Rapid innovation and small to mid market dynamics offer opportunities in a challenging environment
As we enter 2020, we see global challenges as well as opportunities in the private equity (PE) markets. Fund-raising continues apace, investor demand is strong, dry powder remains available, and competition is intensifying (EXHIBIT 1). However, unique opportunities remain for those with discipline and a focused approach.
Dry powder continues to pile up, with the vast majority in funds over USD 1 billion
EXHIBIT 1: PRIVATE EQUITY DRY POWDER, BY FUND SIZE
Source: PitchBook; data as of February 2019.
*As of June 30, 2018.
We see little reason to expect the current competitive environment to change in the near to midterm absent a recessionary or geopolitically induced major dip in capital markets, or a significant upturn in interest rates— which are not our base-case assumptions. Debt financing continues to be accessible at low rates, supporting valuations and activity. Demand for the above-public market returns needed to reach investors’ overall return targets remains robust. Investors are rebalancing out of appreciating public equity holdings and into PE to maintain strategic allocations.
For investors with experience and specialized skills, opportunities can be found. The world economy is still growing, albeit modestly in the U.S., Europe and Japan, and at a declining, though relatively healthy, rate in China as markets seemingly continue to outperform initial forecasts. While the PE market is competitive, the smaller end of the market continues to offer opportunities for disciplined investors, and value can be realized through the creation of unique platforms or investment in companies that may have return-enhancing synergies with existing portfolio companies.
Perhaps most encouraging, the pace of technological change and innovation is accelerating globally and, we believe, will continue to be a major source of opportunity for PE investors.
Opportunity: Where growth and innovation meet experience and common sense
As we emphasized in our 2019 outlook, investing gets harder when fundraising gets easier. But working with experienced, skilled managers can help investors realize their PE objectives across markets and environments. We would add: Be patient. If the right opportunity isn’t presenting itself, wait for it.
Small to midsize private companies
While corporate finance deals are increasingly competitive, we still see attractive opportunities in firms with revenues of USD 10 million to USD 100 million. These investments tend to stay below the radar and be less leveraged, with less inflated valuations than more prominent mega deals. We continue to rely on a global, bottom-up approach, looking for solid investment opportunities wherever they may lie rather than trying to fill prescribed, relatively fixed allocation buckets. Outside the U.S., our focus is on opportunities in Europe. On the venture capital/growth side, the U.S. remains our primary focus, while the high growth areas of China and, selectively, India represent additional areas of opportunity.
Innovation: Assessing the likely winners
Realistically, innovation is far more likely to emerge from smaller, lesser known, private enterprises than from large, visible, public companies—making high growth opportunities difficult to find.
Where will these opportunities be found? E-commerce, cybersecurity and software as a service (SaaS) are a few areas where we continue to see tremendous promise. That said, it is incredibly difficult to see the world as entrepreneurs do; conventional wisdom often dismisses tremendous opportunity as business as usual or even irrelevant. Think Amazon, for example, debuting as an online bookseller (at least, viewed through a traditional lens) and now a multi-faceted, dynamic company valued at well over USD 800 billion.1 Of course, not all companies fare as well in the public market. Some may perceive the recent short-term performance of several high profile company IPOs as representative of a broadly difficult and unattractive public market. In reality, venture-backed IPOs over the past 10 years have performed well, up 25% in the first 12 months following their IPOs.2 Individual company performance is a reminder of the public market’s volatility as it looks for businesses with solid unit economics and strong governance. In our view, the public market continues to represent exit and liquidity opportunities for venture-backed companies with solid vision and strategies.
How then, can investors separate the winners from the losers? The key is having access to unique new economy opportunities and the specialized skills and experience to assess the long-term potential of innovative startups and their management teams. Investors also need to be diversified and consider their own risk-return objectives: Getting in on the ground floor can be very lucrative, while allocating to some later-stage investments may provide attractive returns with less risk.
Sustainable investing: Environmental, social and governance (ESG) factors
A business, to be successful, has to make sense for the long term and be aligned with customers’ values. It must deliver a product or service that consumers need, is easy to use and is produced in a way that not only generates returns but exercises strong governance, protects the rights and well-being of labor, management, consumers and investors, and strives to mitigate environmental risks.
We are encouraged by investors’ increasing focus on these ESG dimensions, which have always been an integral component of our investment due diligence and ongoing monitoring processes. We view ESG factors as common-sense guidelines to be reviewed holistically in assessing the material risks and potential opportunities that can make companies or PE managers more or less attractive for investment. We have an established philosophy and approach to incorporating ESG factors into our investment process3 and actively encourage and help the portfolio companies and managers with which we invest to carefully consider ESG factors in their own business and investment practices.
2 FactSet, Thomson Reuters, as of December 5, 2019.
3 Private Equity Group (PEG): Incorporating Environmental, Social & Governance (ESG), J.P. Morgan Asset Management, 2018.
OVERVIEWS AND OUTLOOKS BY ASSET CLASS