Johanna Englundh: Morningstar's Senior Equity Analyst, Johann Scholtz, has initiated coverage on three major European private equity firms and has assigned them all a narrow moat rating.
Johann, what lies behind this rating for EQT, CVC and Partners Group?
Johann Scholtz: Yes. Well, for both traditional and alternative asset managers, we typically tend to find moats in intangible assets and switching costs. So, we think that clients of these three firms will find it challenging to switch due to the fact that being private market investing, you're typically locked in for anything from four to 20 years. And then also, clients will need to incur significant due diligence costs if they want to switch to another provider which once again makes switching difficult. And then on the intangible asset side of things, we feel that all three of them have a strong track record of outperformance, which is vital in private market investing. And a key driver for them achieving that track record of outperformance is the strong proprietary deal flow that they manage to generate. And to build up a pipeline of deals is something that you can't replicate overnight.
Englundh: You've noted that private equity is opening up to retail investors though. Why is that? And what could the implications be?
Scholtz: Yes, I think it's a bit of a change in the regulatory landscape. It's not opening up in full to all retail clients, but it's definitely – in the past, it used to be the preserve of only ultra-high-net-worth individuals, it's kind of opening up to the, call it, mass affluent market now. I think for the private market firms, it's a bit positive, it opens up a new market for them. However, we think that this could bring greater regulatory scrutiny for the industry. And we are a bit concerned about the impact that that might have on the very high fees that private equity firms have historically been able to charge.
Englundh: I also found it interesting looking at one of the other ratings that you've allocated to all these three firms where you've given CVC a poor stock capital allocation rating, quite a contrast to the other two firms. What are they doing that you don't like in this area?
Scholtz: Yes. Our capital allocation methodology looks at three different criteria. We look at the strength of a firm's balance sheet, the quality of its investment making decisions, and then also we evaluate its shareholder distributions. Now, what we don't like about CVC is their balance sheet is the weakest out of the three. It's got the most debt on its balance sheet. And we really question the need for a private market firm to have any leverage on the firm level balance sheet, while you already have a lot of leverage on the underlying portfolio companies that sits in the funds. And then secondly, CVC, which only recently listed, have got a strange sharing of the performance fees or carried interest, as it's known in the private equity world, whereby some of the founding shareholders gets to share ahead of ordinary shareholders in carried interest. And we don't find that particularly beneficial distribution to ordinary shareholders.
Englundh: So, finally then, for investors interested in private equity firms, what would you say is important to look out for?
Scholtz: Yes, I think looking at private market firms, you really need to focus on management fees, the portion of revenue that comes from recurring management fees, as opposed to the portion that comes from carried interest, which tend to be quite volatile and lumpy and can distort your analysis quite a bit. So, I think that's very important. And then I think it's also important to note that all three of these different firms have got their own unique edge or niche that they focus on. EQT, for instance, is known as a specialist in the field of technology and healthcare. So, one can almost view them as a more growth-focused investor whilst CVC is more of a traditional private equity player. And it focuses more on established firms in its investing. And then Partners Group takes a completely different approach and really focuses more on the needs of investors. And it tries to tailor investment solutions in the private equity world that matches the liquidity and risk profile of its clients.
Englundh: Thank you so much for joining us today, Johann. And until next time, I'm Johanna Englundh for Morningstar.
