The current climate of inflation and bearish market sentiment has altered the math of investment. In analysing public companies, New says InvestX has found valuations were highly correlated with growth rates – a link that makes sense given the operating leverage businesses in certain sectors could draw on. But today, they’re finding a company’s valuation is more highly correlated with its efficiency score, which incorporates its revenue growth rate and its EBITDA margin.
“Certain sectors are less impacted by recessions,” New adds. “For example, putting aside healthcare spend or staffing, companies in the medical space are going to be in demand all the time, so you have a reasonable expectation that they can keep growth rates up.”
Given the current inflationary environment with the potential for a recession ahead, he expects the ability of PE managers in general to deliver outsized returns for clients relative to the public markets will be impaired. Some of it may depend on the vintage of the funds they raise; for example, those that launch during a recessionary period tend to do very well as they’re able to make investments in companies that participate in the subsequent recovery.
Of course, the flip side to that applies to managers that have funds from previous vintages that run into a recessionary period midway through their projected investment horizon. Because companies’ growth rates wind up being lower than initially expected, New says, the funds likely have to push out their liquidity period – possibly by several years – in order to get to a more ideal valuation for their portfolio companies.
“If you think about a five-year fund that’s now going to take seven years to make it’s expected return on investment, it will have a lower internal rate of return,” New says. “It’s not going to be zero, as long as the fund is holding good, high-quality companies. But you’re adding on a couple of ‘dead years’ into the growth profile of the business to be able to capture the returns.”
