prices appear high is not one of them—and that’s because private equity brings a set of tools to an investment that make the market purchase price much less of a determinant of the ultimate outcome.
This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor's individual objectives and circumstances and in consultation with his or her advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
The views expressed herein include those of the Neuberger Berman Multi-Asset Class (MAC) team or Neuberger Berman’s Asset Allocation Committee. The Asset Allocation Committee is comprised of professionals across multiple disciplines, including equity and fixed income strategists and portfolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preferred near-term tactical asset class allocations and, upon request, reviews asset allocations for large diversified mandates. Tactical asset allocation views are based on a hypothetical reference portfolio. Asset Allocation Committee members are polled on asset classes and the positional views are representative of an Asset Allocation Committee consensus. The views of the MAC team or the Asset Allocation Committee may not reflect the views of the firm as a whole, and Neuberger Berman advisers and portfolio managers may take contrary positions to the views of the MAC team or the Asset Allocation Committee. The MAC team and the Asset Allocation Committee views do not constitute a prediction or projection of future events or future market behavior. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed.
This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions.
The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.