June 13, 2024

Now everyone hates private equity I’ll buy some

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The bugger with being a contrarian by nature is when the average joe is right. On how many occasions have I taken the road less travelled only to discover hundreds of potholes and a collapsed bridge ahead?

Such as when I went short US equities five months into a post-financial crisis rebound which continues to this day. Or my shunning of residential real estate. London property is too expensive compared with incomes, I warned a quarter of a century ago.

Sometimes crowds really are wise — loath as I am to admit it. The statistician Francis Galton proved as much in 1917 after analysing hundreds of entries in an ox weighing competition. He found the median guess accurate to within 1 per cent.

For some reason, though, I prefer to go down in a blaze of glory alone. Massive groups of people all cheering at the same thing scares me. In contrast, universal doom-mongering — such as over climate-related financial risk — turns me rabidly optimistic.

Staying cheerful is useful when it comes to investing, however. Especially in shares. Observe a long-run chart of the world’s major stock markets and they mostly go up. Hence why buying when those about you are losing their heads is such a winner.

As I reminded a new equity strategist who joined a bank I once worked for. He wanted to make a name for himself by calling the top of the market, against the prevailing view at the time. Only bulls survive your game, I told him. A year later he was gone.

This of course makes me a hypocrite for selling the S&P 500 last September, despite going long at the start of 2023 when everyone else was negative. Still, buying out-of-favour markets has worked well for me this year.

Most commentators have forgotten how negative they used to be on UK equities. Likewise, Chinese stocks only began rallying in February after it was universally agreed they were “uninvestable”. Energy companies were predicted to suffer from the green transition as well as divestment.

All of this goes to explain why I am warming to private equity — as discussed in my two previous columns — after decades of criticising the industry. Not that it cared. The sound of money being made drowned out my harrumphing.

But now everyone reckons you’ll soon be able to buy second-hand Tod’s loafers, three pairs for a tenner, on eBay. Investment returns are down. Cash cannot be deployed. Liquidity has evaporated. Higher rates make gearing more expensive.

All true — not even PE’s opaque numbers can hide these facts. But let me explain why I’m going to buy some regardless. In my view, the potential upside outweighs my long-held aversion to the half-zip sweater brigade.

First, I reckon borrowing costs will decline from here — and that’s good for an industry that generates much of its returns from leverage. But if they don’t, I’m not too worried either. Higher rates mean a stronger economy. And I believe the more onerous the debt repayments, the more focused PE managers will be on operational returns.

Likewise, I’m comfortable regardless of asset values rising or falling. The former would boost liquidity and performance. If the latter, an estimated $2.6tn of so-called dry powder can be put to work at more sensible valuations.

Indeed, this optionality is a genuine plus, versus listed equity portfolios, which tend to be fully invested. PE funds with the best returns are the vintages launched during a downward correction in prices. It’s an inbuilt contrariness that appeals.

Sure, PE funds will overpay for assets if prices remain high and investors apply pressure on them to spend their cash. But it is no different for listed equity managers — look at the silly valuations of big technology names these days.

In addition, the expected returns of the major listed equity markets are mid-to-low single digits, as I wrote last week, when I reviewed readers’ suggestions on how to double my money in eight years. And, given that academic literature is still divided on whether a privately run company should necessarily outperform a public one on average, leverage is key.    

Which is why other research, such as by AQR Capital Management, concludes that investors would be just as well off buying a small-cap fund (because in reality few PE firms buy large companies) on margin. You get the leverage and you avoid the industry’s high fees.

But in practice this is hard to do, especially in a pension fund such as mine. Leveraged ETFs, meanwhile, are notoriously hard to understand and are themselves expensive. So I couldn’t help screaming “duh!” when a reader suggested I buy an ETF of listed PE firms instead.

I feel like a moron for not thinking about it before. These ETFs trade like equities and only hold equities, so there are no liquidity issues here. You share in the geared upside of assets managed by the likes of Blackstone, KKR and Apollo. Better still, you’re the one receiving the fees!

What’s not to love, concluded the reader’s email — himself an ex-pro in the PE world. My platform has a sterling one, the iShares Listed Private Equity ETF (IPRV), which is up more than 60 per cent over the past five years. For comparison the S&P 500 is 15 per cent higher in pounds.

IPRV also has a price-to-earnings ratio of 12 times. That’s half what large US shares currently trade at — though PE valuations are largely self-constructed. You only really know the value of the underlying assets upon their sale.

Sure, you pay fees of 0.75 per cent, but that is less than Scottish Mortgage Trust, which I also wrote about last week as an example of another way of gaining PE exposure. In conclusion, then, I think I’ll buy some IPRV before I take a contrarian view of myself.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__

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