Curated content from Rick Nathan of Kensington Capital Partners, August 9th, 2010
Investors have been on a scary ride in the public markets through the past few days. With near back-to-back 500-point drops, all of the major North American stock market indexes have turned decidedly negative for the year to date. The historic S&P downgrade of US Government debt adds to the weight of worry on investors, alongside falling commodity prices and the continuing risks in Europe and Japan. Most investors have suffered from these rapid and severe declines in public markets.
Private equity investors have greater stability in their portfolios. Of course, all markets are affected by a weakening economy. And if access to capital becomes restricted, the effects will spread to private equity dealmakers soon enough. We saw this happen in 2007-2008, when banks stopped lending, public equity markets fell, and private equity firms found it difficult to buy businesses at realistic prices through 2009.
The correlation between public and private equities is indirect. Private equity portfolios will obviously be affected if the current market correction leads to a sustained period of lower valuations, or a new recession. But only after investors have connected this capital market activity back to the real economy. Private equity portfolios are not seriously affected by day-to-day gyrations in the public markets that do not lead to new economic conditions.
When public market turmoil does foretell a slowdown in the economy, the impact on private equity portfolios is typically muted. The chart below shows the Net Asset Value (NAV) of the Kensington Global Private Equity Fund measured against the major public market indexes in the period from August 2008 through July 2010.
Kensington Global Private Equity Fund vs. Public Market Performance
July 31, 2008 – July 30, 2010
As can be seen in the chart, the sharp declines in the public markets in September 2008 and following did not have as significant an impact on the Fund’s NAV. The values of private companies were re-set more gradually over subsequent months as it became clear that a recession had begun, with weaker prospects for sales and profits across the Fund’s diversified portfolio of more than 100 companies. During that period, the valuations of private companies declined, but nowhere near the levels reached at the depths of the public market panic.
Private companies are valued on Main Street, based on the real economy. Their prospects change with the economic cycle, but not every day or every minute. This can create a sharp contrast to the valuations of public companies established on Wall Street and Bay Street, so heavily influenced by rapidly changing market sentiment, program trading and other immediate distractions.
One reason for the different valuation approach is the lack of liquidity in the private markets. Investors cannot buy and sell at will, and so they see no need to continuously revalue their portfolios. When valuations are prepared, they are based largely on business fundamentals or completed corporate transactions (such as the sale of the company), which results in much less volatile pricing.
An allocation to private equity can therefore act as a shelter from stormy public markets, or at least as a shock absorber. Large institutional investors such as public pension funds have learned this lesson, and continue to increase their allocations in recent years, now in the range of 10% to 20% of total assets.
Individual investors can find similar shelter through a similar allocation to private equity in their own portfolios. A diversified private equity investment such as the Kensington Global Private Equity Fund can add real stability during times of market stress.
Of course, a diversified private equity portfolio such as the Kensington Global Private Equity Fund is not immune to public market fluctuations. Many private equity funds hold a small portion of their portfolios in publicly traded stocks, typically as a result of an IPO of one of their portfolio companies. For example, our Kensington Fund currently holds shares in a company that completed its IPO on the NYSE in June. These shares remain restricted under standard underwriters’ lock-up agreements for a six-month period following the IPO date. As a result, the Kensington Fund will experience some volatility based on this exposure. Public market stress may also reduce our ability to sell additional portfolio companies into the public markets for some time. However, since most of our portfolio companies are in the mid-market where company sales are primarily completed through strategic M&A transactions, this impact should be relatively less significant.