Private Equity Cracks

We look at emerging evidence of the distressed situation for private equity and highlight why you shouldn't be chasing big tech after this rally.

Private Equity Cracks

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Private Equity Cracks

We’re currently living in strange times.

We live in a world where private equity asset prices are trading at a premium to public ones. This is a weird set up if you consider that private equity assets should, and typically do, trade at a discount to public markets given (1) lower liquidity and (2) traditionally higher leverage. The latter matters significantly more in a world of higher interest rates.

Understanding what’s happening with private equity prices (and, to an extent, venture capital) is not that straightforward partially because private market investments are not marked-to-market continuously, as is the case in public markets. This gives them (private markets) the ability to obfuscate performance for a long period of time, which is again counter to the daily performance metrics supplied by public markets that anybody with a smartphone, anywhere in the world, can get access to at any moment in time.

But, for Verdad, that’s a hard pill to swallow, which is why they’ve recently crunched some numbers to give us an indicative idea of what’s happening behind the curtain. As always, all credit to them for their outstanding work:

The conclusions are, as expected, not painting a pretty picture.

Debt Cost Interest Rates Private Equity

According to Goldman, family offices across the globe currently have 26% of AUM allocated to private equity.

What’s more interesting (read: worrying) is that few plan to reduce allocation to private equity over the next 12 months.

asset allocation next 12 months goldman sachs family offices

Time to call your private banker?

Don’t Chase Big Tech

We’ve all heard about stock market concentration this year. If you exclude the 7 largest companies in the S&P 500, the market was up 3.8% in the first half of the year (instead of 16%).

multiple expansion top 10 S&P 500

Chasing big tech at these levels looks a bit too risky for me, especially as this chart gets scarier and scarier (the US 10Y yield is trading at levels last seen during the SVB collapse…):

Nasdaq 100 US 10 year yields

Keep an Eye on Europe

Europe stock market index
economic surprise europe and US

2Q Earnings Season

consensus earnings estimates

What the Bears Will Say

Mike Wilson from Morgan Stanley has been a persistent bear throughout the year as he believes EPS will come in below consensus estimates in the second half. His latest thoughts, according to Market Ear, are:

“1. The liquidity picture is starting to deteriorate due to record levels of Treasury issuance and QT. Morgan Stanley estimates bank reserves will contract by $500-800B over the next 6 months, which is likely to have a negative impact on equity valuations.

2. Fiscal support has been much higher over the past 12 months than most investors appreciate, based on our conversations. This is expected to peak and reverse next month and could amount to a 6ppt headwind to nominal GDP over the next 12 months.

3. The technical picture remains poor with recent breadth improvement failing yet again.“

Where to Look

Goldman has put forward the idea of the catch-up trade for 2H, which we covered last month:

Whilst there’s probably some upside on the table still, the reality is that most of the money that could have been made at the index level has already been made. That’s also consistent with price action in past inflationary cycles.

S&P 500 around inflation peaks

But unremarkable index performance doesn’t necessarily mean that there is no alpha available in the market – quite the contrary. Investment opportunities are now to be found in the segments of the market that have lagged behind the performance of big tech in 1H. Some areas that are worth looking at:

valuation discount value growth
S&P 500 sector valuation vs history dividends buybacks

1. “Japanese equities trade at 25%-30% P/E discount to US, as they have since 2016

2. Record increase in stock buybacks driven by corporate governance reforms (i.e., Sony spinoff/buyback)

3. Governance reforms: [a] ~50% of companies trade below book value and must outline a plan to maximize shareholder value and comply with shareholder, liquidity and outside director reforms; [b] 10%-20% of companies do not comply with cross-holding and free float criteria and must remedy or face delisting

4. Half of Japanese companies have positive net cash positions vs <20% in the US/Europe

5. Very low positioning in Japanese equities by non-Japanese investors

6. A recent surge in non-Japanese LBO activity in Japan, which is extremely rare (discussed earlier)

7. Lower wage pressures than US/Europe, COVID supply chain pressures easing

8. Earnings expected to be flat vs contractions in the US and Europe

9. The lowest real effective exchange rate in Japan in 50 years according to CEIC; the Yen has also depreciated by 30% vs the Chinese RMB, which is relevant since Japan now exports more to China than to the US.”

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Thanks for reading through! Obviously, none of this is investment advice.

As always, we'll see you out there...

Published in: Markets
Diego Tremiterra

Co-founder and Editor-in-Chief. Covers Markets, Business, and Thematic Oversight. Currently a hedge fund Jr. PM, ex-Goldman Sachs capital markets and startup COO.

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