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Offense is the new defense

Against a challenging backdrop of low growth and geopolitical uncertainty, we believe “offense is the new defense” in private markets investing. We seek opportunities to build resilience instead of buying it by focusing on assets with value creation potential in sub-sectors with above-average growth rates.

Private markets outlook

Looking back on what is now the longest (US) economic expansion since the 1930s, we note the unprecedented scale of accommodative monetary policy still driving progress. Although asset prices have rallied strongly, in most cases decoupling from fundamentals, GDP growth has remained modest and far from pre-2008 averages. Valuations for most assets are at the upper end of 20-year historical ranges, and, as the business cycle extends further, they will become more sensitive to underlying growth assumptions.

A pick up in volatility is a typical development for a mature stage in the cycle, and this materialized in the Q4 2018 market correction, which was uncharacteristic in speed but not excessive in scope for a late-cycle correction. Looking ahead, our base case macroeconomic scenario assumes the low growth environment will continue, predicated on the assumption that central banks will maintain loose monetary policies. We also expect valuations to come down slightly from their current frothy levels. However, any deviation from this balancing act of fragile top-down fundamentals, low discount rates, and inflated valuations could result in a more pronounced correction in asset prices.

While we believe the global business cycle has further to run on the back of robust private demand and continued monetary policy support, we have lowered our economic growth outlook to reflect the signs of a cyclical slowdown and increased geopolitical uncertainty, including ongoing trade tensions. Slowing capital expenditure and manufacturing activity were two key drivers behind the sharp decline in US and European corporate earnings. Hiring is coming down from strong levels. Growth in China and several other emerging markets has slowed. 

Looking ahead, our base case macroeconomic scenario assumes the low growth environment will continue, predicated on the assumption that central banks will maintain loose monetary policies.

Short term, we do not rule out the possibility of a more pronounced slowdown, particularly in parts of Europe, as already reflected in the data. This is driven by idiosyncratic developments (UK), on the one hand, and by the spillover effects of trade tensions, on the other, given the manufacturing industry’s relatively large share in select economies across the region. In particular, Germany is deeply ingrained in the global supply chain. For emerging markets, given the disparities in fundamental conditions and political risks, our investment approach relies on a case-by-case analysis. We are also weary of currency implications as trade tensions evolve.

Longer term, there are other factors that should keep global growth on a modest path only: overall productivity growth remains low, and record high leverage levels are putting an additional barrier on sustainable credit-led growth. Simultaneously, the advanced integration of emerging markets into global supply chains and structurally lower growth in China is dampening emerging markets growth.

In this late-cycle environment, investors would typically shift their focus toward increased defensiveness by investing in assets offering cash flow security and operating in less cyclical sectors, such as big brands, large-cap companies, and core assets with a bond-like payout structure. This time around, however, these assets come at a significant premium as yields are suppressed and valuations stretched.

Barring another decade of multiple expansion and falling rates, the expected returns for these assets are likely to be mediocre at best, and the vulnerability of their valuations is often high. Disruption risk adds to downside vulnerability, potentially even threatening established large-cap incumbents as consumer preferences and technological innovation evolve. Recent examples include Heinz Kraft, which has not been able to keep up with changing consumer tastes, and traditional car makers, which are being marginalized by electric vehicle innovations.

In our view, investing in what has traditionally been perceived as defensive no longer represents a cautious approach. Investors will need to think differently to generate attractive returns and protect capital. We argue that “offense is the new defense.” Our aim is to identify transformative trends generating higher growth rates across specific sub-sectors. Within these subsectors, we look for companies that enable us to actively build out cash flows and develop valuation resilience at the asset level through value creation and strong entrepreneurial governance. This approach is particularly well suited to private markets investments because the universe of assets operating in attractive sub-sectors is much broader compared to public markets, facilitating a direct exposure to the transformative trends identified.

Investing in what has traditionally been perceived as defensive no longer represents a cautious approach. Investors will need to think differently to generate attractive returns and protect capital. We argue that “offense is the new defense.” 

Private equity

The private equity investment environment remains highly competitive, with valuations near the upper end of historical ranges. The pick-up in volatility in public markets at the end of 2018 and early 2019 had a temporary knock-on effect on private equity transaction volumes. Combined with a more challenging macroeconomic backdrop, this led to a gap between sellers’ high valuation expectations and buyers’ willingness to pay, which, ultimately, meant volumes declined by 30% year-on-year in H1 2019. Market weakness, however, was short-lived, and private equity volumes have since recovered, with high levels of dry powder and very strong competition in the market keeping valuations high.

Average purchase price multiple of pro forma trailing EBITDA for LBOs 

Source: Partners Group; S&P Global Leveraged Lending Review, Q3 2019.

The one trend that has persisted is the more pronounced bifurcation we see in the market. Stable, non-cyclical assets are trading at record multiples. Recently, we have witnessed several companies change hands at EV/EBITDA multiples in excess of 20x and, in some instances, even 25x. The companies fetching these prices tend to be technology enablers, supported by long-term demand drivers and a high share of recurring revenues. In our view, although these factors mitigate downside risk, they only partially justify exceptionally high valuations given these companies’ inherent sensitivity to changing fundamentals such as growth assumptions.

At the opposite end of the spectrum, we see an increasing number of failed auctions for lower quality assets and/or assets that are perceived as having exposure to cyclicality or disruption risk. Over the last year, within the scope of our investment activities alone, we saw over 100 failed auctions globally. This phenomenon is also driven by asset sales from a number of relatively young private equity portfolios. Given the absence of portfolio management pressures, general partners have the flexibility to stop sales processes if the bid price falls below their expectations.

As part of our “offense is the new defense” investment philosophy, more so than ever, identifying sub-sector trends that generate higher top-line growth and value creation opportunities at the asset level is vital for achieving attractive returns. This approach allows us to build more resilient valuations and, in turn, should enable companies to be more insulated from economic swings. Finally, we remain prudent in our underwriting by factoring in multiple contraction for potential investment opportunities.

As part of our “offense is the new defense” investment philosophy, more so than ever, identifying sub-sector trends that generate higher top-line growth and value creation opportunities at the asset level is vital for achieving attractive returns. 

Private real estate

Global real estate valuations remain high, supported by continued demand and low interest rates and notwithstanding softening GDP growth clouding the prospects for rental growth. After a strong investment year in 2018, we have seen a 9% drop in global real estate investment volumes in the first half of 2019 compared to the same period in 2018. We believe that this is due to a combination of economic growth concerns and the impact of political uncertainty. For instance, investment volumes in the UK have fallen by 35% year-on-year during the first six months of 2019.

Competition for core assets remains particularly high, and prime office yields are currently below 3% in key European locations such as Berlin, Frankfurt, and Paris. These low yields reflect investor sentiment that core assets offer defensive qualities supported by an element of income yield. However, at these valuations, core assets are particularly at risk should there be a change in the accommodative monetary policy adopted by central banks and should valuations revert to long-term averages.

European prime office yield: low in historial context

Source: Knight Frank, 2019.

Given strong competition in the market and the threat of an economic slowdown, we believe smart investing must combine both offensive and defensive thinking. This means we seek assets that provide both value creation potential and downside protection. To originate these assets, we continue to focus on strong locations that benefit from fundamental demand drivers, such as population and employment growth, and favorable real estate fundamentals, such as low vacancy rates and the limited threat of excessive new supply. We are prepared to pay market prices as long as we know the fundamentals will provide a tailwind from a relative value perspective. Conversely, we avoid seemingly attractively-priced properties in locations or segments that face headwinds and are not well positioned to withstand the cycle.

Given strong competition in the market and the threat of an economic slowdown, we believe smart investing must combine both offensive and defensive thinking. This means we seek assets that provide both value creation potential and downside protection.

For office and residential assets, we look to identify gentrifying suburbs that offer live-work-play environments with plentiful amenities and good public transport connectivity that appeal to a growing millennial workforce. These locations also offer interesting opportunities for last-mile logistics assets, which facilitate the fast delivery of goods from logistics hubs to end users and which cater to rising e-commerce penetration rates.

Private debt

Despite signs of slowing global growth and rising volatility in capital markets, demand for private debt remains strong, with total assets under management at a record high. Although senior loan issuance has eased in 2019, the private debt market continues to be borrower-friendly. Loan documentation in many parts of the market is weak, with high shares of covenant-lite structures in the syndicated space. In this environment, underwriting discipline and access to attractive transactions remain key. This means having strong relationships with sponsors to help source transactions and the ability to provide comprehensive, tailor-made financing solutions at an appropriate risk-adjusted pricing.

US market overview

After two record-setting years in 2017 and 2018, first lien leveraged loan issuance decreased during the first half of 2019, in line with a slowdown in global buyout volume and a vibrant high yield market. Retail money has been moving out of floating-rate loans and into fixed-rate high yield bonds due to expected interest rate cuts. Demand from collateralized loan obligations (CLOs) and business development companies (BDCs) remained strong, benefiting from an increase in spreads to 3.9% from 3.3% at the beginning of last year.

Weighted average new issue institutional spreads

Source: Bloomberg; S&P LCD, Q3 2019.

In terms of credit metrics, the market remains mostly disciplined. Leverage levels for US buyout transactions are just shy of 6x, with equity cushions at 46%, both significantly better for investors than pre-Global Financial Crisis (GFC) when they were at 6.2x and 33%, respectively. In the large-cap space, US banks continue to underwrite the majority of financing packages in the syndicated debt market well beyond previous leverage lending guideline limits of 6x leverage, which were adopted by US regulators in 2013. Banks are likely to continue to do so until there is a market correction.

We see relative value in directly placed large-cap/upper-mid-cap second lien transactions with a cash spread of roughly 850bps, limited execution risk, and an absence of flex language (i.e. the ability to amend financing terms if necessary to successfully syndicate loans). Selectively, we seek upside participation through equity kickers. We also find attractive opportunities in senior unitranche financings in the mid-cap space, where we can provide the entire and only debt tranche in the capital structure of a business and actively control documentation. This mitigates downside risk in case of unexpected challenges.

Loan documentation in many parts of the market is weak, with high shares of covenant-lite structures in the syndicated space. In this environment, underwriting discipline and access to attractive transactions remain key. 

European market overview

Similar to the US, year-to-date senior loan volumes in Europe are roughly 40% of full-year 2018 volumes, a marked decline compared to the strong pace witnessed over the past two years. Meanwhile, CLO issuance remains strong and on track to surpass 2018 volumes. CLO issuance comprises 40% of the overall syndicated loan market and, as long-term capital vehicles, should add stability to the market.

Credit fundamentals remain broadly unchanged and more disciplined than those seen in pre-GFC years. Leverage levels in Europe remain stable at 5.8x and equity cushions remain at 47%, still well above 2007 levels of approximately 35%. First lien spreads have seen a mild widening from 3.7% at the beginning of last year to 4.0%.

Early repayments of senior and subordinated loans remain market standard – both in Europe and the US – and require an even stronger focus on sourcing transactions and re-investing capital going forward. For our high-conviction credits in the subordinated debt segment, where we assume solid growth in our base case (which typically results in a refinancing), significant prepayment penalties and equity kickers compensate for early repayments and enhance returns.

We see relative value in mid-cap direct loans, especially in “sole” and “club style” executions, where the limited number of lenders in a debt tranche have significant negotiation power, resulting in a return premium and stronger documentation. We also expect more attractive risk/return profiles and solid volumes for mid-cap stretch senior debt and unitranche financings. Having the flexibility to offer multiple European currencies and implement customized prepayment profiles can give private debt providers an edge.

We see relative value in mid-cap direct loans, especially in “sole” and “club style” executions, where the limited number of lenders in a debt tranche have significant negotiation power, resulting in a return premium and stronger documentation. 

Private infrastructure

The search for stable returns and recurring yield in a low interest rate environment has prompted investors to steadily increase their allocations to the infrastructure asset class over the last ten years. This has contributed to a significant expansion of the private infrastructure market. At the end of 2018, unlisted infrastructure fund managers had a record amount of USD 460 billion in assets under management, around four times more than ten years ago.

The market expansion has helped lift infrastructure asset valuations to the upper end of historic ranges. On the one hand, this makes for an attractive exit environment, which we have actively taken advantage of: over the last two years, we have successfully sold six mature assets into the core market, realizing an average gross multiple of 2.3x on invested capital and returning USD 914 million of capital to our clients. Before the sales, we had been working with these assets for several years, managing three of them through their construction phase, which allowed us to capture a meaningful construction premium.

On the other hand, although higher asset valuations are justified by the low interest rate environment to some extent, we observe a material decoupling of valuations from fundamentals. In turn, this is putting downward pressure on future returns. This growing disconnect is particularly problematic for core brownfield infrastructure assets, which have been trading at record prices across sectors and regions. Although generally perceived as safe and defensive, we argue that some of these assets are at risk in the current environment.

There are two main reasons for this: first, a normalization of valuation levels back toward long-term averages could result in a substantial drag on returns and, second, these assets are often more susceptible to disruption risk given the absence of true operational levers. Disruptive trends such as the digitization and electrification of many aspects of life are quickly eroding the traditional ways in which infrastructure is utilized, putting some legacy core systems under strain. A good example is the advent of distributed energy generation – essentially, the direct generation of power by consumers, for example, through residential solar installations – which is challenging the business models of core infrastructure assets such as conventional power plants.

Disruptive trends such as the digitization and electrification of many aspects of life are quickly eroding the traditional ways in which infrastructure is utilized, putting some legacy core systems under strain. 

We continue to focus our origination efforts on infrastructure assets and businesses that offer value creation potential; operate in sectors and sub-sectors supported by long-term transformative trends; and have business models that are either less likely to be disrupted or that may benefit from disruption. Currently, we see the most attractive investment opportunities in themes arising from the ongoing energy transition. These include midstream energy infrastructure, clean energy infrastructure, and energy reliability solutions. We also continue to see particular value in services-focused infrastructure businesses, both in the energy space, for example in energy management companies, and in other sectors, for example in transport logistics and mobility-as-a-service businesses.

Portfolio perspectives

To illustrate the portfolio implementation of our relative value weights and themes, we are providing a return-focused and a yield-focused private markets portfolio. Both portfolios maintain an overall diversified approach and take into account technical factors such as deal flow, 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. We calculate expected returns for the model portfolios using the five-year broad industry returns derived from the Partners Group's Expected Return Framework.

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 2019.

In the return-focused portfolio, we continue to overweight private equity over real assets given the greater scope to create growth and harness transformative trends in the late-cycle environment. 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.

Given our softened views on rising rates, we now underweight junior debt due to its less attractive risk/return profile – lower total returns and lighter covenants mean we need to be more selective in this segment of the market. For equity investments across asset classes, we are factoring in longer holding periods and multiple contraction given the current high valuation environment.

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 2019.

In the yield-focused portfolio, floating-rate debt remains a major building block. We favor corporate debt over asset-backed debt as the yield differential more than compensates for the “perceived” additional risk, in line with our view that “offense in the new defense.” Real asset debt is a continued underweight.

We overweight senior debt compared to our long-term allocation given the better downside protection the segment offers at this stage in the cycle. Within second lien, we focus on select credits that exhibit sufficient covenants and/or sizeable equity cushions to provide appropriate downside protection.

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. 

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