Lennertz & Co. Ihr Multi Family Office

FAZ
(11/2020)

Record Year Appearing Possible

mho. FRANKFURT. Private equity, i.e. the large-scale direct investment in private companies, has become increasingly popular since the financial crisis. While USD 173 billion flowed into private equity funds globally in 2010, that amount has more than tripled in recent years. This is partially due to the low interest rate environment, which makes private equity more attractive to investors. “If you want to achieve higher returns than you generate with money markets alone, there is no real way to get around alternative asset classes,” says Detlef Mackewicz, Private Equity Consultant at Münchener M&P.

Private equity promises not only higher returns than standard equity investments. The so-called illiquidity premium refers to the disadvantage that you cannot sell such an investment as quickly as you can with publicly traded stocks. However, investors also enjoy greater stability in their portfolio. This is because the equity investment value is only determined on a quarterly basis and is affected less by the volatility on public stock markets. Since 2000, the share of private equity as a percentage of “public equity” in the portfolios of institutional investors has risen from 1.5 to just under 4 percent.

Private equity is frequently equated with the PE type called buy-out funds, which acquire companies in whole or in part, increasingly with the goal of raising their value by making operating improvements and selling them for a profit. Buy-out funds have typically generated annual returns of more than 10 percent over the last 30 years, but with immense fluctuations of more than 40 percentage points. Funds for equity investment capital have achieved substantially lower returns at 6.6 percent in the U.S. and only 3.6 percent in Europe.

The corona crisis has also been challenging for the private equity business. Funds have received around USD 190 billion since the middle of August, according to Pitchbook, a service provider in the sector. That is “historically strong,” if we exclude the record period from 2017 to 2019.

By no means is sentiment negative, however. “The declines of 5 to 10 percent in value that funds saw in the first quarter had been reversed by September. Some funds have even risen. So, not much has actually happened here,” says Mackewicz. Older funds have been affected more, he continues, because managers had recent experience preparing for a crisis.

Ferdinand von Sydow, Managing Director at HQ Capital, the private equity arm of the Harald Quandt Group, sees changes occurring more in the structure of the business. 60 percent of the funds have gone into existing investments and companies in the first half of the year, in the form of additional financing or add-ons. This is a very high percentage and certainly to be viewed as a reaction to Covid-19. “We have also been more active here. There is a large number of co-investment options. However, you have to pay careful attention to quality, as you do in the secondary market. But it is worthwhile checking whether such an add-on, which looked even more expensive eight or ten months ago, has become more attractive.

New business has slowed substantially in the meantime. In part, that is because meetings to get acquainted and the due diligence for acquisitions are not possible on site or only possible with great difficulty. The effect of the strict restrictions on personal contact, which is very important in the sector, can be seen most clearly in sales, says Mackewicz. The number of so-called exits has dropped from 2,212 in 2019 to just 776 in the current year – just above the number in 2009, according to Pitchbook. No investor wants to sell at a discount, so they limit themselves to waiting and portfolio management before hard decisions have to be made, according to the analysts at Pitchbook. Philipp Lennertz, founder of the Hamburg multi-family office Lennertz & Co., views this more pragmatically. Fund managers simply have a lot of challenges with the companies, as far as he sees it, whether they are suffering from the crisis or profiting from it on a large scale.

New fund providers are also having a difficult time. “Like many others, we as investors are also relying more on established business relationships and are concentrating on trusted partners. Preference is given above all to managers who have already handled crises well. Investors currently view the private equity sector as strong, adaptable and flexible. Naturally, it is difficult for new players to provide evidence of this.”

One thing is not lacking in the sector: money. Pension funds and church institutions are investing less, von Sydow says, probably because they have suffered in part substantial loses in income. But demand continues to be strong. “New investors now have difficulty investing in the funds of top firms because their regular investors have been adding to their investments,” says Lennertz. That leads to acquisition pressure in the sector, he continues. In this regard, 2020 was a lost year for funds that were in the investment phase at this time, according to him. “Pressure may cause decisions to be made that are not sensible,” Lennertz fears.

There are high hopes for the coming year. Lennertz, for example, believes that 2021 could be a new record year, while von Sydow prefers a wait-and-see attitude at the present time. The greatest opportunities are seen in digitization. All observers believe that accumulated, uninvested funds or “dry powder,” will flow into this sector. It is a trend that began some time ago and has accelerated as a result of the pandemic – almost too much, says Lennertz. There will still be some difficulties, say the experts. “Only when the tide goes out do you discover who's been swimming naked,” says Mackewicz, quoting Warren Buffet. “Then it will become evident where flaws have been covered up.” This will not be an “enormous wave” and the process will also unfold slowly after the crisis begins to recede. And isolated losses in funds will be possible to deal with due to their diversified portfolios, he explains.

“There will also be opportunities, for example in the area of restructuring,” says von Sydow. In Germany, this will start becoming an issue in April when bankruptcy filings resume again, according to Lennertz, who also foresees political support for involvement of the sector. Jim Barry views it similarly. The managing director responsible for investments at Blackrock Alternatives Investors said in regard to the elections in the United States: In comparison to what was to be expected in the case of a Democratic “blue wave,” the scope and amount of any fiscal stimulus should now be lower. “The economic consequences of the pandemic should be drawn out and result in investment opportunities with distressed assets.” Private equity always profits from price uncertainty in turbulent times, says Sydow in summing up the situation. “In a calm market with perfectly priced assets, it is difficult to find good quality at reasonable prices.” A major topic should also be sustainable investing. Only because of corona have we not reached this point already in 2020, according to von Sydow. Investors are under pressure from all sides to demonstrate a social benefit from their capital investments, he adds.

It is not easy to be a private investor in private equity. The funds of well-known private equity firms such as KKR or Blackstone require minimum investments in the double-digit millions. The sums are somewhat lower for investments with firms such as HQC or Feri Trust, which allow smaller institutional and larger private investors to participate. The hurdles are even lower for specialized investment boutiques such as Circle Eleven or fintechs. The digital asset manager Liqid offers closed-end umbrella funds; and the fintech Moonfare facilitates so-called fractional investments in individual large funds. In the meantime, the minimum investment sum here is a six-digit figure. With a lower limit of 50,000, this makes a fund from Schroeders almost revolutionary. The reason is in part that these funds are reserved for so-called qualified investors due to investor protection, i.e. ultimately investors with more assets.

Private equity umbrella funds with low minimum investments flourished in Germany for a while. But their benefits are disputed. Administration causes additional costs, and many of these umbrella funds have already run for a long time. This reduces returns and tends to erode the illiquidity premium. An alternative is to invest in the equities of private equity firms and publicly listed exchange traded funds (ETFs) for this. However, this is ultimately “public equity” again, which is subject to the laws of the securities markets. Furthermore, there are a handful of publicly listed investment trusts in the UK. Relative to the shares of private equity firms, these trusts offer a direct investment, but are naturally also subject to the laws of the market. For example, the price of BMO Private Equity Trust dropped 45 percent from its 20-year high as a result of the corona crisis. If you ultimately choose a real private equity instrument, you are bound to it for the long term. In the first few years, funds are successively drawn down, and only gradually do you receive returns. As a result, a private equity investment only generates noticeable yields after several years.

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