Private Equity: The game that ends with a credit crisis

The current drawdown is 39% so if we see a repeat of 2008 then listed private equity could decline much further from here. The recent decline has revealed that private equity does not deliver good risk-adjusted returns for shareholders. The annualized return since November 2003 is 5% which is 2.7%-points lower than S&P 500 in the same period and with significantly higher average drawdowns.

The catalyst for these large drawdowns is high debt leverage and high valuation multiples, and the fact that private equity firms cannot adjust their portfolio risk when a liquidity and credit crisis is unfolding. We observe that private equity firms have been valued at a premium to the overall equity markets since 2013. Given the bad risk-adjusted returns we expect private equity valuation to fall below that of the market extending the drawdown from current levels. The financial market is experiencing one giant margin call and private equity firms will be hit as well.

However, when the market bottoms private equity firms will represent a leveraged high beta play. One of the best ways to get exposure to private equity is either through an ETF (IQQL:xetr) or some of the listed private equity firms with solid balance sheets and low default probability. Private equity firms such as Hamilton Lane, 3i Group, Apollo Global Management, Ares Capital and Blackstone group fit these characteristics as of today. But overall we believe more pain is ahead for private equity.