Where to Next: A Framework for Resilience
January 22, 2019
We believe the next decade is unlikely to mirror the last. We witnessed the second-longest bull run in history with the S&P 500 index rising 17.9% annually since March 2009 (as illustrated in Display 1). In our view, predicting the exact timing of the next downturn is impossible but building a portfolio that seeks to withstand it is essential. We believe that this preparation requires applying a multidimensional investment methodology and discarding conventional wisdom.
While historically defensive sectors— such as utilities, healthcare, and consumer staples—have long been considered “safe” areas to invest and cyclical sectors have been perceived to have higher risk, we believe painting broad brush strokes about sectors and cyclicality is ineffective as a guideline for constructing a resilient portfolio. Rather, we believe that deep evaluation of company fundamentals alongside a clear understanding of industry forces is critical to the success of creating a portfolio that seeks to withstand the next market downturn.
Since the inception of AIP Private Markets in 2000, the team has collectively committed $18.0 billion to over 800 private equity transactions.1 Through this experience, we formed an investment philosophy that we believe helps enable us to endure challenging environments and to thrive in robust market conditions. Therefore, with a forward-looking lens, we developed a three-pronged framework for seeking to select resilient companies with strong value creation prospects that entails the following:
1. Identifying efficiency producing businesses with exposure to stable end markets
One of the challenges to investing resiliently is to identify businesses that will grow in both benign and challenging market conditions. One such niche that we believe has this characteristic includes companies that provide a solution or service that lowers the overall costs for customers, and therefore improves margins. Such offerings can be the result of minor or major technological advances or services that better fit the current needs of customers; often solving problems that did not exist 10-15 years ago. Businesses that focus on producing such efficiency can consistently do well through market cycles as they improve the profitability of their customers, agnostic of where in the market cycle they are implemented.
For example, we invested in the largest private label oral care manufacturer in the United States. Since the global financial crisis, retailers have experienced declining footfall and in some cases declining revenues. In response, many retailers materially increased their promotion of private label brands which are typically cheaper for end consumers and could be 3x as profitable as branded goods.2 As a consequence, consumption of private label brands has risen. The private label oral care manufacturer that we invested in is a significant player in this space and, in our opinion, is the chief beneficiary of this trend. As a result, this business has been able to grow even in a period where revenues for retailers are broadly under pressure.3
In a similar contrarian vein, we acquired a medical scribe company that serves medical providers including both hospitals and outpatient physicians. Our internal view is that healthcare providers will face both revenue and cost pressures going forward due to the U.S. government’s desire to control overall healthcare spending and a continued shortage of both doctors and nurses. However, this company provides material efficiencies to these providers by solving issues related to the recently implemented electronic medical record systems (“EMR”). This business provides qualified medical scribes that complete the EMR notes. This company has grown revenues organically at a rate of nearly 30%4 and we believe that its growth can continue even in more challenging environments for medical providers due to the cost savings the company provides.5
2. Partnering with highly aligned and specialized investment partners
In our view, assessing resiliency involves dissecting the experience base of owner/ operators and the payouts they receive from their compensation plans in both up and down markets. We seek to align ourselves with highly specialized private equity sponsors and management teams with proven track records of executing value creation plans and navigating operational challenges in the specific industry they invest in. We seek to achieve a strong alignment of interests with our partners by investing in businesses where the current sponsor/ manager of the asset believes in its go-forward value creation potential and their compensation structure encourages both capital preservation and generation of strong returns for investors.
By way of illustration, we invested in one of the leading healthcare providers of respiratory products. The company operates in a highly fragmented subsector ripe for industry consolidation. The value creation thesis going forward was predicated upon pursuing a consolidation strategy. Such a buy-and-build strategy, in our view, requires an experienced team that can identify and execute add-ons successfully. In the case of this company, the management is led by a CEO with 27 years of experience in this particular healthcare niche who had already completed over 60 accretive tuck-ins since 2006. The private equity sponsor is purely focused on growth-oriented companies in the healthcare sector and brought deep and complementary experience in the segment to this investment. The sponsor, who was the current owner of the asset, believed in the trajectory of the asset and they agreed to roll all proceeds generated from the profit share during their prior ownership alongside us in this transaction and to make a meaningful additional commitment to the investment from their personal balance sheets. Through this alignment mechanism, we sought to ensure our partners were incentivized to both preserve capital and produce positive investment returns.6
As another example, we purchased a platform of franchise boutique fitness brands in 2018. The CEO has a demonstrated track record of scaling fitness businesses, even through the global financial crisis. Confident in the value creation potential going forward, he rolled over his entire stake in the business to this transaction. Additionally, the option pool was increased for the management team and structured with performance hurdles. The private equity sponsor in this transaction is a highly regarded growth investor that has focused on the boutique fitness space over the last eleven years. This sponsor also made a considerable investment alongside us. This degree of alignment is representative of what we seek in our partners’ levels of commitment to the companies and their conviction around the growth prospects.7
3. Seeking value on the buy with businesses exhibiting high cash flow generation and conservative leverage
Investors architecting for resilience, we believe, are almost certainly concerned with the peak absolute pricing levels paid for assets in the current market, but many may forget that further fragility is added when we consider the impact of leverage. With average valuations hovering around 10.5x in the U.S. private equity market and 12.9x in the public equity market (as illustrated in Display 2), the environment continues to be challenging for investors seeking high quality companies at attractive prices. Nevertheless, we remain disciplined in seeking to purchase assets at discounts to fair market value and with strong relative value. The average discount to fair market value and entry multiple across the investments we closed in 2018 are 16% and 8.1x EBITDA, respectively.8
We believe that the key to accessing value in frothy markets is to take a proactive approach to deal sourcing. Through our relationship-driven sourcing efforts, we seek to generate proprietary deal flow that allows us to invest in high quality companies at reasonable purchase prices.
However, in our view, an attractive purchase price provides only limited protection in a downturn if the company is over levered. Although current leverage multiples have surpassed pre-crisis levels, we maintain our focus on conservative capital structures. The average debt/ EBITDA ratio for our investments made in 2018 is 1.9x EBITDA9 versus market leverage of 5.8x EBITDA.10 In addition to leverage, we also assess a company’s cash flow characteristics to seek to determine how stable, recurring, or sensitive they are to cyclical fluctuations. We seek to acquire highly cash flow generative businesses that continue to provide value to equity investors through downturns.
There are many strategies to look at when building a resilient portfolio. Our experience has led us to develop a framework for selecting companies and constructing a portfolio that seeks to withstand changes in the economic cycle. They should be well-capitalized, led by strong management teams, and fall within pockets of growth in less cyclical industries. We believe this guiding philosophy can enable a portfolio to perform well in both economic booms and recessions.
For illustrative purposes only. The statements above reflect the opinions and views of Morgan Stanley AIP Private Markets as of the date hereof and not as of any future date and will not be updated or supplemented. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions. Past performance is not indicative of future results.
Risks Relating to Private Equity Investments. Certain funds will typically invest in securities, instruments and assets that are not, and are not expected to become, publicly traded and therefore may require a substantial length of time to realize a return or fully liquidate. The respective general partners cannot provide assurance that they will be able to identify, choose, make or realize investments of the type targeted for their fund, or that such fund will be able to invest fully its committed capital. There can be no assurance that a fund will be able to generate returns for its investors or that returns will be commensurate with the risks of the investments within such fund’s investment objectives. The business of identifying and structuring investments of the types contemplated by these funds is competitive and involves a high degree of uncertainty. In addition to competition from other investors, the availability of investment opportunities generally will be subject to market conditions as well as, in many cases, the prevailing regulatory or political climate. In addition, investments in infrastructure may be subject to a variety of legal risks, including environmental issues, land expropriation and other property-related claims, industrial action and legal action from special interest groups.