Jun 2019 by Kunal Shah and Tatiana Esipovich
What most advisors overlook is that although companies are trading at historically high levels, today’s private markets trade at a meaningful discount to public markets and also offer more top-line growth.
This may seem counterintuitive given that we appear to be late in the market cycle and private market valuations have been high on an absolute basis, which has generated a fair amount of cautionary headlines in the media. Indeed, since 2014 the average U.S. PE1 purchase price multiple has hovered above 10x EBITDA,2 levels last seen in the pre-Global Financial Crisis years. However, looking at asset classes in isolation never paints the full picture and high multiples alone should not deter investors from allocating to the private markets.
If one looks to the public markets, valuation multiples are even more elevated, with the public markets having remained on average more expensive than the private markets since 2012. Private and public market valuations tend to move in tandem, although in some periods the gap widens. As shown in the following chart, private markets have generally shown a greater discipline in valuation when compared to the S&P 500 and Russell 2000 over the past several years.
In 2018, the S&P 500’s average Enterprise Value-to-EBITDA multiple was higher by three multiple points (or 28% higher) — and the Russell 2000’s eight multiple points higher — than that of the U.S. private equity market. In other words, although today’s high valuation environment is pervasive, the private markets generally offer more attractive values.
The private markets are also generating the fastest growth in the U.S. economy. In fact, private middle market companies (which make up about 98% of the entire U.S. middle market3) have consistently experienced revenue growth in excess of major public indices and overall U.S. GDP. Over the last three years, the average revenue growth rate for middle market private equity was 411 basis points higher than the S&P 500.
The private markets therefore provide investors with more reasonable valuations on a relative basis as well as access to a faster growing universe of companies. An Ernst & Young survey4 concluded that in 2018, over half (58%) of private companies targeted growth rates in the high single digits. Another 28% of privately held companies planned on double-digit growth in 2018, 800 basis points higher than their public peers. Meanwhile, the universe of publicly-listed companies in the U.S. continues to contract and grow older — the average age of public companies has increased from 12 years at the peak of public listings in the mid-1990s to over 20 years in 2018.5 It is then of little surprise that these faster growing private companies continue to outperform the public markets across both high valuation environments as well as more measured ones. Median private equity has continually outperformed, while the top quartile has generated significant outperformance ranging between 810–1,510 basis points over the S&P 500 since 2013.
Another important aspect of private market valuations is that many traditional PE transactions are control buyouts, where the buyer takes over majority control of a firm. This comes with a significant benefit, in that the new PE owners are typically focused on driving significant value creation in the portfolio companies by adopting long-term strategies which they can oversee and closely monitor. In fact, experienced private equity managers are almost obsessively engaged in these three- to six-year strategic plans, which is the typical length of PE ownership — in contrast to public businesses that often suffer from "short-termism", placing heightened importance on short-term profits and the pressures of quarterly earnings reports. These PE managers spend a significant amount of time with the senior executives running their portfolio companies, focusing on long-term plans such as expanding into new markets, making add- on acquisitions, selectively consolidating a fragmented sector by acquiring smaller companies at lower entry multiples, and/or improving operations by streamlining costs and selling non-core assets. These are all levers that help drive value, and therefore the ultimate valuation at which a portfolio company is sold. Arguably, public markets appear more expensive after factoring in lack of control or influence investors have on decisions made by underlying companies’ management teams.
Overall, the private markets represent an attractive proposition as well as a way to diversify an investor’s portfolio. Not only is there significantly higher revenue growth potential (even from a purely organic growth standpoint, without considering the effects of any M&A), but one can enter at a lower entry valuation, compared to the public markets. However, valuations are often driven by sentiment and frequently tend to deviate away from fundamentals. It is key to focus on the quality of current revenues and earnings when analyzing a company’s long-term viability. As the chart on the following page indicates, if all things were equal from a valuation perspective, by then focusing solely on revenue growth, investors have the potential to generate significant additional returns in the private markets.
Together, private equity’s historically lower valuations, focus on long-term value creation and ability to generate more growth compared to public market peers should result in higher returns. This has been the case historically and is reflected in the illiquidity premium associated with investing in private equity funds. Over the past 15 years, private equity has generated 433 basis points of outperformance against the S&P 500 and 490 basis points of outperformance over the past 20 years6 — and top quartile PE managers have generated an even more significant premium over public market returns. Investors seeking to build out a diversified portfolio would therefore do well to dig deeper behind the headlines of lofty valuations, as the private markets have much to offer.
(1) Private equity ("PE")
(2) Earnings before interest, tax, depreciation and amortization ("EBITDA")
(3) Source: NAICS Association, Firmographic Breakdown of Business Establishments by Company Size; as of Q4 2018
(4) Source: Ernst & Young, How Private Companies Are Driving Growth, November 2018. Survey was commissioned in Q1 2018 surveyed over 2700+ C-suite execs from 21 countries. https://www.ey.com/en_gl/growth/how-private-companies-are-driving-growth
(5) Source: René M. Stulz. The Shrinking Universe of Public Firms: Facts, Causes, and Consequences; as of 2018
(6) Source: Cambridge Associates, LLC. US Private Equity Index Summary, as of September 30, 2018.
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