The years since the financial crisis have seen increases in valuations for both public and private companies, but modest economic expansion and flattening corporate profit growth present possible headwinds for continued appreciation. Nonetheless, both markets offer opportunities with attractive yield and return potential. Joseph Amato, President and Chief Investment Officer—Equity, and Anthony Tutrone, Global Head of Alternatives, recently discussed potential opportunities and challenges associated with private and public equity markets.
Elevated Equity Valuations in both Public and Private Markets
JOSEPH AMATO: We are cautious as we look at the public equity markets, in large part due to interest rates and the Federal Reserve. Historically, at the beginning of rate-tightening cycles, equity markets have been choppy, which is understandable, as investors assess the impact of higher rates on economic activity. Also worrisome at this point in the business cycle is stagnant earnings growth. Earnings for 2015 will end up flattish—modestly down if you include the energy sector, modestly higher if you exclude energy. For 2016, forecasts call for 8% to 10% earnings growth which, in our view, seems aggressive given the slow-growing economy and revenue growth, which has been hard to come by.
Public equities are more fully valued in our opinion, especially given the challenging macro environ-ment. A narrow group of stocks is driving equity indices, which makes beating the benchmark more challenging. Either you jump on the bandwagon and buy those momentum stocks at high valuations, or you stick with your discipline. We want our managers to remain disciplined and focus on the rigorous fundamental analysis that has produced solid results over time.
ANTHONY TUTRONE: Over the last several years, multiples in the public markets have increased more than those in private equity. The Russell 2000, for example, has gone from a valuation of 12.0 times earnings as of the end of 2008 to 21.0 times, as of the end of 2015. By comparison, private equity multiples have expanded from 8.8 times to 10.3 times during the same period, a much smaller move. Although we consider both markets to be at fairly high valuation levels, the discount for private equity has not only been maintained, it has grown, so it appears as though there’s an opportunity to buy companies less expensively in the private markets.
Keep in mind that valuation is only part of the story in private equity. In addition to being disciplined on price execution, operational expertise and improvements in the business are important factors contributing to more attractive returns in buyout strategies. It’s important to focus on manager selection, transaction selection and making sure that managers are properly aligning themselves with investors.
In venture capital, we believe early-stage situations are more attractive, with valuations that are far more modest than they are in the so-called “unicorn” companies with multibillion-dollar valuations. In our view, the opportunity in those unicorns has diminished, and many are having an increasingly difficult time going public at valuations higher than in the last round of capital raised.
Mergers and Acquisitions Contributing to Shareholder Value
AMATO: Companies will continue to pull financial levers to support earnings in a slow-growth environment, and mergers and acquisitions are one way to do so. Accordingly, we believe M&A will continue although credit markets are stressed, which may impact overall deal volume. Interest rates, though rising, are likely to remain low compared to historical standards. Margins for large companies are at peak levels, and the drivers of margin enhancement over the course of the past four to six years of the cycle—labor costs, energy costs, interest rates and tax rates—may act as a headwind over a similar forward-looking time horizon. These factors that have boosted profit margins do not appear to us to offer much upside in the future, which may enhance the appeal of M&A. The pace of mergers and buyouts will likely remain robust, and we believe that’s positive for shareholders.
TUTRONE: Given what’s going on in the commodity markets, which has spilled into the credit and equity markets, there have been significant redemptions in public equity funds and less money to participate in initial public offerings. We believe the highest-quality IPOs will still get done, but it’s a challenged environment and private equity firms are likely to be more dependent on M&A for exits. With a slowdown in China and higher interest rates in the U.S., companies are looking to buy growth because, as Joe said, organic growth is difficult to achieve.
With regard to M&A, it’s important to point out that there are two distinct stories when comparing the U.S. with Europe, where deal activity is well below 15-year averages due to slower growth and structural issues overhanging the market. Europe in 2015 accounted for about 21% of total private equity investment, compared to more than half of deal activity 10 years ago. We think buyout volume will increase in Europe as expansionary policies of the European Central Bank drive better earnings growth and liquidity in the market, which will give more confidence to acquirers of businesses to make both corporate buyouts and take-private transactions.
Investors Seek Yield in Low-Rate Environment
AMATO: Given long-term investor demographic trends, income will continue to be an important consideration and a key deliverable for clients. We believe it’s important to build a stream of income from a diversified portfolio of securities. In particular, we think an unconstrained approach that can tap into various segments of the traditional fixed income market (corporate, high yield, TIPS and non-U.S. bonds) is well positioned in the current environment. Also, a multi-asset class portfolio, which incorporates fixed income, equity and pass-through vehicles like MLPs and REITs, provides the ability to be opportunistic in seeking income in what remains a dynamic market backdrop.
TUTRONE: Over the last several years, we’ve seen investors looking for yield and shorter durations, and they want it from sources with low correlation to the overall economy or markets. Right now, we see opportunities for private equity investors in private debt, like lending to smaller and private equity-backed businesses that are too small for the high yield market. Traditional sources of capital in some of these areas, like banks, have been pushed out of the markets for regulatory reasons. In private debt, illiquidity premiums can be quite high, which translates into higher yield potential for investors. Other unique opportunities are in buying distressed debt as default rates in the high-yield market increase, as well as royalties on drugs, medical devices and even music.
For investors with a greater appetite for risk, we see opportunities in smaller developed buyout markets like Italy and Spain, and in emerging markets, provided that the manager is experienced and has a deep understanding of their local markets.
