The team at Hermes GPE had recently a meeting with Benedetta Balducci, who is Head of Portfolio and Client Solutions Europe at Hermes GPE about what is the added value of the private equity markets at the moment, how the war in Ukraine is affecting the sector or what are the main trends.
What is the added value of Private Equity Markets in these times of uncertainty?
I would mention 2 main advantages of this asset class, which investors have shown to appreciate, and which led private equity to experience significant absolute growth rates, but also relative growth in share of investment portfolios over the past 10 years.
- The first is the more consistent, as well as relatively higher performance or private equity with respect to fixed income and public markets. Private Equity has proven to be able to deliver not only less volatile returns – also thanks to their slower response to market fluctuations thanks to quarterly portfolio valuations – but also relatively higher returns vs. public market across cycles.
- The second reason is linked to the real nature of these asset classes, which gives investors the opportunity to be relatively closer to the underlying assets and the real economy – a feature which is especially appreciated by family offices and it is proving to be one the driving forces of the very interesting phenomenon of democratization of private equity.
But Private Markets are very wide, right?
Absolutely, it is quite broad in terms of offering and new sub-segments, but also, as a consequence of its private nature, it tends to have very different stages of developments and maturity across geographies and even regions.
Some interesting examples include the sub-sectors and evolutions of Private Debt instruments alongside the risk-return and seniority spectrum – with so many new offers which emerged in the last 5 years – but also the completely uneven adoption rates and development phases of this asset class in general, even across regions in Europe.
Another highly debated example is the difficulty in having a common definition of mid-market between North America and Europe – with the former including even $7-10bn funds!
Last but not least is the emergence of hybrid private equity products, in which Hermes GPE has played an important role – bundling different private equity products – from fund of fund components, co-investment exposure, as well as secondaries in one fund or SMA to create more bespoke solutions and enable investors to model a product to meet their return targets.
This breadth also implies higher complexity versus public markets – which requires more in-depth due diligence and higher investors maturity – the reason why it has until now been solely dedicated to highly institutionalized and sophisticated investors.
Lately we are experiencing a higher democratization of private markets – a very interesting phenomenon which implies the increasing possibilities of retail investors to benefits from the returns from an asset class that has always been inaccessible in the past. Having said that, because of its natural complexity, the high-risk profile, the fact that private investments are illiquid by nature and have long lockup periods, this process is not plug and play and requires some sort of intermediation needed to make sure the investors access the market in the right way, identify the segments of the market that they’re really interested in and understand the risk-return profiles of the instruments.
What are the implications of the war for private markets?
The magnitude of the impact of the ongoing Russia-Ukraine war is different depending on the specific exposures of each portfolios to this area of the world.
However, generally speaking, investors with sizeable allocations to private markets have been less impacted by the contingent volatility for two main reasons:
First of all, Russian and CEE private equity have been historically less established compared to Europe, North America and Asia and, as a consequence, allocations to this part of the world in investors PE portfolios is generally speaking limited.
Second, as mentioned before, thanks to the quarterly valuation of private market positions, immediate fluctuations in valuations tend to be perceived in private portfolios with delays – from 3 to 6 months. As such, while investors with substantial exposures to public markets have experienced dramatic losses in value of their listed portfolios, private portfolios have been only partly impacted and would rather experience the consequences of the war in the medium term, as well as in an indirect manner – from increased cost of energy for the underlying companies, or impacts on customer demands in the region.
On the flip side, we are witnessing an indirect implication of the war: family offices and private bank clients – affluent, high and ultra-high net worth individuals – who are responding to private equity draw down notices during this period are required to free capital from public markets, thus booking significant losses as a consequence the contingent situation. This implication would need to be taken into account by fund managers with high deployment rates in 2022.
And what are the main trends?
There is a consistent growth both in demand and supply in private equity, with the emergence of new geographies and regions. At Hermes GPE, we have been committed to a global portfolio since as early as 2011, when we set up the Singapore and NYC offices – with the aim of increasingly investing in North America and Asia.
Interestingly, the approach to Asian investments has been relatively opportunistic by global private equity co-investors, with a share of allocation to this geography hardly reaching 10% of portfolios for the vast majority of the players.
Conversely, for us, Asia is a key market, accounting for 20-30% of our co-investment funds and we are committed to scouting and executing “hard-to-find” deals in this geography in the coming years.
But Asia is very big…
That’s right. There is no such thing as a single approach to Asia.
As a franchise we have multiple committees in charge of macro reviews, including a bi-yearly forum to discuss specific trends across geographies of the world, which help us understand which sub-regions could be more or less risky to approach systematically, in response to specific trends, political and economic circumstances.
For instance, we have now a more cautious approach to Mainland China and India, while keeping very interesting pipeline of deals in relatively new geographies, like South Korea, to benefit of very attractive growth rates as well as fully proprietary opportunities.
In addition, local presence, deep knowledge of the local culture, as well as strong network of connections among local players are key for operating in Asia – especially when operating in the mid-market and being able to prioritize opportunities.
To sum up, Asian markets are very interesting in terms of capturing high growth Private equity investments. Surely, I would love to see opportunities in other geographies such as Latin America or Africa, but the reality of those regions is that, nowadays, the supply for the private equity is not large and developed enough, just yet.
What about other trends and your thematic approach?
We are strong supporters of the attractiveness of the mid and lower-mid markets across geographies – and we have made this believe the heart and soul of our investment strategy. We solely operate in these sub-segments, with median size (EV) of our deals in the latest fund being $200m. We believe that hard-to-find deals with higher growth potentials are to be found in this market sub-segment and we have already seen the benefits of it, with a 28% median revenue CAGRs of our portfolio.
It is hard to say whether this is a trend shared among all players – given that most players have stepped out of this segment by raising much larger funds compared to only 3-5 years ago – but we have been seeing the positive results of our consistent focus to this segment in terms of performance and growth until now.
On general macro themes – as a firm we decided to be concentrated only on four macro trends, which account for c.90% of our allocations.
The first one is connected to people and demographics, such as the aging population, mental health and changes in behaviours. The second one, is Environment, Net Zero and energy transition, and we are committing as a franchise to a Net Zero/neutral portfolio by 2050. This second trend is in line with the increasing relevance of ESG strategies, a market which witnessed over $700bn raised in 2021 by over 500 funds according to Preqin. The third trend is innovation and digitalization – where we focus on the improvement in efficiency and operational models via tech adoption and digitalization – even by more mature industries. The last theme is what we call: The global centre of gravity shifts, which goes along our commitment to Asia. A shift in global power in the World is taking place and you need to think about how to capture that from an investment point of view. Some industries that are very mature and experience limited to no growth in Western markets – education and the broad healthcare industry, etc.- are instead benefiting from double-digit year on year growth rates in Asia and we want to be able to capture that.