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Entrepreneurial ownership holds the key to private markets outperformance

While our base case economic outlook projects a period of continued modest growth, we are aware that the ride may become bumpier as multiple challenges emerge. In this environment, we believe entrepreneurial ownership and strong value creation skills are the only way to generate outperformance.

Private markets outlook

As we near the end of 2018, the global economy appears to remain on a solid growth path. Looking ahead, we expect the expansion to continue, albeit at a slightly more modest pace. Following a strong year for the US economy, tighter financial conditions and the fading impact of fiscal stimulus should result in milder growth rates. Nonetheless, these should be sufficient to translate into rising inflationary pressure and wage growth across the country and keep the US Federal Reserve (Fed) on its tightening path. In fact, our base case economic outlook assumes that the Fed will raise its target rate above current market and analyst expectations. 

In Europe, we forecast modest growth, with relatively muted inflation and continued accommodative monetary policy. In their current form, ongoing trade conflicts should only have a minor direct impact on overall GDP growth across regions, barring a more material impact on confidence. In China, more supportive monetary and fiscal policies and the Chinese Renminbi depreciation should counteract negative effects.

Our base case economic outlook assumes that the US Federal Reserve will raise its target rate above current market and analyst expectations.

However, the combination of rising interest rates in the US, the potential effects of trade conflicts, structural challenges in Europe and divergence in emerging markets should raise volatility in capital markets, as already witnessed in the October equity market sell-off. This is typical for the later stages of an expansion, especially in a market where elevated valuations are largely based on a low risk-free rate. Over a five-year horizon, we expect valuations to come down in light of higher US inflation and rising interest rates and incorporate this into our base case underwriting assumptions across asset classes.

Economic and market scenarios: main parameters

*For the asset testing scenarios, real GDP and inflation reflect Partners Group projections, NAV-weighted as per Partners Group’s asset split across the US, Europe, other advanced and emerging markets.
**Market valuations refer to price-to-earnings ratios for public equities, enterprise value to earnings before interest, tax, depreciation and amortization for private equity, capitalization rates for private real estate and underwriting internal rate of return for private infrastructure.
Source: Partners Group, November 2018. For illustrative purposes only.

The importance of asset testing

More challenging macroeconomic conditions are emphasizing our focus on creating value and strengthening market positions across our global portfolio of companies and assets, both of which we achieve through a long-term, entrepreneurial approach to governance. In addition, as the risk of a deviation from our – admittedly market-friendly – base case is rising, we focus on businesses and assets that are well positioned to withstand a variety of alternative economic scenarios. 

The scenarios we use to test assets include a faster-than-expected “adverse” US rate hike cycle, where rates rise faster because of a more pronounced increase in inflation (expectations) or wages and rising longer-dated government bond yields, and a recession, possibly as a result of escalating trade disputes, a Eurozone government debt crisis (Italy) or a cooling in China’s economy. We are also not dismissing a more positive outcome, such as a stock market rally scenario, where modest inflation and accommodative monetary policy continue to boost investor sentiment. Nonetheless, we believe this scenario is less likely to materialize given the advanced stage of the US business cycle.

As the risk of a deviation from our – admittedly market-friendly – base case has been rising, we focus on businesses and assets that are well positioned to withstand a variety of alternative economic scenarios.

While these scenarios are more relevant to some private markets asset classes than others, across the platform, we seek assets and business models with strong pricing power and margin stability. These elements are vital to protecting and strengthening revenues and valuations.

Private equity

The past year has seen private equity valuations rise yet again from an already high base. We attribute this to ever-increasing competition from private equity managers, strategic buyers and new market entrants, encouraged by the search for yield while interest rates remain low and by strong debt markets for leveraged buyouts. Quality assets typically trade at EBITDA multiples in the mid-teen range. In contrast, assets still trading at low multiples tend to be underperforming or operating in highly cyclical sub-sectors.

Average purchase price multiple of pro forma trailing EBITDA for LBOs 

Source: Partners Group; S&P Global Leveraged Lending Review, Q3 2018.

As we do not operate in isolation, elevated valuations are a reality in our underwriting as well, especially given our focus on high-quality assets in high-growth segments. In order to mitigate the risk associated with paying competitive prices, our strategy is twofold. 

On the one hand, we remain selective, investing in only around 1% of the opportunities we screen. Increasingly, when it comes to due diligence, we are using the visibility afforded by a large database of private markets assets to preempt sales processes, aiming to identify target companies and conduct thorough research on them before they come up for sale. This enables us to source opportunities in a systematic manner according to high-conviction investment themes and develop substantiated value creation and governance plans for our target assets early on.

Wrapping around target assets before the sales process has started

Note: formal vs. pre-process due diligence timelines for Partners Group direct private equity investments (2015-2018).
Source: Partners Group, October 2018.

On the other hand, we maintain our belief that to achieve attractive returns in this environment, private markets investment managers have no option but to excel in their value creation capabilities. For this reason, the focus on highly entrepreneurial ownership and active value creation is a fundamental trait of our investment strategy. That same focus offsets the multiple contraction assumption we use in our underwriting, which has increased from around 0.5x for investments made in 2016 to around 1.4x for investments made today.

Increasingly, when it comes to due diligence, we are using the visibility afforded by a large database of private markets assets to preempt sales processes, aiming to identify target companies and conduct thorough research on them before they come up for sale.

Private real estate

Global real estate transaction activity has further increased in the US and Asia-Pacific compared to last year, supported by high amounts of available capital. In Asia-Pacific, China and Japan remain the two largest markets. In contrast, European volumes are experiencing a marked slowdown and have fallen across most sectors, driven by lower levels of investment activity in the UK, Germany and Spain.

Since the Global Financial Crisis, low interest rates have supported real estate prices by lowering both borrowing costs and discount rates on future operating income. With the growth of real estate asset values, yields have compressed and are now at the lower end of their historical ranges across many markets. In parallel, global capital values have risen by around 30% since their low point in the cycle in 2009. Looking ahead, the potential impact of rising interest rates on the asset class warrants close attention.

Since the Global Financial Crisis, low interest rates have supported real estate prices by lowering both borrowing costs and discount rates on future operating income. Looking ahead, the potential impact of rising interest rates on the asset class warrants close attention.

The potential impact of rising rates on real estate 

With rising rates in the US and further rate increases expected to come, we are more cautious on the mid-term outlook for US real estate as the spread between cap rates and 10-year US Treasury yields continues to narrow and is now below the long-term average of around 430bps. 

Historically, cap rate spreads have acted as a buffer to absorb rate increases without cap rates increasing in lock step. If yields continue to rise – as we expect them to – there will be a reduced capacity to absorb rate increases without upward movements in cap rates. This especially holds true if net operating income (NOI) growth is not able to offset the rate increases. 

Our broad estimate suggests that 5% of NOI growth can offset around 25bps in cap rate increase. NOI growth, however, while still above the long-term average of 3.2%, is slowing, as highlighted in the following charts.

Long-term spreads between cap rates and 10-year US Treasury yields

Source: Costar; US Federal Reserve, November 2018.

Long-term NOI growth in US real estate

Source: Costar, November 2018.

Our prudent underwriting standards take into consideration the impact of rising rates. We currently allow for a 50-100bps cap rate increase over our hold period. In addition, in this competitive environment and against the backdrop of rising rates, our continued focus on investments that have a value-add component provides us with the opportunity to actively drive NOI growth. 

In terms of property types, office, logistics/ industrial and residential assets with tangible value creation potential or limited development risk still offer attractive opportunities in many parts of the globe, especially if sourced outside of competitive auction processes. For our older vintage investments, we are seeking exit options to lock in favorable market conditions and strong returns.

Private debt

Stable demand for financings driven by high transaction activity continues to serve as a tailwind for institutional investors in private debt. Investors have generally increased allocations to floating-rate private debt investments to protect against interest rate increases and obtain stable yield. Overall, the inflow of liquidity into the market, as well as the first steps toward deregulation in the US market, have kept competition for high-quality investments at a healthy level.

US market overview

In the US, demand for second lien remains robust and is even finding its way into syndicated processes. In combination with strong demand for new loans, new issue spreads continue to be tight, although we have noted an uptick to 388bps in Q3 2018. At the same time, the floating 3-month Libor base rate currently stands at 2.5%, providing a positive impact on private debt investment returns for USD investors.

Base rates plus weighted average new issue institutional senior debt spreads

Source: Bloomberg; S&P LCD, Q3 2018.

Leverage levels for buyouts in the US are still high at close to 6x, similar to pre-Global Financial Crisis levels. While equity cushions continue to be very high at around 40%, compared to just over 30% in 2007, prices in the private equity market have increased since then as investors have been willing to pay higher valuation multiples. In this environment, focusing on credit quality is crucial.

Currently, we see relative value in second lien for (upper) mid-cap companies. These businesses tend to exhibit superior stability and resilience – and the second lien debt is secured. Second lien spreads continue to be attractive at around a 390bps return difference to first lien spreads. 

In select cases, investing in preferred equity in attractive sectors with high-quality private equity partners or taking equity kickers to increase returns can be good relative value opportunities. We further expect attractive risk/return profiles in unitranche financings, where we can position ourselves as the sole debt investor in a business and therefore gain more influence in documentation.
 

Currently, we see relative value in second lien for (upper) mid-cap companies in the US. These businesses tend to exhibit superior stability and resilience – and the second lien debt is secured.

European market overview

Senior leveraged loan volumes in Europe are tracking at roughly the same pace as last year. Leverage levels for buyouts in Europe increased slightly in Q3 2018 to 5.6x. In contrast to the US, this remains well below pre-crisis levels. Moreover, equity cushions in Europe have increased to near-record levels of 47%, although we expect this to normalize and come down slightly in the coming months. 

On the back of this supply and demand dynamic, spread levels in Europe have seen upticks in the first three quarters of 2018 to a level of 402bps, although Euribor remains in negative territory. We have further noted an increase in the rate of repayments, with debt often being repaid in one to three years. Early repayments require an even stronger focus on sourcing transactions and re-investing capital going forward.

Unlike in the US, the regulatory environment remains stable, and we observe no deregulation efforts. Relative value remains to be found in mid-cap direct loans, in particular club-style executions, which can offer a premium and solid downside protection, with a small group of high-quality lenders in the club. 

Directly placed second lien debt continues to be an attractive financing solution for issuers of mid-cap transactions given the limited execution risk, the certainty on the terms and conditions of the financing and the comparable cost to syndicated solutions. For these transactions, the flexibility to offer multiple European currencies can give private debt providers an edge. 

Our investments in the liquid loan market have been focused on the primary market, where we can leverage relationships from our direct loan business.

Private infrastructure

The infrastructure asset class has experienced an impressive growth trajectory, with both transacted volumes and available capital growing at a high pace over the past few years. The continued increase in demand from investors has led to more competition in the sector and is putting upward pressure on valuation multiples. In turn, this is leading to lower overall expected returns, particularly for core operating assets. 

Investors justify paying high prices by pointing to the quality of the underlying assets and the long-term nature of infrastructure investments – a compelling argument in the past few years’ low-yield environment. However, as interest rates are set to rise in the US and potentially elsewhere, and as the promise of further growth in valuations appears to be slipping away, the risk of overpaying is high.

Looking at how public utilities have performed during past rate hike cycles, it becomes clear how sensitive infrastructure valuations are to interest rates. The following chart illustrates two findings: valuations are cyclical, and periods of rising rates have usually coincided with declining valuation multiples.

Infrastructure sensitivity to rising rates: public utilities

Note: shaded areas mark periods of Fed rate hikes.
Source: Partners Group; Bloomberg, August 2018.

For Partners Group as an investor, these observations have two main implications. On the one hand, we ensure that we maintain our portfolio’s exposure to rising interest rates at a minimum. This means that we select investments with inflation-linked or correlated revenues and low correlation to GDP and hedge the cost of debt. Additionally, in order to limit the potential impact of buyer discount rates at exit in light of rising rates, on average, we have prudently assumed over 10% multiple contraction in the underwriting of our investments over the last two years.

On the other hand, we focus on investments that have a value-add component, providing us with the opportunity to actively shape business strategy and manage operations to increase profitability. We have long emphasized the need for investors in this environment to build value rather than buy it, and we continue to seek opportunities to create value through our three key strategies: operational value creation, platform expansion and building core. These strategies allow us to actively achieve multiple expansion in our assets by de-risking and scaling up their asset base and leveraging non-market-based drivers such as earnings growth.

We have long emphasized the need for investors in this environment to build value rather than buy it, and we continue to seek opportunities to create value through our three key strategies: operational value creation, platform expansion and building core.

Portfolio perspectives

To illustrate the portfolio implementation of our relative value weights and themes, we are providing model return-focused and yield-focused private markets portfolios, shifting asset class allocations within predefined bands. Both portfolios maintain an overall diversified approach and take into account technical factors such as the breadth of asset classes and incremental risk/return factors. The return portfolio combines investment themes and segments of private markets catered toward capital appreciation, while the yield portfolio focuses on income-oriented opportunities. 

Return-focused portfolio allocation in our base case

Note: the outer circle represents long-term portfolio weights. The inner circle represents current portfolio weights. The ranges in brackets show the target bandwidths. There is no assurance that targets will be met.
Source: Partners Group, November 2018.

In the return-focused portfolio, we continue to overweight private equity and have further increased our allocation to the asset class from 45% to 50%. In particular, we focus on direct investments in companies with high pricing power and margin stability that offer potential for value creation enabled by an entrepreneurial approach to ownership and a long-term view. Our focus on value-add and market segments that benefit from transformative trends should largely offset the negative impact of multiple contraction. In light of rising rates, we have placed a greater underweight on real estate. 

While real estate secondaries involving a special situation (e.g. requiring a bespoke structure) still offer attractive returns, tight cap rates and their sensitivity to rising rates warrant a more cautious assessment of direct real estate investments. 

The portfolio weightings for private infrastructure and private debt (corporate second lien and mezzanine) remain unchanged. Within infrastructure, we clearly overweight greenfield (as opposed to highly valued brownfield), where a delivery premium can be captured, and long-term financing and future income streams (contractual revenues, tariffs) can be locked in during or before the construction phase, thereby making greenfield assets less sensitive to interest rate shifts.

Yield-focused portfolio allocation in our base case

Note: the outer circle represents long-term portfolio weights. The inner circle represents current portfolio weights. The ranges in brackets show the target bandwidths. There is no assurance that targets will be met.
Source: Partners Group, November 2018.

In the yield-focused portfolio, we strongly overweight floating-rate corporate debt, which benefits from rising rates environments. First lien debt has an even stronger overweight given it provides better downside protection. In these segments, we seek companies with resilient business models in high-growth market segments. Club-style or unitranche facilities with bespoke features provide for superior returns in the first and second lien spaces alike.

Real asset debt, which is typically fixed-rate, is a continued underweight given tight spreads. We have placed an underweight on private infrastructure equity, which for the yield-focused portfolio would consist of yielding brownfield assets. Brownfield infrastructure has less value creation upside potential and is sensitive to rising real rates via higher discount rates.

Our focus on value-add and market segments that benefit from transformative trends should largely offset the negative impact of multiple contraction.

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