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Tough markets prompt hopes for strong private equity vintage
In private markets, like in winemaking, vintage years are important, and some of the best vintages of both arise in challenging environments – consider the Napa Valley cabernet sauvignon’s need for a dry, hot climate to produce its boldest flavour. Similarly, according to Franklin Templeton’s Tony Davidow, ongoing economic stress could create perfect conditions for a strong 2023 vintage in private markets.
“In our view, the disruption of 2022 and early 2023 should create an environment where seasoned private market managers can effectively deploy capital,” Davidow, senior alternatives investment strategist at the global investment manager, says in a recent analysis, citing falling valuations, slowing exits and tighter lending conditions.
“Much like we see with wine vintages, the best investment opportunities can be produced in challenging periods where declining equity markets, rising interest rates and economic uncertainty prevail.”
Recession and ‘golden vintages’
Examining a paper released by alternative investment platform CAIS earlier this year, titled “When might ‘golden vintages’ appear in private markets?”, Davidow looks at how today’s market conditions, with recession fears swirling, might affect private market vintage, or the year when a private equity fund initially deploys capital to a project.
The January paper expanded on a previous analysis that found private equity funds that deployed capital in lower-valuation, recessionary environments tended to outperform those with other vintages, drilling down to the sub-asset-class level and the potential importance of entry point and vintage diversification. It focussed on buyout and venture capital funds and private real estate.
“Since they are typically paired with downturns in the stock market, recessions may provide private equity investors with an attractive backdrop of depressed valuations,” the paper stated. “Given the potential for acquiring companies or assets at cheaper prices, funds that make investments through these periods may be positioned for better ultimate outcomes relative to funds that deploy capital in richer valuation environments.”
Organising vintages for private market strategies around their proximity to either the dot-com crash of 2002 or the Global Financial Crisis from 2008 through 2009, CAIS looked at whether entry point influenced the strategies’ performance. It found that in most cases across asset classes recession-year vintages averaged the highest net multiple return compared with funds vintaged in the three years leading into a recession.
“We find that ‘golden vintages’ in years of recession did seem to apply historically across buying, venture and private real estate funds in most cases – although the degree of outperformance differed based on funds’ relative peer performance ranking and strategy,” the paper stated, concluding that recessionary conditions would support a “relatively strong vintage” in private markets.
Resilience through challenges
Applying the winemaking metaphor, Davidow explains that some wines do well in challenging conditions because they have to work harder to source water and nutrients. With cabernet sauvignons, for example, “some of their best vintages have come during periods of droughts.
“Similarly, private market results vary by vintage years, and data suggest that certain strategies perform best in challenging environments,” he says. “It is not yet clear when or if we’ll have a recession in 2023 – but it has certainly been a challenging market environment, and with dislocation comes opportunity,” Davidow says.
Private markets have seen an “incredibly strong” last 10 years, with increased demand and elevated valuations providing support and fundraising surpassing US$1.2 trillion annually the past several years, he says. “Despite the economic headwinds of 2022, private markets remained relatively resilient throughout the year, with record amounts of dry powder on the sidelines.”
And banking stress earlier in 2023 put further pressure on private market valuations, he noted, with credit conditions now considerably tighter.
“Private market managers who can effectively prune, cultivate and harvest their portfolios should be rewarded with a resilient vintage. We believe in the long-term merits of private markets and think that 2023 may represent a compelling investment opportunity and a strong vintage year.”
