In the Marvel Superhero saga, the god Loki uses his substantial magical powers to disrupt the plans of our heroes and creates chaos and disruption in the universe. In financial markets, we measure chaos and disruption with a mathematical formula, and we call it volatility.
Loki, the trickster god creating disruption and chaos.
For the past several years, volatility has been under control, and the global financial markets have benefited from benign fundamentals, plentiful liquidity and rising asset prices. Investors with heavy weightings in liquid equity, credit and private equity have been well rewarded. While we’re not necessarily saying that the party for risk assets is over just yet, Loki has made an appearance in recent months stoking volatility in the listed equity markets. The VIX index - a gauge of short-term risk in large-cap U.S. equities – rose from an average of 11% in 2017 to a high of 37% in February 2018 and remained elevated throughout March and April.1 Perhaps not surprisingly as a result, strategies designed to benefit from a low volatility bull market have been called into question.
Just as growing economies and calm markets serve to inflate the values of risk assets, common sense tells us that rising volatility and heightened risk aversion should lead to a crash. At times like this, there is no shortage of market experts arriving on the scene to spew sage advice to investors: Returns for large-cap equities are headed south, and over-levered buyouts will be hit even harder! It’s time to sell everything! Invest in Bitcoin and gold! Move to a bunker in Switzerland!
Before we outfit the bomb shelter, let’s first take a step back from the proverbial ledge and look at the relationship of volatility and buyout performance from prior cycles, and present our conclusion of what it might be telling us about this cycle.
STAND BACK – HE’S GOING TO USE HIS DATA!
Let’s assume that we have returned to a regime of higher market volatility: What might this mean for listed equity markets? What about the illiquidity premium we expect from investing in private buyouts? Some readers may object to what follows as a fruitless exercise. Private markets deal professionals might say, “The VIX is a just a short-term trading barometer and therefore irrelevant to buyouts with multi-year holding periods.” Then liquid market quants might chime in, “The quarterly marks in buyouts are not real market prices. Comparing short-term buyout returns to public markets is pointless.” Wow, tough hypothetical crowd. Fortunately, we can address both concerns by looking at realized equity volatility and buyout returns over a three-year rolling basis, which is a long enough time frame to span the bulk of a typical buyout holding period, but not so long that it smooths over market extremes.
Well, we crunched the numbers and the results are in. During benign economic environments with low volatility, loading up on equity market beta through a low-cost index fund has been a winning strategy. Looking at the Russell 3000 as a proxy for the large and mid-cap U.S. equities, three-year annualized returns averaged 14% when volatility was below its long-term median. If, however, we have in fact entered a new regime of higher volatility, then things might not be looking so hot for the listed equity markets. In times of highest volatility, public equity returns turned negative. Yikes! I guess that’s why they’re called “risk assets.”
Looks like volatility is not so good for public equity returns, but what is the impact on private buyouts? For the purposes of this exercise, we’ll focus on the illiquidity return premium – that is, the returns of buyout funds minus those of public equities.
In this case, the results in high volatility environments don’t look so bad for buyouts after all. The outperformance of buyout as a strategy has been a little bit higher on average when public equity volatility is low, but when we apply our statistical tests, we do not see much of a relationship between the two variables.
Wait a minute. These are deal-level returns, right? Won’t all of the buyout premium be swallowed up by fees paid to the GP? Sorry to disappoint, but no. This analysis is, in fact, based on fund-level cash flows net of GP fees, carry and fund expenses. That is the real return premium experienced by LPs.
Let’s look at the same data sliced a slightly different way just to drive home the point. (And because, you know, we like to be thorough….) When we separate the time periods into quartiles from lowest volatility to highest, we see that the buyout risk premium is not exclusive to low volatility regimes. Compared to the disappearing equity risk premium, the robustness of the buyout risk premium really stands out.
Some private market critics - and quants of all stripes - like to claim that investing in buyouts is no better than levering up a public equity index. In other words, they claim that buyouts don’t outperform listed equities after adjusting for risk. But if buyouts really were just public equities with more leverage, then we should expect buyouts to underperform when equity returns are negative. In reality, our analysis shows that buyouts have maintained their outperformance across volatility regimes, while public equities have underperformed risk free assets in the wake of high volatility.
Buyouts save the day
Since, after all, Hamilton Lane is focused on the private markets, you didn’t really expect us to hammer on buyouts in our quarterly newsletter, did you? Still, you may find the implication of this analysis surprising. In high volatility environments, the equity risk premium has collapsed, but the buyout risk premium has not. Aren’t you a little bit curious why that is?
If you were hoping for an elegant mathematical derivation of this phenomenon, once again, we’re afraid you are in for a disappointment. To paraphrase U.S. Supreme Court Justice Potter Stewart – we can’t define it with a Monte Carlo simulation, but we know it when we see it. We do have a theory, however, of how some aspects of the buyout structure allow managers to outperform public companies in volatile environments.
Buyout owners can outperform public companies by adding value in four key ways: (1) buying at attractive valuations though negotiated transactions; (2) resetting capital structure to optimize the cost of capital; (3) changing strategy and improving operations; and (4) exiting to the buyer that assigns the highest value to the asset. For the buyout model to work, the return added must pay the GP’s generous fees with enough left over to compensate LPs for taking on the illiquid exposure.
The key for our purposes here is that an environment of heightened volatility actually enhances opportunities in the first three value-add opportunities:
- Volatile environments can produce motivated sellers of corporate assets, or at least temper seller price expectations.
- Many GPs are experts at debt structuring and operating a leveraged balance sheet. Volatility can highlight the value of covenant-light debt, PIK toggles and the ability to call capital to cure balance sheet problems.
- A GP with operating capabilities can react quickly to changing conditions. This is in contrast to listed or family-owned companies that can be notoriously slow to swap out management and modify challenged business models.
We theorize that advantages in these three areas more than offset risks to buyouts from a challenging exit environment and higher debt loads relative to conservative listed company balance sheets.
OK, so this is a perfectly fine story we have made up, but wouldn’t it be nice to have some kind of validation for our theory? If only there existed a group of investors who focused on the relative risk of GP sponsored and unsponsored companies across business cycles. Behold! The universe of direct lenders has years of experience doing just that. And our contacts in the lending space tell us that they see much less risk of loss in sponsor-backed companies. In addition to the advantages highlighted above, buyout sponsors are focused on their long-term reputations and do not take imprudent risks in a downturn the way an unsponsored management team might. In fact, one lender told us it routinely charges unsponsored companies an additional 50 basis points credit spread for the same level of leverage. Another group we spoke with has moved exclusively to sponsored lending at this point in the cycle; the additional risk of unsponsored companies was just not worth it for them. That feels like a pretty solid validation that the risk-reducing characteristics we have identified are real.
We have come through several years of relatively smooth sailing and low market volatility, but we always knew that Loki could not stay away forever. The period we are entering may not be so tranquil. While buyout GPs have maintained their return premium in volatile markets on average, by no means are all managers alike. If we meet a GP whose strategy is to buy companies for top dollar at auction, lever up the balance sheet and pray that everything goes well, we are most likely to sit out its next fund. But, we are not pulling back on private markets investments overall. Managers with the right skillsets can profit from volatile conditions and produce the return premium that LPs expect.