Over the past 30 years, this has always been a buying signal.
Take a look at Britain’s largest listed private equity firm 3i Group, for example.
It took a majority stake in Zwaagdijk-Oost-headquartered Action in June 2011. The fastest-growing non-food discounter in Europe, Action has more than 2,300 stores across the Netherlands, Belgium, France, Germany, Luxembourg, Austria, Poland, the Czech Republic, Italy, Spain, and Slovakia.
There is considerable market positivity around Action, encouraging cash flow, and the company’s valuation is very high. Earlier this year, Action was ranked first in EY-Parthenon’s annual study of France’s retail landscape, and in the year to January, it reported a 30% jump in revenues of €8.9 billion.
But even though Action makes up just over 60% of 3i’s portfolio, the private equity firm had a price/earnings (P/E) ratio of only 4.5 in mid-June. Calculated by dividing the share price by its earnings per share, a high P/E ratio means that investors are willing to pay a premium for the stock while a low P/E ratio often means that the stock is undervalued. In comparison, at the same time, the UK FTSE All-Share index had a P/E ratio of 14.4, which suggests that 3i has been trading at a significant discount to the main index.
Similar valuations were seen in 2012 during the euro crisis and the discounts were even higher after the great financial crisis of 2009. But the major difference is that the leverage ratios – the extent to which a company uses debt to finance its operations – were much higher then.
The bottom of the market
Private equity is the only asset class that gives investors access to unlisted companies that are innovative, no matter whether you are talking healthcare, industry, biotech, software companies or, like Action, retail.
It is true, of course, that investors can look to established corporates to get access to emerging businesses as they often invest in startups within their own field. Investors could, for example, buy into Volkswagen or Novartis to get exposure to the automotive or healthcare sectors. But the capabilities of a corporate manager that is looking after those companies are completely different from those of a private equity manager. The latter does nothing all day except search out the next big companies. If they buy a company, it is for no other reason than they think it is a good deal.
Above all, private equity is the only asset class that can profit both from bull and bear markets. According to the LPX50 NAV Index which measures the returns of Private Equity valuations, it returned 8.34% in the decade to June 2020.
It benefits from a recession because then it’s a good time to buy companies, while during times of expansion, private equity can boom because it is easier to achieve higher valuations and make trade deals for the companies within their portfolios.