(Forbes) The last couple of years count as only the third time in history when private equity-backed acquisition values, measured as a multiple of cash flow, have exceeded valuations in global stock markets, according to Bain & Company. Previous manifestations of this phenomenon were ephemeral. But fundamental changes in the private and public markets may mean that PE’s premium to stocks is now both justified and sustainable. What’s still perceived as historic anomaly - assets more highly valued by private equity than by the stock market - is very likely to prove the new normal. That has big implications for financial markets and even the broader world.
Absolute returns may decline with greater competition for assets and higher prices; the average valuation in the U.S. private equity market this year stands at a record 12.9 times cashflow and PE funds have an unprecedented $2 trillion-plus on hand for investments. Yet private equity’s superior corporate governance should keep returns well above those of stocks, even as it pays more for assets.
Over the past two decades, as the private equity industry has matured and gotten more competitive, it’s been obliged to move away from financial engineering (read leverage) and rely to a much greater extent on long-term operational transformation to create value at its portfolio companies. Over the same period, public companies, which have always tended to focus on short-term profits, frequently to the detriment of long-term growth, have become entangled in well-meaning but heavy-handed governance codes. These codes create an atmosphere of excessive caution at public companies and take up valuable management bandwidth. This growing governance gap has become sufficiently wide that it is now permitting PE funds to pay a premium for assets. Cambridge Associates Private Investments Database shows that through 2018 PE funds in the U.S., Europe and Asia-Pacific have outperformed major stock indexes over one, five, ten and twenty years.
Private markets have been growing at the expense of public markets for a long time. As the latest quarterly from Triago, the fund advisory I founded in 1992 notes, twenty years ago in the U.S. there were 8,100 listed companies, now there are 4,300. Over the same period private equity buyout-backed companies have gone from roughly 1,000 to some 7,500.
In 2018 for just the second time (the only other time was in 2006-2007) the value of companies purchased by private equity firms exceeded the value of companies going public. If private equity can comfortably pay higher prices for companies than public markets can, the number of listed firms will continue to shrink as the number of private firms grow.
Public markets won’t disappear, but they’re likely to be a home to larger, more mature companies, while growth juggernauts seek the better value creation potential offered by private equity. As time goes by, investors may well adopt a barbell approach to investment, seeking beta from a stable of very large, low-risk listed companies and outperformance from high-growth private equity-backed firms.
If relative high pricing persists, private equity vehicles are also likely to get much larger in order to handle larger take private deals. Sustained high pricing will also reinforce the trend of private equity managers becoming specialists in particular strategies and industries. Specialization increases managers’ ability to add value and can permit them to source deals with less competition.
Private equity managers may also employ their ability to invest more over longer time periods by turning to fields largely ignored by public markets. Cancer, neurodegenerative diseases and climate change are seemingly intractable problems in part because short-term focused public markets have failed to fund efforts to find solutions. In an environment where private equity pricing is higher than inflated public markets values, fund managers may find opportunity addressing such neglected investment opportunities (indeed, the trend towards even longer term PE funds seems to fit this narrative). That could produce amazing returns not just for investors, but for the world. As private equity funds grow at the expense of stock markets, pressure will also grow to open up PE to retail investors. Everyone should have an opportunity to profit from private equity’s superior corporate governance.
