ERIC DERAM says the inherent agility and long-term nature of private equity have afforded investors and asset managers new opportunities stemming from the pandemic disruptions. As Australia’s private equity market develops and investors continue to seek long-term performance and more efficient governance models, the outlook for private equity is strong.
Assessing companies and investment opportunities on the basis of good management teams, strong and resilient business models with predictable cash flows and a growing end market, are bread and butter techniques used by private equity managers.
But does this still apply when the world is turned on its head during a pandemic? Fortunately yes, because private equity actually benefits from market disruption.
Its ability to quickly reallocate capital makes private equity a fantastic catalyst of change. Using foresight informed by analysis, private equity effectively takes capital away from industries with poor future outlooks and reallocates it to a sector with a better one, for example strengthening and supporting companies operated according to ESG values. And this is what we have seen happen since early 2020.
The COVID-19 pandemic certainly impacted private equity opportunities, splitting sectors into clear haves and have-nots while also making it much more difficult to assess the strengths of business models long term.
Further, agility became much more important, particularly at the company level where business managers needed the vision to adapt and pivot. According to PwCs Global M&A Industry Trends Mid-Year 2021 Report, the acceleration of trends such as digitisation had a knock on effect to private equity:
“COVID-19 gave companies a rare glimpse into their future, and many did not like what they saw,” said Brian Levy, PwC’s Global Deals Industries Leader, Partner, PwC US. “An acceleration of digitisation and transformation of businesses instantly became a top priority, with M&A the fastest way to make that happen – creating a highly competitive landscape for the right deals.”
The pandemic has accelerated change – particularly long-term trends such as working from home and acquiring new technology to make this possible.
Companies shifted to cloud-based technologies and rather than innovating themselves, supported SaaS (using software as a service solution) instead of building a business infrastructure, and fast-forwarded their Environment, Sustainable and Governance (ESG) journey.
Businesses changed how they looked to grow, ignoring the build option and jumping straight to selling unfavoured assets to buy and make the most of investment opportunities.
Yet despite these impacts and changes, the fundamentals of a good private equity deal remain the same – clear business case, clear road map for value creation and sensible valuations. The exception to this has been pricing which has become more complex with more aggressive deal-making due to greater competition for premium assets.
In the wake of the COVID-19 pandemic, private equity managers and investors have sought to avoid sectors where the outlook for the long-term impact of the new reality is unclear. These sectors include those heavily impacted by pandemic lockdowns, quarantining and zero travel zones – such as retail, offices and hospitality.
Although not a good short-term place to be, the dramatic change in market conditions and outlook has presented these sectors with an opportunity to rethink their business models and adapt to new long-term trends such as contactless payment and delivery, and ethical production.
Favourable sectors for private equity investing have been healthcare and technology, perhaps obvious beneficiaries in a world experiencing a pandemic crisis and in lockdown. According to Bain and Company’s 2021 Global Healthcare Private Equity Report, healthcare private equity deals increased by 21 per cent to a total of 380 in 2020, compared with 313 the year earlier, despite a 14 per cent decline in total global private equity activity. Meanwhile, in technology M&A activity, deal value for corporate acquisitions of tech companies crossed $200 billion in each of the last two quarters of 2020, a level last seen more than two decades ago.
As the world begins to emerge from COVID-19, the pandemic has left a lasting impact on private equity and the favourable sectors the market upheaval has highlighted. For example, in healthcare, investment in vaccine development has increased and the likelihood for consolidation is high. Further, there is a lot of pressure on governments to rethink their public health policies and to ensure the delivery of individualised care.
With regards to technology, we anticipate the acceleration of deals in the digital sector and already are starting to see consolidation in the streaming business with Amazon buying MGM and the merger of TF1 and M6 to create a major new French media group for example.
The long-term nature of private equity creates a natural alignment with superannuation as long-term performance and capital appreciation are goals for superannuation funds.
Also in sync is private equity’s active nature where asset owners control investment and have the ability to shape and drive the future which aligns to the long-term agenda of funds and their members.
In Australia, the structure of superannuation funds along industry, corporate and gender lines can effectively organise like-minded investors and make this alignment between private equity and long-term investing even stronger.
But superannuation funds and their members are also looking for yield and there is an added impetus to avail themselves even more to investing into private assets and private equity to achieve their goals. And this is certainly happening – according to the 2021 Preqin and Australian Investment Council Yearbook, Australian superannuation funds boosted their holdings in private capital by $2.1billion (or 9 per cent) in the six months to June 30.
One of the criticisms squared at private equity is cost, however there are a number of trends changing this including the way fees are assessed and the move to fee for alpha.
Also, superannuation funds are negotiating harder, so better prices are now being accessed.
Superannuation funds have a role to play to make sure their members get the best bargain they can but compared to other asset classes it will be expensive because of the value created and the intensive way of investing.
Another area of concern in private equity is strategic drift caused when managers do not stick to their investment philosophy and potentially look to outliers for investment opportunities. Strategic drift can be experienced across assets of different sizes, sectors, types of transactions, geographies and key individuals.
It is interesting to consider the impact of market dislocation on strategic drift, when competition for premium assets is high and performing sectors are dethroned overnight. At the end of the day, talented private equity managers will find opportunities in any market conditions.
Low penetration of private equity in Australia compared with the US and Europe, keeps the Australian market small and local. However, Australia’s private equity market is developing and as at 30 June, was estimated to account for $37 billion assets under management.
The pandemic provided an opportunity for private equity to showcase its active, agile and long-term investment nature. Further, driven by investors seeking long-term performance and more efficient governance models, its outlook is buoyant.
This is expected to continue as fiscal stimulus, coupled with low interest rates, has created an environment of cash and provided companies with dry powder in terms of balance sheet opportunities – the 2021 Preqin and Australian Investment Council Yearbook estimates this to be more than $11bn of dry powder ready to deploy.
Superannuation funds are increasingly aware of the opportunities to leverage and increase their investment in private capital and to enhance their diversification across regions and we are seeing across the world a maturation of private equity managers which is transforming the way it is being approached.
Thirty years ago, private equity managers would buy companies undermanaged and in debt and transform them into efficient and viable investments. Today managers need operational experience, such as time spent working as a CEO, so they understand the dynamics of a company and its surrounding sector.
This operationalisation of private equity and active ownership of investments will develop in Australia as it has in other countries around the world, offering superannuation funds more opportunities to invest and to be confident in their managers.
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