The wider view

Investors the world over are now having to re-evaluate their strategies as factors such as rising inflation in many markets, increasing interest rates and greater geopolitical tensions weigh on their portfolios. What does this mean for private equity?

Private equity investing has long been seen as a largely micro strategy. Historically, what has counted has been selecting individual investments and fostering their capacity for growth and value creation. But as the economic and geopolitical picture becomes more complex, are GPs and LPs now becoming macro investors?

“The beauty of private equity for such a long time has been that it has been in the business of investing in micro plays,” says Yup Kim, Head of Investments at CalPERS Private Equity. “But it will, of course, be affected by the confluence of factors we see today. Idiosyncratic risk has increased. No-one could have predicted what’s happening today and we are starting to see some the growth of economies in Asia slow.”

Mike Barzyk, Managing Director and Global Head of Private Equity at Allstate Investments agrees. “I have always held a strong belief that the majority of private equity GPs are micro-economic investors first and macro second,” he says. “They have historically focused on defining and understanding supply and demand, what the economic moat is around their business, what levers they are able to pull and what factors they can control. Everything else – the exogenous factors – they have dealt with as they came. For the past 15 years, that has been successful because the macro climate has been quite favourable. That contrasts significantly with what we see today. GPs are having to look through a macro lens to see what the implications are likely to be for each business.”

Can things only get worse?

And the general consensus seems to be that things could get worse and are likely to remain challenging for some time to come. Even seasoned investors, who have seen difficult conditions before, suggest that the investment environment will be unlike any they’ve witnessed before. Wai Chiew Chik, CEO & Executive Director of Heritas Capital Management, offers the GP perspective. “We’ve lived through enough crises,” he says. “Many of us thought that if we could get through Covid, all would be good. But there has been a slow realisation that actually, we are in the light of an oncoming train. This crisis spells underlying, deep and discontinuous change that we’ve not seen in our lifetimes. We’re talking about a perfect storm and everything that is happening will have major implications for many years to come.”

He adds: “We now have to think about macroeconomic and geopolitical issues. The tension between the US and China affects business in a very real sense. You need to decide which of these two will be your core market because you can’t do both in a big way. This drives business strategy and how you think about valuations and how you construct your portfolio.”

Given the fact that conditions have changed so rapidly and that we are still in the early stages of a more difficult period, it’s not surprising that we’ve seen a slowdown in fundraising this year. Global private capital fundraising fell to US$645bn in H1 2022, versus US$789bn in the first half of 2021, according to Preqin. Buy-out fundraising saw a particularly precipitous drop – from US$284bn to US$138bn. Some of this may be the result of LPs facing overallocation issues as public markets valuations have declined, but some will also be down to investors taking a pause to take stock.

“Watching the environment today, everyone is on the sidelines,” says Andrea Auerbach, Partner & Global Head of Private Investments at Cambridge Associates. “No-one is sure what will happen with the war in Europe, inflation and interest rates. Dollar-denominated investors are also having to consider what the currency impact of all this is. Experienced investors know that they need to maintain a radiant heating level of exposure and if they have a full portfolio, nothing is going to happen if they step out of investing for a year – their dry powder will still go to work.”

For those building programmes, the picture is more complex, however. “Those new to the asset class or building their allocation need to keep going,” adds Auerbach. “Now is not the time to head for the sidelines. They need to make really critical choices about who they want to partner with in uncertain times.”

Too many issues

Yet while private equity has historically performed well through downturns, the fact that there are so many headwinds all at once makes choosing the right partners in the right sectors and geographies that much more challenging. Indeed, many seasoned investors are having to re-evaluate where and how they commit their capital. “Rising inflation and interest rates have to prompt a change in the way we think about returns across the board,” says Frank Su, Managing Director and Head of Private Equity Asia at CPP Investments. “We also have to change the way we assess risks and opportunities. Many people are trying to figure that out right now.”

It’s clear that the macro picture is informing investors’ private equity portfolio construction plans more than in the past, even if it is less clear in what specific direction these considerations will take investor allocations in Asia and beyond. “The issue is that no-one can forecast accurately how things will pan out,” says Kim. “We’re all long-term investors and so the best way to navigate this is to be prepared. If you had three scenarios in the past, you now need five or six and it will take some imagination to see how bad things can get before they get better.”

Kevin Looi, Head of Asia, Private Equity, GIC, agrees. “In this environment, we are not going to see 10% growth,” he says. “So we need to approach the market soberly and evaluate for each opportunity where the levers for growth are, whether we need to underwrite for multiple compression and what effect inflation will have. We need to understand what the fan of outcomes is, rather than making a point estimate. It’s about how bad things can get, but also how good things can get.”

Taking control

There are some common themes, however. A desire for exposure to more majority positions is a natural reaction, for example. “I’m a strong believer in the long-term growth potential of Asian markets,” says Mingchen Xia, Managing Director, Co-Head of Asia Investments at Hamilton Lane. “The mature buy-out markets of Japan, Korea and Australia haven’t changed, but we have seen change in growth and venture capital markets. I still have confidence here and they have been great at delivering returns in the past. However, we are looking more at control positions because buy-outs are less reliant on IPOs and you have greater control over the value creation and operational aspects of the business and over the destiny of the exit.”

Another theme is optimism about the prospects for LP Asia allocations, in particular as the parts of the region now look to be net beneficiaries of recent disruption. “The region’s GDP growth is fuelled by exports and Asia is more interconnected than ever before,” says Joel Thickins, Co-Managing Partner at TPG Capital Asia. “And if we look at the region as a whole, we’re also seeing supply chain repurposing and that is resulting in capital flows.”

There are some short-term gains in the region, too, as Usman Akhtar, Senior Partner at Bain & Company, explains. “Asia is not homogenous,” he says. “We are seeing dislocations that mean some markets that have customarily suffered from currency drag now look different. Indonesia, for example, is seeing its currency propped up by commodity prices.”

Indeed, the different dynamics at play in Asia compared with more developed markets, but also between different Asian markets, mean that LPs have plenty of choice when it comes to constructing their exposure to the region, notwithstanding the global macro headwinds. “Asia continues to offer good, stable growth and diversification benefits from a portfolio construction perspective,” says Su.

Simon Marc, Senior Managing Director and Head of Private Equity at PSP Investments, agrees. “Asia is providing a diverse set of opportunities at a time when the US and Europe are facing energy issues and inflation,” he says.

“Asia is very heterogenous,” adds Looi. “We are in a bottom-up industry. Every fund and investment we make has to be in the right neighbourhood. While it’s not a zero-sum game, when one door closes, another opens. When we’re at a time of slowing market growth, we ask ourselves: where are the sources of Alpha, what can GPs or we as LPs do to generate returns?”

Which brings us back to private equity as a micro-economic play. It seems that, while macro issues will factor far more heavily in GP and LP investment and allocation decisions than has historically been the case, selecting the best individual opportunities remains key to success in the asset class. “From a portfolio construction perspective, what we tilt towards as a result of macro factors has become more important,” says Su. “But the bottom up still matters.”

As Marc says: “It will be much harder to make money over the next decade versus the past two. Effective asset selection, partner selection and diversification will all be vital.”