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A Private Equity Warning

May 31, 2022 By Jeremy Jones, CFA

By iQoncept @ Shutterstock.com

In the Financial Times, Mohamed El-Erian explains the lagged reporting process of private equity investments, and how that may reveal an unhappy surprise for investors who currently feel isolated from market turmoil. He writes:

Such optimism about the robustness of the asset class may, however, be excessive. Private equity valuations are updated much less regularly than for public investments. Indeed, historically, revaluations have tended to lag behind public markets by a minimum of six to nine months. Moreover, several of the factors that have recently undermined the public markets are also worrisome for private equity.

Higher interest rates and tightening financial conditions will complicate the refinancing of leveraged take-private transactions. They make the paths back into the public markets less secure and the exit valuation less certain. They also curtail new investors’ enthusiasm for buying private equity stakes in the secondary market, putting pressure both on prices and volumes.

The worsening global economic outlook is also a problem. Downturns rob companies of actual and prospective revenues, leading to faster burning of cash reserves, increased debt burdens relative to equity and capital erosion.

There are two additional risks that are specific to private equity in the period ahead. First, that one of its often-cited structural strengths — that of illiquidity that damps unfavourable price volatility — turns into a weakness; and second, that financial regulators and supervisors pay a lot more attention to conduct in private markets.

Private equity is just as likely to experience a shift in operating paradigm this year as the public markets have been undergoing — from a seller’s to a buyer’s market. Indeed, both are in the process of exiting from a world of massive and predictable central bank liquidity injections that over-facilitated a seemingly endless flow of money into a smaller set of investment opportunities. What lies ahead is a world in which the cost of money will be higher and financial flows more selective as they become less ample.

With time, genuinely attractive value will be restored to private and public markets. The process of doing so, however, is likely to be as bumpy.

Read more here.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #5 in CNBC's 2021 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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