The Role of Private Equity in a Volatile World

We live in a world of increasing complexity—one in which technological revolutions are unmaking and remaking every industry. The private equity model offers a way to adapt to, and potentially benefit from, these profound changes.

Private equity can also continue to help investors advance toward their financial goals despite a challenging climate. Since the 2009 market bottom, global public equity markets have seen tremendous appreciation driven primarily by quantitative easing and much lower interest rates around the world. With interest rates currently near all-time lows and equity market valuations at historically high levels, we believe financial market returns are unlikely to repeat the past eight years’ performance over the next eight years. In our view, this suggests that investment strategies with return-enhancing capabilities could play an increasingly important role in investors’ portfolios.

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How to Potentially Enhance Equity Performance in a Climate of Uncertainty

As challenging as the investment landscape has been, we expect it to be even more so going forward. Global growth is slow, and the returns we have seen in recent years have been pulled forward by quantitative easing and the low interest-rate environment. Over the next ten years, returns are likely to be lower across all asset classes than they were during the past ten years.

In that context, we offer three themes investors can potentially utilize to enhance the returns of their equity portfolios. These themes underscore the reasons we believe private equity can be a useful component of investor portfolios in this kind of climate.

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High yield: Opportunity amid the carnage?

High yield debt sure does look scary today. After recording its worst annual performance in a non-recession year during 2015, it realized another milestone earlier this year. The asset class, as measured by the Barclays US High Yield Index, reached its third largest drawdown in history, matching its performance during the 2001-2002 recession. Only the losses in 2008 and 1990 have been larger when compared to the recent period.

Given the steep declines, should investors brace themselves for further losses and liquidate their high yield portfolio en masse? In short, we think not. In fact, we believe this is the best time since early 2009 to be a selective investor in short-duration high yield bonds. Prices have overshot fundamentals in most sectors, and it is precisely these overreactions that sow the seeds for the potential to outperform in the future.

Three key reasons underpin our view:

 

  1. This is not 2008

Nearly a decade after the financial crisis, the scars of 2008 remain fresh in investors’ minds. Fears of another crisis have led many investors to run for the exits with little regard for fundamentals. The fact that high yield recently matched its third largest drawdown in history despite any hint of recession or material change to the default rate environment underscores today’s disconnect between prices and fundamentals. Moreover, the conditions that drove the 2008 crisis—highly leveraged financial institutions and a faltering economy—are not present today.

Financial regulation has resulted in much stronger balance sheets across the financial system, and we believe the risk of a recession is low as job growth continues apace and the services sector—which accounts for 80% of the US economy—has been growing solidly.

 

  1. Current yields compensate the patient investor, even if spreads widen further

For the first time in several years, the math of owning high yield bonds is strongly in the investor’s favor. Why? Both spreads and current yields have increased to multi-year highs and adequately compensate investors to take credit risk at today’s price levels. Annual coupon payments now average nearly 8%[1] at the index level, and bond prices have declined from over par in mid-2015 to 85 in early 2016.

Investors now have the potential for both income generation and capital appreciation over the coming year for the first time since 2011. In the event that the “risk-off” sentiment continues over the near-term and credit spreads widen another 2%, investors could still realize positive returns over the next year based on today’s yield levels, and that may help to provide a relative cushion in the event that prices continue to decline.


[1] Source: Barclays

 

Chart_HighYieldProjectedReturns_020916

 

  1. Look beyond the indices

As we enter the late stages of the credit cycle, sector and security selection now take center stage. In today’s market environment, avoiding the losers is paramount to picking the winners. Index investors are likely at a disadvantage because they assume concentrated exposures to the sectors that have issued the most debt—telecom in 2000 and energy in more recent years, for example—which may be a formula for future underperformance.

Investors that take an active, security-focused approach with a sharp focus on sector and company-specific fundamentals have the ability to identify idiosyncratic risks and opportunities—and therefore may benefit from the price noise—in what is likely to be an increasingly unstable environment ahead.

While caution is needed in this volatile environment, we believe there are outstanding risk-adjusted investment opportunities present in today’s markets. Why now, and not after default rates have spiked? Investors should note the cautionary tale of 2009: default rates peaked at 10.3%, while the ML High Yield Index returned 57.5% that year and 15.2% in 2010. So instead of waiting for the “all clear” signal—which may likely coincide with lower potential returns—investors that have been underweight high yield debt should consider increasing their allocations to the sector today.