Side Letter: Interest rate hikes and PE; AP6’s impact returns; PE’s performance debate

The Fed's rate hike is a silver-lined cloud for PE. Plus: Sweden's AP6 believes impact investing needn't come at the sacrifice of returns – quite the opposite; and does new research settle private equity's age-old performance debate? Here's today's brief, for our valued subscribers only.

Just happened

Your time to shine!
Calling all operators: there is still time to submit an entry for Private Equity International’s Operational Excellence Awards 2022. We want to hear from any GP that has exited a deal in the last 12 months and has a compelling value creation story to tell. Submissions for the 2022 awards will be reviewed by an expert judging panel and the winners will be announced in PEI’s Operational Excellence Special Report, which will be published in October.

Don’t miss the opportunity to show off your value creation chops at a time when securing LP allocations is becoming trickier than ever. You can find out more details about the submission and judging process here.

The Fed: Fighting inflation (Source: Getty)

The L in LBO gets more expensive
Exactly one year ago today, Private Equity International published a report looking at how the world’s biggest private equity firms were planning to tackle inflation. Blackstone, for example, said it was trying to position itself for investment opportunities that “look and feel as least bond-like as possible”, president and COO Jon Gray said, while EQT chief executive Christian Sinding said his firm would continue to invest in growth assets in industries that are non-cyclical with strong secular growth trends.

The US Federal Reserve’s decision overnight to raise its benchmark policy rate by 0.75 percentage points in an effort to tackle inflation – which is running at its highest in the US in four decades – and decisions by other central banks such as the Bank of England, which is expected to raise its key rate today, mean private equity firms could have some respite from inflationary headwinds.

The other side of this coin, of course, is that borrowing becomes more expensive for both private equity companies and their portfolio companies. As Nick Brooks, head of economic and investment research at ICGtold us in this podcast last year: “If that [rate rises] were to happen and we were to see yield curves shift, that would obviously affect a lot of companies that have a lot of leverage. To the degree that GPs are concerned about that risk… clearly, they need to be looking at the leverage levels of the companies they’re invested in and be working with them to try to reduce these risks.”

Last year, we said the test for those who really have invested in strong management teams of high-quality companies in non-cyclical industries will be just around the corner. That’s still true today.

The best of both worlds
Impact sceptics often contend that the strategy must come at the expense of financial returns. That is not the case, according to Katarina Staaf, managing director of the Sixth Swedish National Pension Fund (AP6). Speaking at affiliate title Responsible Investor’s Europe Summit in London this week, Staaf said the institution would “absolutely not” accept concessionary returns from its impact investments. “We believe that in the end, that will generate a higher return over our investment horizon,” she told delegates in remarks reported by our colleagues at New Private Markets (registration required). AP6 invests exclusively in PE and reported a 49.1 percent return in 2021. Its portfolio is valued at SKr48 billion ($4.7 billion; €4.5 billion).

The negative assumption about returns may in part stem from the comparative nascence of impact strategies relative to their more established peers. “I think it’s not quite fair to compare impact funds,” Staaf told NPM this week, referring to returns generated by AP6’s PE fund investments. “They’re quite new to the market, and what they’re compared to are funds that have been in the market for 20 years.” To use a rather hackneyed expression, perhaps only time will tell whether the sceptics are correct.


Debate settled?
It’s an age-old question for some: does PE outperform the public markets? Research from alternative investment manager and adviser Cliffwater suggests that not only has it achieved that goal over the past 20 years, but that these returns have also come with less risk.

Between 2000 and 2021, the PE portfolios of a sample of 53 public pensions produced net annualised returns of 11 percent, compared with 6.9 percent for listed stocks, according to Cliffwater. The annualised standard deviation of returns from PE was 16.1 percent over the 21-year period, compared with 17.1 percent for public stocks, suggesting PE is a better risk-adjusted bet. Cliffwater’s study also debunks the idea that PE has failed in recent years to deliver excess returns over the stock market to the extent it did in the past, finding nothing statistically significant to back up this claim.

“Press coverage of [PE] focuses almost exclusively on second order concerns over disclosure, fees, layoffs, debt, and an occasional scandal. Rarely is attention given to the first order benefit of high risk-adjusted returns,” Cliffwater concluded.

The argument about the true returns of PE may be as old as the asset class itself. Ludovic Phalippou, a professor of financial economics at the University of Oxford and a high-profile critic of PE, concluded in 2020 that the asset class had returned about the same as public equities since 2006, while generating $230 billion of carry for managers. “This wealth transfer might be one of the largest in the history of modern finance: from a few hundred million pension scheme members to a few thousand people working in private equity,” he said.

Money continues to flow into the asset class, even with many LPs being overallocated as a result of PE outperformance in 2021. According to Coller Capital’s Summer Barometer, 42 percent of LPs plan to increase their target allocations to PE over the next 12 months, with 6 percent planning a decrease, PEI reported last week.

Audax returns
US mid-market firm Audax Group is seeking $4.75 billion for its sixth flagship fund, our colleagues at Buyouts report (registration required). Fund VII has won at least two commitments, including $100 million from Louisiana State Employees’ Retirement System and $100 million from Maryland State Retirement and Pension System. If it meets its target, Fund VII would be about 36 percent larger than its 2018-vintage predecessor – a relatively modest step up in a period dominated by ambitious fund sizes and quicker returns to market.

Last year, our colleagues at Secondaries Investor reported that Audax had completed a GP-led process to move assets from its 2012-vintage Fund IV into a continuation vehicle – the first such deal it had closed. The firm moved multiple assets, including Innovative Chemical Products Group, Justrite Safety Group, 42 North Dental and TPC Wire & Cable, into a separate fund worth $1.7 billion.

Dig deeper

Institution: International Finance CorporationHeadquarters: Washington, DC, USAUM: $45 billion

The International Finance Corporation has committed $30.5 million to Growtheum Capital Partners SEA Fund I, €25 million to Partech Africa II and $50 million to LeapFrog Emerging Consumer Fund IV.

As illustrated below, IFC’s recent commitments have focused on diversified sectors in Asia-Pacific, Central/Eastern Europe and Middle East/Africa.

For more information on the  IFC, as well as more than 5,900 other institutions, check out the PEI database.

Today’s letter was prepared by Alex Lynn with Adam Le and Rod James