There are elements of the private equity investment model that can be applied to investment styles in public markets, says Adrian Warner, chief investment officer, Avenir Capital.
Warner told the audience at the Investment Magazine Equities Summit in Melbourne that he based his insights on his more than 20 years of experience in private equity and his current role at Avenir. He noted that the private equity market is now operating with “record amounts” of excess capital to be invested, along with record amounts of debt.
“There has been about $3 trillion of equity capital raised over the last five years, and there is huge momentum in investing in the private equity space at the moment,” Warner said. “But it’s not just the equity that’s flooding into the industry, it’s debt levels as well…The debt levels that are being employed in individual private equity transactions are close to record levels, at six times debt to EBITDA.
“Whenever you have such amounts of capital flooding into an industry, you tend to get only one outcome, and that one outcome is rising prices.”
Despite the challenges that private markets are facing, select parts of the private equity model can be applied to investing in public markets, Warner said.
“One is running very concentrated portfolios and being very selective about what goes into those portfolios,” he said. “Another is focusing on fundamentals and business models and trying to understand the value of the business models rather than trying to predict price movements in the short term or trying to predict movements in the markets.”
Warner cited a study, Replicating private equity with value investing and homemade leverage, and hold-to-maturity accounting, which demonstrates that strategy replicating private markets can outperform over the long term.
“Another element of the study, which I think is quite interesting, is that it suggested that the main value driver that has delivered the private equity returns is less this issue of control, and less private equity firms bringing some kind of operational improvement out of the companies they control, and is more about multiple arbitrage,” he said. “Buying low, selling high, with the benefit of leverage to help turbocharge returns is really the single biggest driver of private equity returns throughout its history.
“That is what I think the private equity industry has done very well is selectively buy good quality businesses, when they’re able to buy them cheaply, and use the very favourable structure of locked up capital, a very loose or discretionary marked-to-market backdrop, and then hold on to those assets until sentiment shifts in the market or they find a buyer who is willing to step up and pay that one or two or three turns of multiples more.”