Q&A with Anastasia Elia of Investment Management Corporation of Ontario, and John Ruffolo of Maverix Private Equity.
By Emily Holbrook
More and more, pension funds are turning to private equity investments to increase returns. And after viewing most available fund data, it’s clear to see why fund managers are going the PE route. For example, data from the British Private Equity and Venture Capital Association’s performance measurement survey shows that over the previous decade, UK private equity generated returns of 13.7%, compared to 9.1% on the FTSE All-Share index, which is composed of public company stock.
Canadian pension funds have taken note and ramped up investment in PE. In fact, recent data from S&P Global Market Intelligence shows that Canadian pension funds lead their peers when it comes to PE investments.
To get a sense of current and future performance, we interviewed Anastasia Elia, CFA, Senior Principal of Private Equity at Investment Management Corporation of Ontario and John Ruffolo, Founder & Managing Partner of Maverix Private Equity. Elia and Ruffolo will be speaking at the CAiP Forum Private Equity Summit in Toronto on June 9.
Are the current geopolitical tensions and recession fears affecting private equity valuations?
Anastasia Elia
Elia: There is a lot of dry powder—or, committed but not yet invested capital—in the private equity markets, which needs to be deployed, so the deal making activity hasn’t slowed down yet, and valuation adjustments tend to lag public markets by a few quarters. However, as the credit market environment starts to deteriorate and interest rates rise, we expect PE valuations to decline. We would expect the impact to be most pronounced in sectors that experienced significant valuation growth in the last few years, such as tech.
Ruffolo: We developed a clear view that the geopolitical and macroeconomic environment would drive interest rates up for the first time by the 4th quarter of 2021. We modeled a view of what would happen to PE valuations if the U.S. Treasury would increase interest rates by at least 200 basis points. As a result of this view, despite closing our fund and screening over 1,000 opportunities in North America in our first year, we waited to make our first investments once the U.S. Treasury announced their expected interest rate increases. It was difficult to hold off on making investments for an entire year, but we were convinced our patience would pay off. Although we did not expect the conflict in Europe, we fully expected interest rates would rise and PE valuations would revert to the long-term mean.
Pension funds are investing in PE at a record pace. Not only pensions, but insurers, sovereign wealth funds and endowments are investing in PE. This is a remarkable change from just a decade ago when such funds would shy away from the risk inherent in PE. Can you explain?
John Ruffolo
Ruffolo: Having been a key executive member of a pension fund for many years, it was very clear that the shift from a traditional asset mix model of 60% stocks and 40% bonds was under attack in a historic low interest rate environment. It was also clear that holding the vast majority of one’s stock portfolio in only public equity stocks would ignore a huge pool of private companies, despite the vast majority of companies being private. So, on a risk-adjusted return basis, it became clear that very large capital pools would be better served in allocating their capital to a variety of alternative assets including private equity, venture capital, infrastructure, and real estate.
Elia: Institutional investors across the board have been looking to boost their PE allocation in search for yield/higher returns, particularly given historically low returns in the fixed income market and the relatively lower volatility of PE vs. the public markets. Investors with long-term time horizons are increasingly taking advantage of value creation opportunities in the private equity markets. We would also note that the PE market has become increasingly liquid with a growing number of secondary funds, thus helping to offset the liquidity risk historically attached to the asset class.
Do you feel private equity is a better investment choice for Canadian pensions in the current market? Would you say it’s a better choice than public equity and why?
Elia: We believe that private equity is and will remain an important and growing component of any institutional investor’s portfolio—regardless of the market environment—given the long-term focus of these investors and the proven long-term return potential of the PE asset class.
In the short term, given recessionary and inflationary pressures, many private equity firms are focusing on market-leading, stable, highly cash flow-generative businesses with pricing power.
From a value creation perspective, there are a number of reasons why private equity exposure and returns cannot be easily replicated in the public markets, including the following:
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Given the administrative, regulatory, and reporting burden faced by public companies, many high-quality businesses have chosen to remain private, and investors can only access these by participating in the PE market
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A typical PE owner takes control of the business it acquires and is able to drive value creation via operational changes, improvements to management team, and acceleration of growth (organically or via M&A). A passive public markets investor does not have access to management teams of portfolio companies and cannot readily drive change
Ruffolo: In order to achieve their target returns to satisfy their pension obligations, pension funds must be investing in private equity. While investing in equity is fundamental in a low interest rate environment in order to generate sufficient returns to meet pension obligations, a strategy solely focused on investing in public equities may be insufficient to satisfy those obligations. As a result, most pension funds now invest in private equity to seek alpha in order to meet those pension obligations.
How can PE firms benefit from massive inflows of capital and large amounts of unused dry powder?
Ruffolo: Private equity firms that raised significant amounts of capital over the last year or so but remained disciplined and did not chase opportunities with excessive valuations, will be well positioned. The opportunity set will significantly increase over the next 6-9 months as entrepreneurs readjust their valuation expectations in line with the long-term mean.
In particular, those businesses that require capital to expand their businesses but raised capital at excessive valuations, or public companies that have experienced massive decreases in their publicly-stated stock prices that were recently taken public either in a traditional manner or a SPAC, will increase the pool of opportunities for private equity not seen since for years.
Elia: PE firms that deploy this capital in a prudent way in the current market environment and focus on operational value creation to drive returns will perform well.
Emily Holbrook serves as owner and head content creator at Red Label Writing LLC, a content studio that collaborates primarily with the insurance and financial services sectors.
