In recent years, private markets have become more widely used and easier to access due to the rise of online platforms and increasingly sophisticated investors.

In this podcast episode, Paul O'Connor, Head of Investment Management at Netwealth, and Roberto Cagnati, Chief Risk Officer at Partners Group, discuss the advantages of private markets compared to listed markets, including private equity, debt, real estate, and infrastructure. Hear how private markets may help diversify and lower volatility in portfolios, along with their unique benefits that make them an attractive investment option to some.

Transcript

Paul O'Connor:

Welcome to the Netwealth Portfolio Construction Podcast series. My name is Paul O'Connor and I'm head of strategy and development for investment options. Today we have Roberto Cagnati from Partners Group who are a specialist private markets investment manager.

So we'll focus today's discussion on opportunities across the private assets landscape. Given the volatility enlisted markets over 2022, it will be timely to hear Roberto's views on whether private markets have experienced similar levels of volatility and how correlated their returns have been to listed markets. Roberto Cagnati is Partners Group's Chief Risk Officer and head of the Portfolio Solutions business department based in Zug, Switzerland. He's a member of the executive team, the Global Portfolio Committee, the Global Executive Board, as well as Deputy Chairman of the Private Markets Relative Value Committee. He's been with Partners Groups since 2004 and has 19 years of experience. Prior to joining Partners Group, Roberto worked at Deutsche Bank Asset Management and Credit Swiss Private Banking in the alternative investment space. He holds a master's degree in economics with a specialisation in statistics and financial markets from the University of Konstanz Germany. Good morning Roberto, and thanks for joining us today for Netwealth's Portfolio Construction Podcast. And I hope you're not too jet lagged given you've just arrived in Australia.

Roberto Cagnati:

Good morning Paul. Thank you for having me. Now we're all right and very excited to be here.

Paul O'Connor:

Yes, well welcome to Melbourne, welcome to Australia. Partners Group is a leading global privates markets firm. Since 1996, they have invested over US 195 billion dollars in private equity, private debt, private real estate and private infrastructure on behalf of their clients globally. They're considered a pioneer of semi-liquid private markets, investing in Australia, the US, and the UK. Partners Group seek to generate strong returns through capitalising on thematic growth trends and transforming attractive businesses and assets into market leaders. There are four Partners Group managed funds on the Netwealth Super and IDPS investment menu covering private equity, private debt, unlisted infrastructure and direct property. Over the last decade, we've seen more investors allocating to private assets in their diversified portfolios. This was led by large institutional investors including industry super funds, but there are now more opportunities for individual investors to access private assets through funds managed by groups such as Partners ,roup.

So why has this occurred? Well, private markets really increase the investment universe across equities, property debt and infrastructure, and are typically less volatile than listed markets as they are not valued daily. Like for example ASX listed equities. Most companies are not listed on equities markets, so private equity can really provide opportunities to invest in businesses earlier in their life at lower valuations. Whilst private debt also affords investors that potential for superior risk adjusted returns and a way of targeting returns, I guess, that are less correlated with public markets. As private assets are not listed, they should not be considered liquid but do offer an additional return over listed assets known as an illiquidity return premium. The challenge for investors is to ensure they understand their liquidity needs when allocating to private assets to ensure they're appropriately used in a diversified portfolio.

2022 was a volatile year for most markets driven by geopolitical risk, inflation, and sharp interest rate rises, but certainly highlighted some of the benefits of private assets. As private equity, for example, generated positive returns outperforming listed equities, whilst private debt also generated positive returns over traditional bonds.

Given most private assets have some debt associated, I'll also be interested in Roberto's thoughts on how inflation and rising bond yields may have impacted on the return profile of private assets. Roberto, I note you've been with Partners Group since 2003, so can you provide the listeners with a few comments on your career journey to being Partners Group's Chief Risk Officer, and head of the portfolio solutions team?

Roberto Cagnati:

I'm happy to, Paul. Well, I joined Partners Group pretty directly out of university. You mentioned before a couple of small stints with some of the banks. I figured that's not something for me. So I joined that what at the time was a relatively small firm with less than a hundred people. My role has been from the early days focusing on the evergreen private markets fund in a portfolio management role. I originally started focusing on one of the funds and I guess then as the time passed by, we went through the GFC, through some of the volatility in the early 2010. More and more funds came into our responsibility and eventually we became a team and I think fast forward to today, it's not much different really. We're in charge of managing the what we call bespoke solutions at Partners Group. That's on one hand [inaudible 00:06:30] where certain institution investors invest bespoke just for them with own guidelines and on the other hand, requiring at least as much attention and complexity the evergreen solutions which cater to towards the private wealth market mostly.

Paul O'Connor:

Moving into the discussion for today's podcast, Roberto, what role do you believe private markets play and how important are they to the economy relative to public markets?

Roberto Cagnati:

Well, I think we've gone through quite a journey since the days of barbarians at the gate. In the late eighties, or most of the older semesters amongst us, might still be remembering Pretty Woman, where Richard Gere was part of putting a company into pieces and selling its parts. I think from what used to really be a fringe strategy, almost an event driven strategy, focusing only on very few industries, over time private markets really has extended, not just across all industries but also across multiple classes such as infrastructure, real estate and private debt. And today really if you look at return drivers and where returns are earned, rather than an arbitrage of some of the parts type of strategy that reminds us more of hedge funds today, this is really has become an investment strategy where superior growth of the underlying businesses or assets are really the main driver of our performance. And has been over the last 15 odd years.

At the same time maybe that's a bit the contrast to it. We all remember in the eighties or the early nineties when an IPO of public listing would be a pinnacle of like a corporate journey. You achieved a listing, you're listed on the New York Stock Exchange and that was in itself a desirable goal for people owning and running companies. I think that since has turned quite a bit. We were just recently we had our annual general meeting and one of the statistics that were shown there was that actually 90% of businesses that IPO today are not even profitable. Public markets have become less and less representative of the overall economy. It's really probably the less spectacular businesses, the bread and butter businesses, I want to call them brick and mortar businesses in private markets, that maybe don't get all the news and the big brands and the big logos, but they tend to be much more representative for the real economy.

Paul O'Connor:

It certainly resonates your comments there Roberto, because I do recall back in the 1990s there was almost no opportunity to invest in private equity. And yes, everyone used to feverishly I guess jump onto IPO opportunities, but that does seem to have moderated there and I think it's an important role that private equity now plays in the evolution and development of a corporate. Private market valuations have been topical in recent times. What are the main reasons as to why private and public market valuations differ?

Roberto Cagnati:

Well, I guess there's a couple of things. To start with, a typical private market portfolio consists of different industries. It's much broader than what you see today in public markets. So if you look for example at public indexes, you see a heavy overweight in cyclical industries, in technology. There's cyclical business models that are energy priced dependent, financials that can see quite some volatility. I think what we're focusing on in private markets is a portfolio of assets or companies. It's much more focused on cash flows and as such you own more the boring type of businesses that are highly cashflow generative, those. So you live less of the fantasy of the potential future growth, but more of the revenue growth, the cash flows in the here and the now. And I think as a result, if I look at 2022 for example, if we start off with public markets, depending which index you take down, probably around 18 or 20%. You look at an industry adjusted index for a private markets portfolio, you end up being down only 10.

So the sheer selection of themes, industry sectors that the private markets have been exposed already provided a good degree of resilience. And I think then the biggest single driver certainly this time around and also in previous setbacks such as COVID, has been the superior growth. So if we look at our broadly diversified private markets portfolio, you see an earnings growth of 17.6% in 2022.

That compares with public markets between five and 8% depending at which index and which country you look at. So this out performance in growth that has reflected itself also in the final performance of last calendar year, which was admittedly a very difficult one. So if you do that whole bridge, you see a public market is at about minus 20, you see an industry adjusted index that gets to minus 10 and the balance that gets you all the way to roughly zero and then it's a give or take depending on which portfolio. That is really driven by earnings growth that has been substantially higher than public markets. One thing that private markets had in common with public markets is we have seen valuation multiples come down. So we have adjusted the valuations to reflect at the interest rate. Environment has been changing both on the private and the public market side.

Paul O'Connor:

I guess as you're responding to the question there, Roberto, am I correct in thinking that you are of the beliefs that private markets are more efficient at pricing and I guess less momentum-driven like listed markets can be at times?

Roberto Cagnati:

Well I guess for sure... I don't know whether private markets are more efficient. I think there's for sure less noise and there's a valuation discloser to how the companies fundamentally develop. So to some degree you're less subject to sentiment and you're more subject to the results that you're producing.

Paul O'Connor:

Before we bring you the second part of this chat a little bit about who we are. Netwealth is an ASX listed company established to help Australians take control of their financial futures with a wide range of super investment accounts, a huge variety of investment options and market leading online tools. We can help you manage your wealth your way. Partner with us to see wealth differently and discover a brighter future. Visit the Netwealth website to learn more and get the PDFs, which you should read before making a decision. Products issued by Netwealth Investments Limited.

Private equity deals usually involve leverage. So can you explain how Partners Group use leverage in your strategies and what gearing levels are currently across private markets at the moment? Has it been going up or coming down? As interest rates have increased significantly over the last 12 months, what impact then has this had on the private equity and private market returns in general?

Roberto Cagnati:

Well, I guess there's two questions here. If I look at leverage levels over longer time periods that certainly come down, so I'm not going to go back through all the history, but if you think eighties, nineties, you talk at the leverage of nine to one, 10 to one. That then moved to somewhat of a one to two in the early two thousands and over the last 10 years we've probably been at 50% equity, 50% debt contribution, so one to one. So as a result, the use of leverage has been relatively modest and relatively moderate over the last decade or so across the industry. And I guess specifically for Partners Group and the way how we tend to invest a bit more conservative also thinking about scenarios that could go wrong. There's two important elements when you think about leverage.

The first one is we're not talking about leverage that for example, hedge funds would take where you then get the ominous margin call if there's volatility in the market, then you run into trouble. Typically the debt of our portfolio company has maturities that are out in 2027, 28, 29. So you pick set at seven years for a seven-year maturity once you invest so your financing is secured, which is actually a plus during more volatile times.

The second element, and that's something that is specifically relevant in the current market environment. So if you take the debt that typically is floating rate, you don't leave all of that unhedged. So anticipating the risk of rising rates since 2018 at Partners Group, we have been starting to hedge interest rate risk. So we went into 2022 and that rising rate cycle with about 84% of interest rate risk hedge, which helps a lot obviously now as effectively the debt servicing costs for our companies has not changed.

Paul O'Connor:

We've heard about private equity vintage years where returns can differ significantly year on year. So is now an appropriate time to consider investing in private equity and what are the current opportunities available in private markets?

Roberto Cagnati:

Well, I guess with regards to vintage years only so much. Generally, I wouldn't advise an investor too time too much, but to expose yourself to each and every vintage year and then get the diversified portfolio across vintage years. That certainly gets you with the lowest overall volatility and the most consistency of results. What we see though, and that's not just the investor in us, would just see obviously if I look at the world today, we can definitely invest at much more attractive prices than about a year ago. And some of the segments that might be interesting here is, on one hand, the secondary market. So that's when you buy private equity exposure off the balance sheet of some other investor who finds a reason to prematurely sell it. Typically you can buy that at a discount and the seller in such environment will hit the bit and provide you with an attractive return profile early on.

I think there's some more general opportunities such that simply companies today you buy at a cheaper price. You buy them at 20% less than you've bought them about a year ago and they've been growing in the meantime.

To other areas that I would like to mention is private infrastructure, which is inflation protection features is something we've been very active in and we have a very long pipeline of opportunities. And I guess last but not least, also in the private debt space, we have seen substantially increase both in base rates and in spreads. So what maybe one and a half years ago has given you a five, six percent return, you now get paid eleven, twelve percent. For with a very similar risk profile, almost twice the return.

There is one maybe more complex, but still I think noteworthy element I want to mention. So there's one element we went into 2022 as many others as you can imagine, and we had lots of ideas of mature companies we would hold in our portfolio that we wanted to bring to market that are performing strongly that we have been working with for a number of years of that they've been considerably improved compared to when we bought them three, four years ago.

But given what was going on in last year's markets and all the volatility, whatever is small private equity manager would do. We did not sell at the price that we deemed unfavourable. So what does it leave us today? I think today we're in a situation where portfolios are more mature than average. The holding period of our portfolio companies is longer than usual. So there's a lot of very mature or ripe for realisation investments and I think in a world where the next twelve, eighteen months do not look like a complete Armageddon, but there is some calm. So I'm not talking about markets go public, markets going up, but just a bit of calm and functioning financing markets. I think there's some considerable potential that can come out of those realisations.

Paul O'Connor:

So what are the deal flow trends that you are seeing and are there any broader industry or sector trends?

Roberto Cagnati:

I think that's very difficult to pinpoint because in reality our metrics or themes that we're following consists of 60 at any given point in time. I for sure want to mention a couple of areas that tend to be somewhat reoccurring. That's the digitization of businesses that can be very traditional businesses in goods and products. Then you bring in some technology, some software that helps digitising processes and making them more efficient and gain market share. Another area that we have been very active in is certainly the broader healthcare sector. There's a lot of interest in developments as well to be capitalised on.

Paul O'Connor:

Is private equity a large holder of technology companies and has the listed markets selloff impacted on some of the tech holdings?

Roberto Cagnati:

I think broadly speaking for the industry, you're certainly right. There is the whole venture capital area, which certainly has been impacted. As far as it goes for private equity in the more stricter sense of things such as buyout investments, technology plays a very minor role. So across our portfolios you talk about a location of somewhere between three and four percent. So relatively minor part compared to what maybe is the coverage that you see in the news for some of those companies.

Paul O'Connor:

And I guess a lot of the tech companies may not be that attractive to you or partners group given they're not positively generating cash flow as well. So I think it goes back to some of the earlier comments you were making there, Roberto.

Roberto Cagnati:

Many of them are way too early in their life cycle and too unproven yet. So that's more of mentality where you can invest and if you pick the right one and the winner takes it all, you get your 10 times the money, but there's also other nine where you lose it. That's not really the type of risk return profile that our clients expect us to go for. So it's not really something you'd find partners could do a lot.

Paul O'Connor:

So you mentioned earlier, Roberto, about the, I guess the growth of the Partners Group business, but also the maturing of the industry and the asset class of private assets. So has the growth of private market strategies over the last 20 years or so impacted, and the capital flowing into private equity, has this impacted on prospective returns?

Roberto Cagnati:

Most certainly has a substantial impact on the how. So I think while in the early two thousands you probably still could claim that you have a valuation arbitrage. You buy companies on the private market cheaper than on the public market. I don't think that is the case today. I think the market is institutional today and the value or the outperformance you create, I think comes less from spotting the asset, but it comes from A, identifying the right theme with growth tailwind, and that's something that we spend as much energy and we spend on finding the right business to invest in. So it's literally a breaking down process. What is the giga theme? What is the sector, what is the right theme and what is the company the business models within that sub sector will benefit? But then obviously, probably even more important once you own the company, that is when as a majority owner in control of the company, you have to implement all the growth initiatives, all the improvement, the savings on the procurement side, the tuck-in acquisitions that complement your business, that allow you to grow into new markets.

That's not something that happens just by buying the shares and sitting in a board once a quarter overseeing how things are developing. That requires a very active role by us as owners, as board members by external operating directors we bring in with very specific tasks and areas of expertise that can bring into that company. So it sounds all very boring because it's super detail oriented work. I really think this is where the difference comes from. Sleeves up and working with the companies, understanding what you're buying and then bringing that over the finish line, over your five, six years old and sometimes holding things even longer if there's further way to go.

Paul O'Connor:

Yes, well I think it also highlights Roberto, the role of the active private assets manager. And it's not a case of just looking at a corporate, finding the sector or the company attractive and investing in it, but it is then working in the business and helping it develop and fulfil and flourish in its potential that which is what attracted, I guess groups like yourself to taking equity in these businesses in the first place there. A very different role is played by an active private assets manager compared to, I guess a traditional active equities manager. What is, I guess some of the key takeaways for advisors and investors from a private assets manager viewpoint? What should investors consider before allocating to private assets in their portfolios?

Roberto Cagnati:

As a starting point, most investors try to gain exposure to the broad economy, and I think that the train of thought we developed right at the beginning around private markets being the new traditional asset class. I think that deserves some digging and thinking because maybe private markets, even though many investors put it into the alternatives bucket, will find better economic exposure represented by your private market allocation as opposed to some public index that is dominated by very few, very large companies.

I think as a second point when it comes to performance, I advise look one level deeper. What are you getting? What are the businesses growing that you have in those portfolios? So I think that is the ultimate driver of long-term performance. And I think that will also point you to good reasons and good evidence why your private markets portfolios outperformed in 2022. Which don't relate to the valuation policy or a gap, but it's actually based on fundamentals driving those businesses.

I guess last but not least, it's complex topic that goes into a lot of different facets and John O'Britt and Markus who are our team here on the ground, are certainly happy to elaborate on our current strategies available on that wealth.

Paul O'Connor:

I do find that... Well, I guess I've always been a little perplexed by the way that from an asset allocation perspective, anything that doesn't neatly fit into the traditional asset class buckets is put into alternatives. And I think I certainly share your view there, Roberto, that private assets I think should be considered an asset class in their own right. And then investors need to think about the breakdown and the exposures then that they can gain, as you've mentioned today, across direct property or infrastructure or private debt or private equity there. Rather than just dumping it into alternatives with maybe hedge funds and other type of strategies there. So some very salient and interesting comments and observations you've provided today there, Roberto.

So I'd like to thank you very much for joining us on the podcast, on the Netwealth Portfolio Construction podcast. I'm sure it's certainly a topical area for our listeners and I'm sure that everyone who's joined the podcast today will have found it interesting, the insights you've provided across the whole private asset universe there. So I wish you all the best for your travels in Australia this week and I'll look forward to joining our listeners on the next instalment of the investment podcast series. So thanking you again, Roberto, for your time and your insights today.

Roberto Cagnati:

It was a pleasure. Thank you so much, Paul.

Paul O'Connor:

Thank you all.