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Trouble Brewing in Private Equity?

In the low yield, low interest rate, low expected return, and low liquidity premium world, cash has flooded into alternative investments such as hedge funds, infrastructure, property, and of course private equity. Asset allocators see these increasingly mainstream "alternative assets" as saviors of sorts, providing lofty return expectations with apparently low volatility.

And it has been a long time since these sometimes little understood asset classes have faced a real test.

But that could be changing.

An obscure index - in truth, a subset of private equity (and some may even call it a misnomer) - the S&P Listed Private Equity Index has undergone a major breakdown. Gliding through its 200 day moving average and slicing through well defined support levels, there is open air before the next logical support level comes into play.

price chart of US listed private equity index

But what's the big deal? Isn't that just normal market volatility? Well yes. It is just normal market volatility, and that can be a big deal for this sector. Private equity relies on a few things to really work at its best: 1. High stock market valuations and buoyant M&A activity to offload mature investments at a premium (this gets put at risk when you enter a market correction, and the 2015-16 twin corrections provided an example of how it can take a while for normalcy to return). 2. Easy access to cheap funding (to load up companies with debt and boost ROI)...

Problem with that latter aspect is credit markets are starting to stir after relative slumber. Although meek movements compared to the price action in equity markets and the VIX, credit spreads have begun to widen across markets (I'm talking US HY, US IG, European HY, EM corporate, Bank CDS). A good example is the trend across US corporate CDS pricing. You can see a clear and steady uptrend in that chart, and if it's a sign of things to come it could mean a double-headache for private equity investors.

Credit risk pricing widening - chart of US corporate CDS premia

Maybe this all barking up the wrong bush, but the very real prospects of a tightening up of credit markets, muting of investor sentiment, and reduced valuations would present real challenges for private equity portfolio managers. In truth it is the type of asset class which is supposed to be looked at over a long time horizon (then again consultants and academics would advise you take a long term approach to most assets - especially stocks!). But it's important to be wary and cognizant of market developments and how they can rattle the foundations of great expectations... "Those who cannot learn from history are doomed to repeat it"

Note: The Charts in this post came from the latest Global Cross Asset Market Monitor

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