SuperReturn Special. What is the private equity sector talking about in Berlin this week?

A large industry conference is a chance to assess what those involved in it are interested in. It is hardly a scientific exercise and the element of subjectivity may be higher in the case of the annual SuperReturn International event in Berlin than in other instances. That’s because the agenda is fixed some distance in advance and is not especially flexible, many of the participants fly in and fly out in short order and relatively few people attend enough of the main sessions, breakout panels and closed door discussions to form a view as to the themes that appear to be important. Furthermore, much of the best intelligence is acquired in various bars across the German capital city and mapping all of that and remembering it subsequently is a challenge (although worth the effort to undertake).

It is, despite all of this, an illuminating enterprise. What follows here is a personal analysis of the internal industry issues that appear to have captured attention, the external social, political and economic developments that have dominated discussions over the past few days and, because it is always intriguing, the subjects that might have been spoken about more but were barely covered.

INTERNAL

Relative Performance

One very much doubts whether the authors of the Bain and Company Global Private Equity Report 2020 expected, even a week ago, that their publication would receive the prominence that it has done. Much of this was the result of the interpretation which the Financial Times chose to place on it in their report of it on Monday, most of which reduced a lengthy and learned document to a single sentence in its introduction, namely “The past year marked the first time ever that 10-year returns in the public markets matched those for private equity” and from that statement then asked “… what does return convergence mean for the future of private equity?”. This became an assertion that would be raised regularly at SuperReturn.

The reaction of many of those obliged to respond was often and unnecessarily defensive. It implied that to a degree the slant offered on the report was correct and that at least to a certain extent it represented a “wake up call” to private equity. Yet the details of the Bain report told another story.

For a start, the sentence which so aroused the FT did not apply to all private equity but only to the US where on the measure employed (end-to-end pooled net IRR 2009-2019), the figure for all US buyout funds was 15.3 percent and the S and P 500 PME figure was 15.5 per cent. The same statistical work for developed Europe and Asia showed that private equity continued to outperform the local public markets by a wide margin and there was little hint that “convergence” of any kind was on the cards.

Secondly, even the US data did not suggest that private equity performance was in any kind of spiral but that exceptional and almost certainly unsustainable stock market outcomes over the past decade was what really explained the numbers. The 15.3 per cent figure over ten years cited for US private equity was notably higher than its performance over fifteen, twenty, twenty-five and thirty years and only beaten in more recent times by its three-year number (and quite marginally at 15.6 per cent). If convergence is taken in its usual sense, a process whereby two entities move closer to one another, then it is not at work in what’s been witnessed here. Over the very long term (three decades) US private equity performance has eased slightly (to be expected as far more funds with far more cash compete for a limited pool of attractive assets) but the performance of top quartile funds is astonishingly consistent and impressive and trounches public markets.

This was all faithfully set out in the Bain analysis conducted with Professor Josh Lerner of Harvard Business School, State Street Global Markets and State Street Private Equity Index, which noted that (a) US public markets had benefited from exceptionally benign conditions in the decade concerned, (b) had a propensity to swing wildly between boom and bust and not offer the consistency of the private equity industry and, therefore, (c) it’s 2009 to 2019 performance was unlikely to mark a trend.

As these observers concluded, “our study found little evidence to suggest that competition from public markets is likely to persist and thus it was entirely rational that ” Most PE investors can’t get enough. Around 50 per cent of LPs are heading into 2020 under-allocated to private equity.” The Bain and Company report has a valid claim to be the internal story of the week but on the basis of what it contained (as one suspects Bain itself would willingly concede) it should not have been. The real story-behind-the-story might instead be why the FT opted to present the information as it did, especially as it fits a year-long pattern of persistently sceptical coverage of the private equity sector.

ESG and Diversity

If it had not been for the above factor, then what would have been the most significant element of the internal dialogue within the industry is the extent to which ESG and Diversity questions have not merely moved to the mainstream of investment decisions but are heading towards the core of it. Multiple factors are operating here but there was a real sense of a Rubicon being crossed.

There were some subtle elements to the debate on this that merit additional exploration. First, that it is no longer enough for private equity firms to declare that they have an ESG strategy or a Diversity initiative. LPs are taking a deep interest in exactly what it is and are comparing firms. Second, particularly in regard to gender diversity, resistance to “targets” of a specific numerical type for fear that they would evolve into de facto quotas which would distort recruitment and retention is fading fast. Aspirations without more direct metrics are not considered credible.

Finally, and at an almost philosophical level, there is something of a division between those who see ESG and Diversity as separate (if to a degree inter-related) matters and others who have come to the view that Diversity is best thought of as a fundamental sub-set of the G in ESG and as an issue not simply at the fund level but for the composition of portfolio company management teams as well.

For that reason, a few provisional predictions might be offered. They are that the ESG “mini-summit” which occurs on the day before the full formal conference starts will soon be blended in to the main body of SuperReturn proper in a more structured manner than it is as of now. Second, that the philosophical divide mentioned above is likely to be resolved by ESG itself reaching out to Diversity in a form that would make the phrase DESG (or something similar) a term that can be anticipated by 2022. Third, that the instinct of the industry towards measurement and relative advantage is such that it will not be long before funds start to market themselves as “top quartile” in ESG and Diversity in the same fashion as they do for their investment outcomes.

Dry Powder.

A further aspect of internal consideration is the record levels of dry powder seen at the moment and the concern that this is boosting historically high prices for assets appealing to private equity. It is understandable why this should be a focus of attention. It is less clear how much angst is needed. The Bain and Company report covered the matter carefully and concluded that while the quantum of dry powder is indeed large, in 2019 the average fund had 2.6 years worth of uncommitted capital compared with the much more dramatic 4.5 years stock in 2007 and 2008. In addition, even smaller funds had comparatively little “old” dry powder (dating from 2015 or before) and that as a rule “young” dry powder was the order of the day across the sector which should be relatively reassuring. Whether this helps at all in terms of stubbornly high prices is another matter.

The Unsaid

Much was said on internal aspects of the industry in Berlin but compared with, say 2015, certain subjects did not seem to have the volume of the past or had moved from centre stage to more specialist breakout formats. The first of these was regulation. This was once a red hot topic (notably in Europe because of the AIFMD) but much of the private equity industry appears to think that the (slow moving) AIFMD2 process will not be a threat to it. This may prove to be true but the risk of central banks taking an interest in more intense regulation (predominantly of debt levels) is one that should not be underestimated. The second was emerging markets which were plainly of enormous interest to those committed to investing in them but which barely passed the lips of industry superstars who spoke. This suggests that the traditional markets of North America, Europe and Asia are firmly restored as not only the safe bets but the best ones (although Africa, rightly, retains an allure to others who have, for the time being, decided that the B, R and even the I in the old “BRICs” combination involve more risk than is acceptable). The third was succession planning at the GP level, a matter of massive interest to LPs but one which the organisers of SuperReturn have never really wanted to raise in front of often founder GP leaders.

EXTERNAL

The coronavirus outbreak

If the Bain and Company report was the surprise source of internal discussions, then the coronavirus outbreak was the shock subject for external deliberation. Those who attended Davos stated that it had barely been on the radar there at an event dominated by the theme of climate change. Evidence that the virus might not be easily and swiftly contained in China but become embedded in Europe as well (a fear heightened by the sudden spike in numbers in Italy) made it the most mentioned topic.

Much of this talk involved an attempt to assess how deep the short-term impact may be and whether what has been lost in economic terms can be recovered later in the year. The tone of what was said implied a recognition that short-term supply chains were likely to be damaged to a much more enhanced extents than was expected even a fortnight ago and that if the virus could not be contained within China then the effect would be much stronger than simply a sharp production dip in Q1 2020 that would largely reverse itself in Q2 once factories in China resumed activities. The estimate of a 0.4 to 0.5 per cent hit to 2020 GDP globally was thought by many to err towards optimism. The sense that we could be near a pandemic with a substantial economic impact involving production which was not just deferred but permanently lost and with disturbingly unpredictable secondary effects for everyone in the business community was manifestly out there. Contingency planning, in so far as it is possible, is at a premium. There was a tentative consensus that we would know a lot more by Easter (although one gloomy Italian told me that Easter in Rome this year would be scrapped). Few thought the virus would trigger a recession internationally but many thought it might in certain locations.

Some of the most stimulating arguments on the possible medium-term impact if a pandemic were to occur were offered by Stephanie Flanders, Senior Executive Editor for Economics and Head of Bloomberg Economics. She essentially dumped her advertised speech (on 2020: An economic cycle at its peak? What implications will the China-US trade war, foreign-policy crises, interest rates, surging populism have for global supply chains?) In favour of some informed speculation about the wider impact of the virus. These included the possibility that big business would think again about long, complex but cheap supply chains. In favour of shorter, simpler if more expensive ones as security against a repeat of the disruption that the virus has caused. She also wondered whether, at the popular or political level, the ease with which the virus had come from a single isolated market in a relatively obscure part of China, would add to the appeal of “de-globalisation” with what is basically protectionism acquiring the aura of a Public health measure. At a minimum, it’s well worth private equity figures thinking through what this might mean for them.

The US Presidential Election

If it had not been for the virus, then the US Presidential election would probably have been the chief source of external consideration. This is partly a matter of timing. SuperReturn came straight after the Nevada caucuses which appeared (at least until we know the Super Tuesday results next week) to render Senator Bernie Sanders as the Democratic front-runner. Although he has not been as direct in his hostility to private equity as Senator Elizabeth Warren has been during the campaign, it is clear that the self-styled democratic socialist would be an extremely unfriendly figure in the White House for the sector. Many of those present who have been distinctly uneasy at the presidency of Donald Trump found themselves in the unexpected position of regarding him as the Devil they knew and taking comfort in David Rubenstein’s assessment that the strength of the US economy plus a leftist Democrat as his rival would be enough to ensure his re-election.

As it would take an improbable result by historical standards for any Trump victory to be of a form strong enough to allow the Republicans to retake the House of Representatives as well, the net outcome would be a continuation of partisan gridlock in Washington, which while an ugly spectacle at times was not an existential menace to the private equity industry. In private conversations many of those assembled expressed a degree of sympathy for the presidential bid of Michael Bloomberg but coupled with the sense that the unprecedented amount of money that he is spending on political advertisements and a generally solid record as Mayor of New York would not compensate for a lack of charisma on the stump and the gut instinct of many Democratic activists to back a “true believer” . Rather less focus was shown in the probable composition of the US Senate, yet what happens there (on balance the Republicans are likely to hold a majority irrespective of the presidential vote) would actually be absolutely crucial as to whether or not a President Sanders could enact his proposed programme.

The economic cycle

This was at least the fourth SuperReturn in a row where the phrase “late cycle” or “end of cycle” was regularly deployed by speakers and panellists. For at least some of them, thought, that very fact has started to stimulate the previously heretical thought that one of the legacies of the global financial crisis may have been to change what we should consider a “normal” economic cycle to be. By June (bar some major event intervening) the US will enter the eleventh year of an economic expansion. This is well beyond the post-1945 rhythm that leads to the expectation of recession after seven years.

A number of strands are nudging at least some in the industry to doubt the previous assumption of a downturn of some sort in 2020 or 2021 (2022 at an extreme stretch) is all but unavoidable. One is that although this expansion has been very long by historical standards it has also been typically shallow as well, which might indicate a longer if flatter duration than would have been experienced in the
past. Another is that virtually no Speaker appeared to believe that central banks would be initiating a real
tightening of monetary policy and raising rates to levels considered standard before 2008/2009. If low interest rates are not a deviation but some sort of “new normal” that has to trigger a debate on whether the examples of economic cycles in previous decades are of continued relevance. Finally, those operating in the tech sphere could cite numerous examples of emerging technologies related to artificial intelligence, machine learning and automation that could transform economies around the world and maintain the economy long past the yardsticks of preceding cycles. This is again worth serious thinking.

The Unsaid

As with the internal discussions here, external factors that were scarcely touched upon are as of much interest as those that command attention. There were, in my view, three worth a mention. The first is the US-China trade war, a matter of immense debate a year ago, but where there seemed to be a consensus that the current “truce” would lead to a settlement between the parties. This is a sentiment that may be stress-tested if the presidential battle is between Mr Trump and Mr Sanders with those who work in US manufacturing in the Mid West Ham proving the pivotal constituency. The second is Brexit which almost all here took to be “done” with the free trade agreement to be negotiated close to an afterthought. That might also be thought a judgement by later on this year. The final “dog that did not bark” much was the succession struggle to replace Angela Merkel.

The absence of dialogue on this last matter might be considered very odd at a conference held in Berlin,
Germany. Then again, SuperReturn (as regular attendee well know) is not really in Berlin or in Germany but takes place in a form of bubble, a world of its own. That much, at least, will still hold true the next time that it occurs.