Princess Private Equity Holding — Withstanding the broader market turmoil so far

While in 2021 the global economy was recovering from the COVID-19-pandemic-induced slowdown, investors are now mostly concerned about high inflation and monetary tightening, as well as uncertainties around global supply chains and trade routes. These have been further exacerbated by lockdowns as part of China’s ‘zero-COVID’ policy and sanctions on Russia following its invasion of Ukraine. These uncertainties prompted GDP forecast cuts across economies, as highlighted by the World Bank, which recently reduced its expected GDP growth in Europe to 2.5% in 2022 from 4.2% earlier (mostly due to rising energy prices) and cut the US growth forecast by 1.2pp to 2.0%.

While monetary tightening represents a clear headwind in 2022, we note that gradual interest rate hikes at a modest pace from the current low levels could, all else being equal, have a moderate impact on activity and returns in the PE market. According to recent analysis by Preqin, the average NAV return in the global private markets (including PE) over 2010–21 was 11.4% per year when the Federal Reserve’s effective rate increased (from late 2015 to mid-2019) and14.4% per year during times of stable interest rates, defined as 12-month periods with effective federal funds rate movements below 10bp on an absolute basis. In this context, we note that a number of PE general partners (GPs) had been preparing for a market downturn before the COVID-19 pandemic began, overweighting more resilient sectors such as tech and healthcare services.

Having said that, we note that interest rate hikes in the US will be accompanied by quantitative tightening at a faster pace than in 2017–19. Moreover, public equity markets (as illustrated by MSCI World Index) performed well in 2016 and 2017 but have fallen notably year to date in 2022 (S&P 500 Index down 13% ytd, MSCI World Index down 14% and Nasdaq Composite Index down 25% ytd). If this trend continues, it may exert pressure on PE valuations. This could be at least partially mitigated by the fact that GPs are encouraged to maintain a strong pace of investment in 2022 due to the significant dry powder accumulated in recent years, exceeding US$3.0tn in 2021 globally (according to Bain & Company, citing Preqin estimates in its Global Private Equity Report 2022, see Exhibit 1). In the short term, however, PE deal activity is likely to be more muted after a very active 2021 as GPs reassess the valuation environment and devote more time to helping their existing portfolio companies navigate macroeconomic headwinds. The global deal value in 2021 reached an all-time high of US$1.1tn (up 94% y-o-y) in over 1,000 deals (up 24% y-o-y), significantly above the long-term average.

However, we also note that a challenging environment may at some stage provide attractive new investment opportunities. Historically, vintages launched during an economic slowdown performed better on average, as highlighted by the 22% pooled internal rate of return (IRR) of US PE funds launched in 2001 (post the dot.com bubble burst) or 20% achieved by US PE funds launched in 2009 after the global financial crisis (according to Cambridge Associates). While PEY’s high proportion of cash and senior secured loans in its portfolio (c €100m net resources available for investment, ie around 10% of the NAV at end-April 2022) weighed on its NAV returns in FY21 (relative to peers), it now means more capital available for new investments.

PEY is managed by Partners Group, a global private markets specialist with US$127bn in assets under management at end-December 2021. The investment manager has over 1,600 employees across 20 offices, with more than 500 private markets investment professionals. Its PE leadership team consists of 20 professionals with average experience of more than 20 years (including more than 10 years at Partners Group).

The manager recognises that risks arising from the unravelling geopolitical and economic situation are hard to gauge and sees scope for fiscal and monetary policy errors. Having said that, in its base case scenario, Partners Group expects modest mid-term growth, higher inflation and a relatively accommodative policy backdrop. Despite the increase in nominal interest rates, it believes the real rates will remain low on a long-term relative basis.

As inflation remains high and supply chains are disrupted by sanctions, trade limitations and persisting COVID-19 lockdowns in some parts of the global economy (China most notably), the manager focuses predominantly on ongoing operations of underlying companies to take all appropriate measures to keep employees safe and mitigate risks. At the same time, it remains confident in its portfolio’s ability to cope with short-term headwinds.

In terms of new investments, the manager remains strongly convicted in the strategy of transformational investing, which combines thematic sourcing with a hands-on value creation approach. The manager focuses on fundamental operational strength, resilience and value creation opportunities in segments of the economy that benefit from secular trends. It sees a broad near-term pipeline of investment opportunities to redeploy liquidity into.

PEY delivered a one-year NAV TR to end-May 2022 of 5.3% in euro terms, slightly below the public equity markets at 8.6% (MSCI World Index) and behind the development of the broad PE market returning 25% (LPX Europe NAV index). However, we note that NAV TR in FY21 was 19.4%, and PEY’s five-year NAV TR was ahead of the MSCI World Index at 73.2% vs 66.9%, respectively (its three-year NAV TR was broadly in line at 45.8% vs 48.7%, respectively, see Exhibit 2).

The main value drivers in FY21 were successful exits, most notably GlobalLogic completed in Q121. High realisation activity has created a certain cash drag (as discussed above), somewhat limiting NAV growth throughout the year. However, this has helped limit the extent of NAV decline so far this year (-1.8% NAV TR to end-May 2022) despite the severe public equities sell-off (14% of PEY’s portfolio was allocated into lower-yielding senior loans investments at end-March 2022). PEY’s year to date performance was further assisted by a positive foreign exchange impact.

We believe PEY’s sector exposure also played an important role in its recent NAV resilience. For a sample of PEY’s portfolio based on 37 companies covering 58.5% of NAV, the average EV/EBITDA multiple stood at 16.2x at end-March 2022 versus 15.8x at end-2021 (40 companies covering 66.4% of NAV) and 15.3x at end-March 2021 (43 companies making up 84.1% of NAV). The company highlighted that this reflects PEY’s sector mix, most notably technology, education and healthcare businesses where valuations of listed peers continued to rise. This was coupled with solid earnings momentum, with a 20.1% and 26.0% y-o-y revenue and EBITDA growth over the 12 months to end-March 2022 for a sample of 34 direct equity investments making up 51.7% of its NAV (vs 20.0% and 26.9% to end-December 2021 for a sample of 32 companies representing 57.4% of NAV, respectively). Importantly margins seem to hold up for now, with a weighted average EBITDA margin of 21.2% vs 18.9% in Q421. A similar sample analysis in Q121 (covering 42 companies representing 82.7% of NAV) implied an EBITDA margin of 20.6% (vs 20.7% in Q420). Some of PEY’s largest holdings had broadly stable valuations versus end-2021, as lower public peer multiples were offset by earnings growth.

In this context, we would highlight PEY’s relatively high weighting to healthcare services providers (as part of its overall 20% healthcare exposure at end-March 2022, see Exhibit 5). Valuation of public equities in the healthcare services subsector proved more resilient than the broader market so far this year, as illustrated by the Dow Jones US Select Health Care Providers Index, which fell by c 9% between end-December 2021 and end-May 2021 versus an S&P500 decline of 13% (to 30 June, the decline was 12% vs 21%, respectively).

At the same time, several healthcare services sectors offer a favourable combination of secular growth and ‘buy-and-build’ opportunities. A good example is EyeCare Partners, the largest vertically integrated, medically focused eye-care services provider in the US, representing 2.9% of PEY’s NAV at end-May 2022. The company’s investment thesis (identified by Partner Group’s team) has been based on ageing society coupled with the exponential incurrence of eye diseases with age, a predictable pricing/reimbursement environment and fragmented market with ample consolidation opportunity (EyeCare Partners had a 1% market share in the US at the time of investment in 2020). The business was revalued upwards by 8.1% in Q122.

Other healthcare services businesses in PEY’s portfolio include:

PEY also holds a stake in PCI Pharma Services, a provider of contract development and manufacturing services to the biopharma industry, which was PEY’s second-largest holding representing 4.2% of NAV at end-May 2022 (Q122 revaluation of +0.5%). Other major healthcare holdings (acquired before Q122) include Galderma (a Swiss specialist in dermatology treatments and skin care products, 1.7% of NAV at end-2021), STADA Arzneimittel (a German pharma company producing generic and over-the-counter drugs, 1.5%), an undisclosed pharmaceutical developer (1.3%, sold in Q122) and Wedgewood Pharmacy (US-based compounding pharmacy for animal health, 1.0%). PEY’s healthcare exposure has been further increased through Q122 investments in Pharmathen (€18m), a contract development organisation and contract manufacturing organisation for complex generic drugs (with PEY’s strategy aimed at supporting the company in entering the US market), and HTL Biotechnology (€4m), a developer and producer of pharmaceutical-grade biopolymers.

Moreover, PEY has several childcare and education businesses in its portfolio, including KinderCare Education (4.0% of NAV at end-May 2022, revalued downwards by 2.8% in Q122 due to lower public peer multiples), International Schools Partnership (1.5% of NAV at end-2021) and Guardian Healthcare & Education (1.5% of NAV at end-2021). We believe such companies may prove less susceptible to a macroeconomic deterioration. We also note that PEY (unlike some of its peers) does not have considerable exposure to consumer-oriented tech companies (eg e-commerce businesses) which, while benefitting from strongly rising valuations in recent years, are now experiencing a significant de-rating.

It is worth noting that one of the top NAV drivers in Q122 was SRS Distribution, PEY’s largest holding and a US distributor of roofing products. Its positive revaluation of 11.9% (increasing by €6.0m) in Q122 was supported by another year of strong performance, including solid like-for-like growth, benefiting from favourable conditions in the US construction market. We acknowledge that this may change during an economic downturn. We also note PEY’s 19% exposure to industrial companies (which may potentially prove more sensitive to the broader macroeconomic conditions).

PEY holds a well-diversified portfolio of direct PE investments (82% of the portfolio), supplemented by debt investments (14%) predominantly for temporary liquidity management purposes, and a portfolio of legacy funds (4%) that are in their liquidation phase. At end-May 2022, the total portfolio was valued at €1.0bn (flat y-o-y), with top 10 investments making up c 37% of the portfolio (and top 50 investments representing 78.8% of NAV at end-FY21). We note that PEY’s portfolio diversification improved following the exits from International Schools Partnership (14.6% of end-2020 NAV) and GlobalLogic (5.7%). While its portfolio is diversified geographically with US at 51% (or 47% excluding senior loans exposure) and Europe at 35% (or 38% excluding senior loans) at end-May 2022, we note that PEY effectively hedges most of its exposure back to euro, resulting in a 92% exposure after hedging at end-March 2022 (with the remaining 8% to US dollar).

PEY completed a record-high level of realisations in FY21 at €462.5m (compared to €178.2m and €104.1m in FY20 and FY19, respectively), representing 53% of opening NAV (24% and 14% in FY20 and FY19, respectively). At the same time, it made €207m new PE investments in FY21 (including re-investment into previously exited holdings, eg Foncia, International Schools Partnership), above the €65m and €69m invested in 2020 and 2019, respectively. Still, it resulted in significant excess liquidity, part of which (€135m) was temporarily allocated to a portfolio of senior loans. PEY’s investment manager is about to start re-deploying this additional firepower into new PE investments, with €58.9m of its senior loans investments redeemed in total in April and May 2022.

Between January and May 2022, PEY invested €52.0m, with the majority of the capital (€34m) allocated to healthcare companies (see above for details). Moreover, PEY invested €5.2m in Climeworks, which designs, develops and operates direct air capture plants used to provide carbon dioxide removal services to companies and individuals, as well as €6.0m in a joint take-private transaction with Permira of Mimecast, a UK-based email security and cyber resilience business. Management highlighted during the Q122 investor call that it had seven to eight transactions in the pipeline that are close to completion in the near term. At the same time, its PE realisations in 2022 year to date were slightly below the above-mentioned investment volume at €41.5m (or 3.9% of opening NAV). PEY still seems to have a decent number of companies potentially ripe for an exit, as 63% of its portfolio value at end-March 2022 is allocated to investments dating before 2018 (see Exhibit 9).

We present PEY’s performance in comparison to a broad group of private equity investing companies, both directly, and through fund-of-fund structures. We note that PEY’s NAV return underperforms the group average over one, three and five years, which is partially due to a greater valuation lag in the case of most peers which (unlike PEY) have their portfolios valued at a date before the market sell-off post-March 2022 (see Exhibit 10). Nevertheless, we note that PEY’s FY21 return of 19.4% was also somewhat below peer average, partially due to a material cash drag stemming from record-high disposals (to some extent mitigated by the senior loans allocation) and foreign exchange movements (as PEY hedges its portfolio to euro, and hedge losses reduced its NAV by 3.5pp in 2021 according to our calculations).

With the uncertainty over global economic growth (driven by the factors described above) and the resulting public market sell-off in recent months, we believe that periodicity of NAV reporting and revaluing of the underlying portfolio is of utmost importance in the context of comparing NAV performance and discount to NAV across listed PE companies. Firstly, within the peer group below (Exhibit 10), only NB Private Equity Partners and HarbourVest Global Private Equity (HVPE) reported their respective NAVs at end-May 2022 like PEY (other companies are predominantly at end-March, except for Pantheon International and abrdn Private Equity Opportunities Trust at end-April, and ICG Enterprise Trust at end-January 2022). Importantly, the equity markets have shown a significant decline in April and May (eg MSCI World Index was down 4.6% in total compared to a 3.0% decrease in the whole Q122).

More importantly, PE companies with a funds-of-funds (eg HVPE, Pantheon International) and co-investment (eg NB Private Equity) structure rely on third-party managers and their portfolios are subject to an inherent valuation lag stemming from the timing of receiving valuations from GPs. These companies have a substantial part of their portfolios still valued at end-December 2021 and/or end-March 2022. As a result, the fact that PEY’s NAV is already fully valued at end-May 2022 weighs on the comparison.

Meanwhile, PEY has the second-highest dividend yield in the group, paying 5.9% on the current share price based on the last 12-month payments (or 6.3% annualised based on the latest semi-annual payment), compared to 3.9% on average by direct investors and 2.0% among funds of funds. We note that the discount comparison is distorted by the above-mentioned valuation lag, leading to higher discounts for companies with more outdated valuations, and the value the market attaches to third-party asset management services provided by 3i and Deutsche Beteiligungs (which are not fully captured in their NAV).

PEY distributes dividends twice a year (June, December) and the board intends to maintain its payout at 5% of the opening NAV in each year. The recently approved payment of €0.38 per share (with an ex-dividend date of 12 May 2022) is in line with this guidance and implies a strong 6.3% annualised dividend yield on the current share price. Shareholders may elect to have their dividends paid in sterling or euro, as well as elect to participate in a dividend reinvestment plan, but this does not result in the issuance of any new shares.

PEY’s shares traded at a 10-year average discount to NAV at 18%, which narrowed to c 5% at end-2021. Recently, the discount has widened to 17% in response to the higher risk aversion across markets, in line with other PE companies (see peer comparison above) in anticipation of potential valuation downgrades on the back of unfavourable market developments. Having said that, we reiterate that PEY’s portfolio is revalued monthly and already reflects the year-to-date contraction of public valuation multiples to end-May 2022.

PEY is an investment company registered in Guernsey, with an objective of providing both long-term capital appreciation and income, as it targets a recurring dividend yield of 5% of NAV based on semi-annual payments. PEY changed its focus from third-party funds in 2011 (which remain its legacy portfolio, making up 4% of total at end-May 2022) and now invests primarily via its investment manager’s (Partners Group) direct private equity investment programmes (funds). It also makes co-investments with other managers and has some exposure to private debt investments to support efficient balance sheet management.

Investments in relatively liquid senior loans (as a higher-yielding alternative to money market instruments) serve as liquidity management. Accounting for these, PEY’s portfolio was effectively fully invested with an investment level of c 101% at end-May 2022.

PEY focuses on direct private equity transactions, both through Partners Group’s flagship limited partnership funds and as a co-investor alongside other Partners Group-managed funds or other PE managers. It invests mainly in mid-cap buyouts with an enterprise value of c €500m to €2bn targeting a relatively diversified portfolio of c 50–80 holdings. While this sits well below the number of holdings common for a private equity fund of funds (which is normally exposed to hundreds of underlying companies), it is enough to reduce cash flow volatility (which might occur with a more concentrated strategy), which is particularly important given PEY’s aim of sustaining a regular high dividend payout.

Partners Group is a relative value investor that seeks to make direct investments in highly cash-generative companies that offer meaningful top-line growth potential and fit into one or more of the following categories:

An essential part of the Partners Group PE investment approach is its industry value creation team, which it uses to help drive through initiatives to enable companies to strengthen their financial and competitive positions and achieve their full potential. Additionally, the investment manager closely monitors investee companies through its board representation, quarterly performance assessments, active engagement with stakeholders and the progress of value-creation initiatives.

Partners Group has a highly selective approach to investments, with less than 1% of around 1,000 potential investments screened on a high-level basis each year making it into the group’s portfolios. After looking at industry developments, market attractiveness, headline company financials, return potential, exit scenarios and how Partners Group could add value to the business, c 10–20% of screened entities proceed to initial due diligence, which assesses a range of quantitative and qualitative factors. The most promising ideas are moved to advanced due diligence stage, including in-depth financial modelling, scrutiny of legal terms and an assessment of ESG factors, which results in a detailed investment thesis (including an operational assessment by the Industry Value Creation team) and a 100-day plan for execution of the deal and implementation of value-creation initiatives. The final step of the process is a positive or negative investment recommendation. New private equity positions typically represent 0.5–3.0% of NAV (ideally around 2.0%), but this is dependent on the size of the investee company and PEY’s liquidity position. The standard holding period is three to five years, with exits executed through trade sales, listings or sale to another PE buyer.

The company makes commitments to Partners Group’s flagship direct PE funds, although it may take several years to draw the commitments made at launch to make new investments. Therefore, to smooth the pace of investment and avoid cash drag (which may occur when cash is returned to the portfolio but is not drawn down by the direct funds), PEY may conduct direct co-investments with other managers, which brings additional diversification.

PEY also holds private debt investments (albeit making up a small part of PEY’s portfolio), overseen by Partners Group, which serve two purposes: uninvested cash may be used to purchase first-lien senior loans, which are relatively liquid but offer higher returns than other near-cash investments, while second-lien or mezzanine investments are longer term and may be used to gain exposure to favoured private companies that are not (yet) seeking additional equity financing.

Partners Group positions itself at the forefront of the sustainability trend in the sector and has been integrating ESG in its PE investing since 2006, when it established its Responsible Investment Policy (now the ESG and Sustainability Directive). We note that Partners Group has been a signatory of the United Nations Principles for Responsible Investment (UNPRI) since 2008. Partners Group received the highest A+ ratings in UNPRI’s annual ESG benchmarking assessment (within the strategy and governance section) for direct PE and governance in each of the six years to 2020 (no ESG ratings were provided by UNPRI for the 2021 submission). Moreover, Partners Group has been included in the FTSE4Good Index series since 2018 and the Dow Jones Sustainability Indices since 2021.

ESG integration and risk management at Partners Group is overseen by the investment oversight committee at the board level (which acts as an adviser to the global investment committee) as part of assessing the quality and consistency of the investment process. All investment/divestment recommendations made by the global investment committee are based on their Responsible Investment Screening Framework and ESG Due Diligence Assessment. Partners Group has a chairman of sustainability (since July 2021, the position is held by Partners Group’s former co-CEO, André Frei) and a dedicated ESG and sustainability team spread across Asia, Europe and the US. The team’s activities are well embedded within Partners Group’s investment process and the team is managed by Carmela Mondino, who we interviewed in April 2021. Partners Group has in-house ESG tools and processes implemented at the onboarding of a new investment to establish ESG governance, as well as define and implement operational and strategic ESG initiatives. Moreover, it has developed an ESG dashboard to initiate, lead and monitor the progress of ESG initiatives at the relevant holding’s level. This includes tracking and reporting more than 50 ESG key performance indicators across its portfolio (based on an annual survey introduced in 2015). This is aimed at quantifying and being transparent about the ESG impact Partners Group and the management of its portfolio companies have on the sustainability of Partners Group-managed portfolios.

Partners Group is committed to be net zero in terms of emissions and offset key corporate greenhouse gas emissions in cooperation with Natural Capital Partners through funding a global portfolio of low-carbon sustainable development projects. Its Climate Change Strategy outlines the steps the company is taking to reduce carbon emissions across its organisation and investment portfolio and is aligned with the task force on climate-related financial disclosures. Partners Group is also committed to the Paris Agreement as an organisation and to managing its investment portfolio towards the agreement’s objectives. In 2019, Partners Group established a diversity and inclusion committee and introduced several initiatives to increase the number of senior female professionals at the company (which stood at 10% in 2021 vs 39% of total headcount). Partners Group conducts an annual employee engagement survey and has established talent attraction and retention programmes through PG Academy, a proprietary learning and development platform. The company has also published a tax strategy, summarising its commitment to paying its fair share of taxes and creating a positive impact in the communities in which it operates. Partners Group’s charitable contributions, including its Sustainability Foundation and the Partners Group Impact Foundation (run by Partners Group employees), stood at CHF6.5m in FY21.

PEY aims to maintain a substantially full investment level over time and does not use structural leverage. It has an €80m revolving credit facility in place (maturing 2024) to secure flexibility and to bridge cashflow gaps, of which €38.5m was drawn at end-May 2022. The net gearing (which includes other short-term payables) was 1.3% of NAV at end-May and including the senior loans investment as near-cash item the net cash position stood at 6.3%.

The credit facility allows for drawdowns in three currencies (US dollar, euro, sterling), with interest based on floating rate (undisclosed margin). Given PEY’s strong balance sheet at end-May 2022, the covenants in place (below €350m NAV and 25% gross gearing) are unchallenged. We calculate that PEY’s NAV would need to decrease c 65% to trigger the first covenant.

PEY commits capital to Partners Group advised products and usually maintains the ratio of unfunded commitments to NAV at a low double digit percentage level (11% at end-May 2022). We need to highlight, however, that out of the current €111m commitments, a significant part (€43.2m at end-March 2022) is to legacy funds and are unlikely to be drawn. Adjusted commitments stood at c 7% of NAV – materially lower than the capital temporarily allocated to senior loans investments. During FY21, PEY made €319m new commitments (FY20: €52m).

Partners Group receives a management fee of 1.5% of PEY’s NAV per year, which is paid quarterly. Additionally, the manager is entitled to an incentive fee on direct investments of 15% with an 8% hurdle rate. Fees are calculated investment by investment and fund investments have lower incentive fees (10% on secondaries, none on primaries). Funds represent 4% of portfolio (only primary funds) and PEY does not intend to increase this exposure.

In FY21, total ongoing charges amounted to 1.81% (vs 1.65% in FY20). The incentive fee amounted to €39.8m (compared to €10.6m in 2020), and ongoing charge including performance fees arrived at 5.83%. The incentive fees reached 4.3% of opening NAV, accompanied by a 19.5% NAV increase in TR terms; compared to 1.2% and 10.0% in 2020, respectively.

PEY is structured as a limited liability investment holding company domiciled in Guernsey and listed on the Main Market of the London Stock Exchange. It has one class of share, with 69.2m ordinary shares in issue, although the shares are quoted in both euros (PEY) and sterling (PEYS). Renewed annually, the board has the authority to repurchase up to 14.99% of shares or allot shares up to the equivalent of 10% of issued share capital, to manage a discount or a premium. However, no shares have been issued or repurchased since 2014.

PEY has six non-executive directors, five of whom are considered independent of the manager. Richard Battey, who joined the board in 2009, became chairman in September 2018 following Brian Human’s retirement from the role. Henning von der Forst became a director in 2012. Felix Haldner (a partner at Partners Group, and as such deemed non-independent) and Steve Le Page (chairman of the audit committee) were appointed in 2017, with Fionnuala Carvill and Merise Wheatley joining the board in September 2018. The directors have professional backgrounds in investment management, accountancy and risk management.