In the vast asset management industry ($85 trillion of assets under management in 2019 1 ), private equity accounts for only 6% (around $5 trillion) of total assets under management. Perhaps because this segment has one of the industry’s most impressive rates of asset growth, or because the expected financial returns on these funds are high, this business attracts much of the attention focused on asset ma-nagement. Sometimes considered as a complex and confidential investment acti-vity for the elite, and sometimes promoted as a powerful corporate finance vehicle, private equity crystallises a host of clichés and perceptions that, depending on how they are viewed, represent major challenges for the entire asset management industry.

This is why we decided this quarter to focus on how we view this investment acti-vity, which represents one of our traditional lines of expertise. The implications are enormous as we are convinced that investing in small- and medium-sized com-panies is much more than an investment solution for knowledgeable investors. We believe private equity as we practice it is a powerful financing tool for the real economy. It is this idea that we want to develop in this letter, leaving aside any attempt at a cynical or demagogic communication stunt, to focus on what is our true conviction. Why is this so important? In a post-COVID world that needs to rethink its growth model, patient capital is the best way to reconcile sustainable growth with reasonable financial returns. Financing the real economy is a major challenge, not only for businesses, but also for the governments that have supported them in order to save jobs which guarantee the social stability of our democracies. Against this backdrop, it is therefore crucial for us to have a clear strategy and a sufficiently developed approach to achieve our objective of helping to provide the capital needed to build a sustainable growth model over the long term.

D E C E M B E R 2 0 2 0

Private Equity or the Connection of Finance to the Real Economy

Emmanuel LAILLIER Head of Private Equity

Thomas FRIEDBERGERCEO and Co-CIO, Tikehau IM

CIO L E T T E R

1 Boston Consulting Group Global Asset

Management 2020

2

CIO L E T T E R

Accommodative monetary policies have contributed to rising inequality between a population close to finan-cial markets with debt capacity (cor-porates as well as individuals), and another composed of people lacking savings capacity 2 . The impressive increase in «zombie» companies 3 is a side effect of economic support policies. The number of these com-panies had tripled between the begin-ning of the century and the beginning of the COVID crisis. According to the Bank for International Settlements, 12% of a l l companies wor ldwide could meet this definition in 2020 4 . On the other side of the spectrum, those with significant debt capacity can buy financial assets with values inflated by the lower rates.

As a result of this increase in inequality, inci-dents in the financial sector (banks or asset management) are likely to be widely used by

public figures and the media to lambaste finance. Yet finance is central to the economy. The future of asset management therefore depends on the connection of asset management activity to the real economy. Financing the economy is probably the only possible long- term goal for active mana-gement since managers offering strategies that are out of touch with the real economy will find it diffi-cult to justify their risk-taking in the event of a crash. Their large-scale development will be jeopardised by having no reason for their existence other than to enrich themselves and their investors. Long-term management must be able to demonstrate that pro-ducing results is coupled with developing successful sectors of the real economy, creating jobs and, more generally, improving the living conditions of our fel-low citizens, according to financial and non-financial criteria. In a sense, it was by deviating from this path that the banks suffered both significant losses and the wrath of the political arena and the general public after the 2008 crisis. By stepping out of their role of financing the real economy to engage in trading and intermediation strategies in complex products, the banks not only allowed their debt levels to get out of line in order to optimise their return on capital, but also committed themselves to a direction that was in-comprehensible to the general public which damaged their reputation and image. The COVID-19 crisis pro-vides an opportunity for asset management to avoid drifting into risk-taking that is difficult to explain to the general public, and instead commit to financing the real economy by shifting an increasing share of glo-bal savings toward financing companies that create or attempt to preserve jobs. The challenges are also great for regulators and the public sphere. If asset management had to justify significant losses for sa-vers on strategies substantially using overly-complex

2 Tikehau CIO letter

December 2019: Qes are eternal

3 Deutsche Bank

defines zombie companies as companies whose

operating profit is lower than their debt service

for two consecutive years. In theory, many of these

companies should go bankrupt for lack

of additional financing

4 Source :

Deutsche Bank Research

Financing the economy: A major challenge for asset management

3

instruments or excessive leverage, or even short-term speculative tools, the public would likely penalise this finan-cial sector, which is essential for the economy to function smoothly. If, on the other hand, asset management could show its effectiveness in finan-cing the real economy, it could then be turned into a real tool for employ-ment, i.e. the preservation of a certain social balance. This aspect is essen-tial in light of the growing disconnect between the financial economy and the real economy, between large mar-ket capitalisations, which benefit from accommodative monetary policies to boost their competitive advantage, and small- and medium-sized enter-prises, which are at the heart of the real economy and will find it difficult to restart their activity once the health crisis is behind them. As a result, as of 30 July 2020, the five largest mar-ket capitalisations within the S&P 500 were up more than 35% year-to-date, while the other 495 were down 5%. Those five technology stocks repre-sented a record level of 20% of total US capitalisation 5 12% of its profits and are racking up impressive results (Amazon’s sales in the second quarter of 2020 were up 40% year-on-year). Without those five stocks, the mar-ket capitalisation of the United States would have contracted over the two and a half years 6 . In July 2020, the Nasdaq’s market capitalisation excee-ded the GDP of the Europe of 27 7 . In Europe, the situation is similar, with large caps in the healthcare, luxury

5 3,450 listed companies with a market capitalisation of $32 trillion, of which $6 trillion were those five companies

6 Between January 2018 and July 2020

7 The GDP of the 27 member states of the European Union in 2020 was around €17 trillion the Nasdaq Composite market capitalisation in September 2020 was around $20 trillion

and consumer sectors increasing their competitive advantage by being able to issue large amounts of low-rate debt in order to consolidate their sector. The increased weight of these securities in stock market indices, justified by their good health, disconnect the level of the real economy indices from the geographi-cal area they are supposed to represent.

The problem is that if the real eco-nomy is struggling to bounce back for lack of accommodative monetary policies for small- and medium-sized companies, the social challenges could quickly become political challenges. How can we justify the new record highs set by the major indices as a re-sult of a few leading companies when economies are suffering?

It seems to us that the future of active management, in particular what is known as ‘alternative’ management (in the sense of investing in private assets), lies in shifting global savings towards financing the real economy.

4

CIO L E T T E R

For more than three decades, the fall in interest rates has probably accounted for a significant part of the financial value created in most other risky asset classes: debt, real assets and equity investments. This trend has enabled a large number of asset allo-cators who have perfected their portfolio construc-tion to generate value by exposing their portfolio to asset classes generically, by using indices or ETFs in «liquid» asset classes, funds of funds or mega funds in private assets. Because investing in these very large funds requires that asset managers either do very large transactions (these are often more visible and more intermediated and therefore often more expensive), or do a lot of transactions and therefore compromise on selectivity, which for such a fund ulti-mately amounts to representing the market, hence a certain form of beta 8 .

The COVID-19 crisis may mark the end of this 30-year cycle of declining interest rates, lea-ding to the potential end of the beta reign, i.e.

generating value through asset allocation by means of diversified instruments exposed to the overall per-formance of an asset class. This may explain why the financial manifestation of the 2020 crisis did not look like any other crisis. Low interest rates and aggres-sive monetary and fiscal policies allow different risky asset classes to trade at higher-than-average mul-tiple levels, even during a cyclical trough. However, if the correction does not result in a prolonged bear market (the correction in March 2020 was due to the purge of excessive leverage), it will result in a massive dispersion of results between the best companies and the others. We mentioned earlier that one of the manifestations of this dispersion is the loss of index representation caused by the significant increase in the weight of some leading stocks which erases the impact of other companies in forming the index price. By keeping alive a large number of companies that

Private Equity and financial value creation Contrary to what some communica-tions about expected returns might suggest, private equity does not defy gravity in the economic cycle. Let’s look for a moment at value creation in this asset class.

In the 1980s, interest rates started a downward trend that is probably coming to an end before our eyes:

Short rates are zero or low throu-ghout the developed world and 90% of government bonds worldwide trade at a yield of less than 1%. The world seems to be uncomfortable with nega-tive long-term interest rates, especially if a resurgence of inflation follows this period of fiscal and monetary policy of unprecedented magnitude.

The almost continuous fall in inte-rest rates had two extremely positive knock-on effects for capital invest-ment. On one hand, it enabled private equity participants to increase their re-turn on investment, not only by having increasing access to debt but also by generating value on refinancing. On the other hand, low rates have facilitated the inflation of valuation multiples to the extent that discounting cash flows at lower rates yields a higher valuation.

8 Coefficient indicating

the extent to which an asset changes under

the same conditions as the market

5

What does this mean for private equity? It is likely that return differentials will widen between the best funds - those able to identify the best invest-ments and use the quality of their analysis and access to transactions to be highly selective - and the others. In this new cycle, it will be necessary to be focused and selective.

It also means that the creation of financial value in private equity will be attributable more to the shareholder’s ability to contribute to the growth of the partner company’s profitability than by in-flation of the company’s valuation multiple after a few years because of lower interest rates. It is for this reason that growth equity may be the seg-ment of the future for private equity.

What is growth equity? It is a private equity segment between venture ca-pital and majority private equity. Venture capital is about betting on the future profitability of a compa-ny through the development of a technology or an innovation that will enable it to take a market. It is therefore a question of financing losses in exchange for the great hope of profitability in the future. It is an essential part of the economy that makes it pos-sible to finance innovative young companies. At the other end of the spectrum, majority private equity or a Leveraged Buyout (LBO) involves taking control of a company through a total or partial buyback from its existing shareholders. Historically, this business has been more focused on companies that are mature enough to throw off regular cash that, in turn, enables the sponsor 9 to use debt to finance its acquisition.

could not meet their obligations wit-hout these monetary or fiscal policies, governments and central banks are creating another form of correction. The most successful companies, those positioned in the growth sectors, which have the best management teams and practice the best capital allocation, are taking advantage of highly favou-rable monetary and fiscal conditions to increase their competitive advantage over their competitors which, unfortu-nately, are in «survival mode «. In this context, stock picking takes over from asset allocation in generating returns.

In this new cycle, which is likely to be

characterized by an end to the continued decline

in interest rates, stock picking will be the differentiating element

for taking advantage of this dispersion

of returns in a low-growth

world. 9 A management company that takes stakes in private equity transactions

6

CIO L E T T E R

Where a controlling fund can use financial leverage to accelerate shareholder value creation, this mino-rity segment does not rely on these criteria, as the decision to use leverage is the responsibility of the controlling entrepreneur in their growth strategy, not the minority partner. In this case, it corresponds so-lely to optimising the company’s financing cost. As such, the only two value creation tools remain expan-ding multiples and growing earnings via the value contributed by the minority partner. This is enough to create long-term value without resorting to massive leverage, and we think it is in line with the mission of financing the economy. There are dozens of excel-lent majority funds. There are very few pan-European minority funds in which we deploy a lot of resources.

Why are we convinced that this segment of private equity can produce financial outperformance?

Because the combination of a talented entrepreneur with

the implementation of sound governance has always been

the key to generating value for the equity investor over the long

term, regardless of whether the company is listed

or not.

In his 1979 letter to Berkshire Hathaway sharehol-ders, Warren Buffett mentionedy 10 that the best measure of quality for investing in equities was not

the price of a share but its return on invested capital, which derives from the quality of the capital allocation decided by the management of the company in ques-tion: how does management invest and what returns does it expect on its investment, or conversely, how does it return capital to its shareholders if there is no opportunity to invest it? When and how does it go into debt and why? When and how does it increase its capital? Buffett considers, for example, that a share buyback program below the company’s intrinsic value is comparable to buying one-dollar bills for 80

This activity is therefore essentially to finance a cash out, insofar as the entry of the sponsor leads to the exit of an existing shareholder, who will receive a significant sum. The LBO, which today represents a large part of assets under management invested in private equi-ty, can be seen by the entrepreneur selling his company as an alternative to a sale to a competitor or an IPO, and is thus an important component in financing the economy, allowing the development of mid-sized companies. From this primary transaction, there will be one or more secondary tran-sactions that will allow the sponsor to resell to another sponsor every three to five years, creating liquidity in the LBO market.

Positioned between these two segments, growth equity is fo-cused on supporting an entre-

preneur in his growth strategy by be-coming a shareholder and partner of his already-profitable company. The fund injects new financial resources in the form of capital increases, makes additional resources available that the entrepreneur may call upon as he or she needs and, if necessary, enables the former business angels or funds to find an exit from their investment. Such investment is often a minority interest. This new capital will allow the compa-ny to continue to grow its business in its market or from new opportunities. The entrepreneur does not exit from their investment and receives additio-

nal capital.

10 Letter

to Berkshire Hathaway

shareholders 1979. Warren Buffett bought

Berkshire Hathaway in 1962 and transformed

the business into an investment company

7

In that respect, the capital base provided by

a private equity player is likely to be more stable and likely to generate

more value for the company’s management than any other shareholder structure.

Perhaps for this reason, companies that receive capi-tal contributions from private equity are particularly active in acquisitions.

One final factor in value creation for investors is multiple growth. The primary driver of this growth is entry price formation. When dis-

cussing a deal in terms of a new capital contribution to a fast-growing business, the discussion of the acquisition price becomes one part of the dialogue, but not the only one. While the entrepreneur retains control, the minority’s ability to provide economic value through its know-how, network and knowledge of the sector carries a lot of weight that makes price an important, but not necessarily the most important, part of the discussion. The second driver consists in lowering the risk premium which, along with the interest rate, allows for the creation of the multiple. The lower the risk premium, the higher the valuation multiple. The risk premium depends on the size of the company. A larger company will have a larger cus-tomer base, be more diverse geographically, attract talent more easily and can more easily pay for it. In addition, work on ESG aspects also helps reduce the risk premium. The framework developed since the early 2000s has provided a set of non-financial benchmarks for auditing, monitoring and evaluating the progress of companies on the issues of environ-mental footprint, social performance and implemen-tation of effective and robust governance that also takes into account compliance.

cents. Conversely, buying them at 1.2 dollars, i.e. when the company is tra-ding for more than its intrinsic value 11 is a very bad capital allocation deci-sion that destroys shareholder value. Factors influencing this type of deci-sion to invest or not invest are in large part related to the managerial team’s talent and the quality of the company’s governance. This is one reason why we are convinced that one of the best measures of a portfolio’s environmen-tal, social and governance criteria is its long-term financial performance, and that financial and non-financial per-formance are intricately linked when considering a long investment horizon.

In private equity, shareholders (majo-rity or active minority) have a signifi-cant impact on governance. If they do their job well, this governance will be a value creation factor. In the case of growth equity, a talented entrepreneur with good positioning that gives him a competitive advantage can see his minority shareholder as a formidable governance backup by which to boost his competitive advantage.

The minority private equity inves-tor will be able to provide sector expertise, real operational sup-

port and a network for the portfolio company.

Finally, because private equity funds can have additional liquid assets, the famous «dry powder», a minority share-holder can contribute additional capital throughout the life of a fund to finance organic growth or acquisitions, and all the more quickly since he knows the fund so well.

11 This is often the case when the financial markets trade at too-high valuations

8

CIO L E T T E R

Why is this strategic for the public authorities? Shifting savings towards patient capital and using a moderate level of financial leverage is essential to financing the real economy and represents a social and political challenge for the public sector in Europe. Why?

First, because the opportunity for minority private equity partially addresses one of Europe’s big-gest structural weaknesses compared to the US

and China - the absence of a homogeneous domestic European market. This weakness probably explains the lack of a European technology giant in the face of the American and Chinese giants, which have been able to develop as a result of their huge domestic data market. In all sectors, it is much more difficult for a growing Spanish medium-sized firm to expand its business in Germany than for a California firm to expand its business in Texas. Medium-sized firms therefore need stable and active minority partners to help them structure their business, expand internatio-nally and access capital markets.

Secondly, the COVID-19 crisis has required unprecedented deployment of budgetary measures by states, particularly in developed

countries. These measures have taken the form of guaranteed loans and financing plans for strategic industrial channels, which have led to a significant increase in outstanding corporate debt. In the coming years, some of these companies will have to spend much of their cash generation on debt repayment. This will be all the more problematic given that we are likely entering a decade of weak global growth, due in particular to the decline in productivity resulting from supporting less profitable companies, but also the slowdown of globalisation, which has enabled com-panies in recent decades to optimise not only their production costs but also, to a certain extent, their taxation and the amount of capital with which they could operate.

We have supported our partner companies for many years by providing them with a dedica-ted internal team to help them formalise a multi-year progress plan, and highlighting this pro-gress to the financial partners that will take over. These drivers of value creation, growth acceleration and improvement of non-financial performance are a source of added value for the investor, while at the same time they create sustainable value for the company and the econo-my in general.

For all these reasons, minority private equity, called growth equity, is central to financing the real economy, by provi-ding the entrepreneur with a flexible and stable additional capital source, as well as strategic and operational support.

9

sation of work that will lead to the redirection of capi-tal. Some new sectors will be considered as strategic by governments. To achieve this, an efficient eco-system is necessary. It is therefore the responsibility of local investors to create favourable conditions for relocation. Without funding solutions at the European level, relocating will be complicated.

Furthermore, one of the priorities of European go-vernments is to preserve jobs. Private equity as well as private debt in Europe operate mainly in

the mid-market segment. The 180,000 medium-sized companies in Europe 12 account for one-third of Euro-pean Union jobs and generate one-third of added va-lue. The mid-markets of the United Kingdom, France, Germany and Italy combined would represent one of the world’s top ten economies in terms of gross do-mestic product generated. The mid-market therefore represents many more jobs than the Euro Stoxx 50 companies, for example, just as in the US the mid-market would be the third largest economy in the world by itself, while the components of the S&P 500 account for only 10% of US jobs. There is a great deal at stake. Whether the mid-market works will probably depend on the future of the middle classes in Europe and the United States, and hence on the social stabi-lity of these countries. Rising inequality resulting from a failure to preserve jobs is a threat not only to the balance of the middle class but also to democracy that has historically relied on the moderate vote of these middle classes. The public sector therefore has a strong interest in channelling savings towards financing companies that generate these jobs, adap-ting the regulations to encourage patient, stable and long-term investment in equity and financing for these companies.

The global economy, which, like any over-optimised structure, had hidden its extraordinary vulnerability behind its strength, has likely reached a turning point. As a result, firms will have to ope-rate with higher production costs, more local taxation, and larger capital buffers

In this context, having local actors capable of injecting capital alongside value-generating entrepreneurs has powerful advantages. First, it increases the chances that the debt is repaid. When this debt is guaranteed by the state, it is a significant relief from the potential burden on developed-country taxpayers. Secondly, this capital makes it possible to finance some form of in-dustrial relocation for sectors conside-red strategic. Finally, by going to growth companies, this capital maximises op-portunities for job creation.

That is because this type of pa-tient capital is also a solution for governments that want to relo-

cate part of the production to strategic sectors within national territory. This relocation can happen gradually, provi-ded that local skills have not been lost. Relocating is therefore not necessarily easy to achieve. Moreover, a company must be competitive in order to relo-cate. Relocation can always be forced, but in the long run, that is not neces-sarily productive. Therefore, it is also necessary to find ways of attracting capital through an appropriate organi-

12 The European mid-market comprises companies with over 250 employees and €50M of revenue. Source: The Mighty Middle Why Europe’s future rests on its middle market companies,Essec business school

10

CIO L E T T E R

Consumer awareness is what will lead to the change that businesses must adapt to. And that is just as well, because companies are at the heart of the pro-duction system. Those companies that are already profitable today, and not states, will (or will not) in-fluence the way to produce that will change the cli-mate trajectory in the medium term. These issues no longer relate just to production, but also to energy efficiency, i.e. services. It is therefore a question of financing profitable businesses in the real economy in a very fast-growing market. Equity investment in these companies will unlock the entire value chain that will give them access to bank debt and enable the development of sustainable infrastructures. There are plenty of excellent infrastructure funds turning to invest in these assets developed by companies that we support. Strong demand is also developing for green bonds, which these companies will be able to issue, once they are well capitalised. Until recently, however, there were no private equity funds dedica-ted to the energy transition. Investing in the capital of companies involved in renewable energy production, energy efficiency services, or low carbon transporta-tion will help develop a production system for which a large buyer market already exists. The marginal euro invested at the top of the capital structure will there-fore have a much greater impact than that invested in a green bond or an already developed asset.

The good news is that growth will have to be sustainable if it is to be profitable. And, in the post-COVID global economy, energy transition

should be, along with digitalisation and/or health care, one of the few sectors with strong growth in a flat-growth world. It is also a sector in which Europe has a strong competitive advantage and is positioning itself among the world’s leaders.

Before the COVID-19 crisis, the energy transition was a fast-growing sector in which we had identified a strong need for equity injection, which would not only help compliance with the Paris climate agreement but also enable us to develop growing companies in an area where Europe has a competitive advantage. Be that as it may.

The case for energy transi-tion as central to Europe’s economic recoveryEnergy transition is emerging from the COVID-19 crisis as one of the most promising and strate-gic growth sectors for economic recovery. In a previous letter 13 , we mentioned that redirecting about 12% of the annual increase in global savings to this sector over the next ten years would be sufficient to finance the total expenditure needed to comply with the global warming targets of the Paris agreements 14 .

But that can be done only if those investments are profitable. In that regard, financing losses

with venture capital in order to find the technologies of tomorrow that will save us is probably useful but very far from essential. That is because, in this res-pect, innovation is no longer the only thing the world needs to change the climate trajectory. New technologies are, by definition, those of tomorrow. But for global warming, tomorrow will be too late. We have to make an im-pact now and over the next ten years, and the existing technology already allows for that.

13 Tikehau CIO Letter: The myth of infinite

growth, the COVID obstacle and the climate wall,

September 2020

14 Source : IEA World

energy outlook 2019 http://www.iea.org /

Boston Consulting Group Global Asset Management 2020

11

The competitiveness of the energy transition is ap-pealing. Allowing companies to reduce their costs through improved energy efficiency in buildings and production processes is a major competitive advantage for a country that wishes to repatriate its production facilities. In that respect, energy transition is a major economic asset in a less glo-balised, less over-optimised economy.

Countries have a strong interest in encouraging the flow of capital towards energy transition, not only for environmental reasons, and not just because this sector is growing and potentially creating jobs. Energy transition is also a major weapon for compe-titiveness in all sectors of the economy.

Valuation premium relative to listed sharesPrivate equity and listed equities are often presented as contrasts. Yet, considering our long-term invest-ment horizon, the two activities of investing in compa-nies have many similarities. The stock selection crite-ria are similar, as are the valuation methods. Bridges between the two worlds obviously exist and the two worlds serve each other. A private equity fund may introduce a portfolio company on the stock exchange or remove a listed company from the exchange. A listed company may acquire a company belonging to a private equity fund or sell one of its subsidiaries to the fund.

So why has there historically been a valuation premium for private equity compared to listed equities?

Why are we so convinced that the crisis gives this sector a highly strategic dimension, placing energy transition at the very heart of the post-COVID econo-mic recovery?

Because it is probably one of the few growth sectors in the low-growth world that will characterise the next econo-mic cycle; but also because the eco-nomic challenge for all companies in all sectors is enormous. In this weak growth world, being cost competitive will be key, and at a time when political pressure to repatriate production sys-tems will be increasing. Some sectors will be declared strategic by govern-ments in the various major geographi-cal areas. Globalisation has probably reached this turning point, and this means an increase in the cost of labour for companies since they will no longer necessarily be able to produce in the areas where the cost of labour is the most advantageous. While this may be desirable from an environmental point of view, the competitiveness of the companies concerned will become an issue. And this is not just a problem for shareholders; it is also a problem for lenders and governments. Having to keep unprofitable businesses alive on the pretext that jobs have to be preser-ved is not likely to be very viable over the long term for state budgets and taxation of their citizens.

12

CIO L E T T E R

But let’s not deceive ourselves. This does not mean that private equity can be claimed to be superior to listed equities. In both cases, the quality of the stock selection makes the difference over the long term. And the massive increase in asset price dispersion that is likely in its infancy will accelerate the transi-tion from asset allocation to stock picking in gene-rating financial returns. The best funds will be those managed by asset managers able to select the best stocks in a low-growth world and capital allocation disrupted by intervention by states and central banks and debt burdens.

To the extent that the difference in returns will increasingly be explained by the quality of stock selection, concentrated, high-conviction port-

folio management based on in-depth financial and non-financial fundamental research will be key. In this context, valuation premiums from one universe to another will become increasingly anecdotal.

Another aspect that deserves a few remarks is liquidity. Paradoxically, an institutional investor wishing to deploy significant amounts of capital might find it easier to invest in private equity than in small- and medium-sized listed companies. Moreover, the development of the secon-dary market in private equity offers investors multiple exit windows for supposedly illiquid investments. There seem to be many advantages to the secondary market: access to mature portfolios, already deployed to soften J curve effects, diversification of investment lines and portfolio acquisition at a discount. But, as in any fast growing bu-siness, there is the risk of runaway growth. In particular, the acceleration of the portfolio turnover speed should not come at the expense of alignment of interests. This was the problem of bank balance sheets until 2008. The acceleration of loan turnover speed via securitisation prompted banks to sacrifice the rigour of financial ana-lysis to the volume of debt origination, since the risk did not remain on bank balance sheets and was quickly shif-ted to other entities. Investment selectivity and discipline should not be at the expense of increased volumes and rapid exits from positions by the team that made the initial investment decision. This is why we believe that the align-ment of interests between the investor and the manager or structurer of the product remains a key investment cri-terion in any type of financial support.

First of all, to be objective, it is worth highlighting that private equity valuations have a much

shorter history than listed equities, and therefore the notions of relative premium remain to be confirmed over the long term. But for some years now, the valuation premium between private equity and listed equities has often been justified by the lower volati-lity offered by private equity funds. We remain sceptical about this argument because the lower volatility is artifi-cial. The underlying businesses are no less volatile. It is just the difference in valuation frequency that produces this advantage which, when looked at over a long-term horizon, has little impact.

On the other hand, this valuation premium could be explained by the qua-lity and stability of the capi-tal contributed by private equity, as well as the added value of the network of connections and expertise it provides. When we talk about the alpha contribu-ted by private equity 15 , that is likely where it is and can be measured.

15 Alpha is defined as the

additional return generated beyond that of a bench-mark. Alpha realises the value added of an active

manager compared to a passive investment

in a given asset class

13

That being said, the development of the secondary market for private equity should be viewed in relation to the drying up of liquidity observed for listed mid-caps, due in particular to a shortage of published research on low volume stocks for economic reasons.

That is why we consider that investing in listed

small and mid-cap stocks through patient capital vehicles without daily liquidity

can create a lot of value over the long

term.

These liquidity considerations may there-fore counter-intuitively explain in part pri-vate equity’s valuation premium relative to listed shares.

Europe, a particularly attractive investment regionWe mentioned that one of the handicaps Europe faces compared to the US and China is the hetero-geneity of its domestic market. But this diversity of languages and cultures also represents an imposing barrier to entry for the international asset allocator, in a geographic region that holds tremendous value for investors.

Despite all the challenges facing the Old Continent in the twenty-first century, Europe remains a unique land of investment and continues to attract capital from all over the world. It is one of the most stable peaceful regions on the planet, where the culture of investment and entrepreneurship is as deep as it is sustained by a rich history and a well-functioning education sys-tem. The legal systems that govern economic flows are stable, so Europe remains to date one of the only alternatives for a global asset allocator seeking to in-vest significant amounts of capital by diversifying its portfolio outside of just the US. This is of paramount importance at a time when global savings continue to increase, and it makes Europe a compelling invest-ment area.

It is very difficult for an investor with no presence in Europe, or with only one European office in Lon-don, Frankfurt or Paris, to invest in Europe. ‘Good

transactions have no weels’ is often repeated when we are asked why Tikehau has opened offices in se-ven European countries to date. And there are plenty of good transactions on this continent imbued with economic and entrepreneurial culture. In Europe, you need to be local, which means being fully integrated into national or even regional economic ecosystems, and considered as a local investor, which de facto sets up an extremely strong barrier to entry and gives a competitive advantage to those who have made this bet. The prize is worth the effort insofar as this complexity partly explains the lower market multiples in Europe for companies, whether listed or not, of a quality equivalent to their American competitors.

14

CIO L E T T E R

The lack of a homogeneous do-mestic market reinforces the need for fast-growing European

companies to turn to minority private equity. Bringing in a partner capable of supporting a national champion in its international development stra-tegy is an alternative that hundreds of medium-sized actors can envisage. Achieving success requires a detai-led understanding of national or even regional ecosystems, as well as a network for selecting the right partners and the right contacts.

It is quite possible that the investor wishing to deploy capital in Europe may still have to cope with this cultural heterogeneity and economic specificity for a long time to come. This is what we believe opens up unique strategic spaces.

But this fertile land of skills that exists within a favourable legal and cultural framework can only be maintained if this region remains politically stable. The eurozone countries have common problems and there is more unity than disunity in their solutions. How could a country like Belgium or France, let alone Scotland or Catalonia, negotiate trade deals in any advantageous way with China or the US? Brexit will be an interesting example to keep an eye on. The United Kingdom will soon leave the European Union, but it is likely that the country will remain closely lin-ked to the EU, at least from an economic point of view.

In this respect, the European Commission’s esta-blishment in July 2020 of a €750 billion fund, par-tially financed by pooling the debt of the member

states, is a major step forward. As a first step towards a possible fiscal union, this agreement will dispel the prospect of a breakup of the eurozone and strengthen Europe’s willingness to preserve the continent’s eco-nomic stability. This is excellent news for investment in Europe.

ConclusionWe therefore see within private equity a real interest in growth equity, which enables entrepreneurs to grow their business and maintain control, whilst benefiting from additional capital injections (which is lacking in Europe), but also from the contribution of expertise and a network by an active minority partner.

The challenge is not just economic. It is strate-gic for countries in a context of slowing globa-lisation that will force some form of relocation

of industrial production and services, at a time when costs and capital can no longer be as optimised as before the crisis. Capital, an abundant resource be-fore this crisis, is once more a scarce and strategic resource.

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But the challenge is also social. The response of states and cen-tral banks to the COVID-19 cri-

sis has probably been proportionate, appropriate and justified. But it has problematic side effects. Low interest rates and central bank purchases of corporate debt above a certain rating are allowing a small number of very large firms to enhance their competi-tive advantage by eliminating or buying off their weaker competitors and domi-nating their supply chains, often com-posed of smaller firms that do not have access to the same financing condi-tions. The capitalisation of these large players is increasing and is having an increasingly significant impact on stock market indices that are disconnected from the rest of the economy. Even if these very large players create jobs, the risk that economies will continue to suffer in this environment will inevitably create political and social tensions. There is still a high risk that the ‘Main Street’ versus ‘Wall Street’ theme, dri-ven by populist or nationalist waves, will resurface in Western economies. In this context, financing the real econo-my appears to be a social issue that is absolutely essential for maintaining democratic systems. Shifting global savings to financing the real econo-my by providing financing and equity therefore has a dimension that goes beyond the simple considerations of economic profitability for the investor.

It is thus hardly surprising that retail investors are increasingly demanding meaningful investment solu-tions. Access to strategies for financing the real eco-nomy, via unit-linked products or investment formats available to non-professional investors, is a strong and much better trend for the cohesion of our eco-nomic systems.

In this respect, the asset management sector has a crucial role to play :financing the economy, and showing that savings can be used, via patient capi-

tal, to develop sustainable growth. Asset manage-ment is probably one of the private sectors that can have the most impact on an economic model change. This opportunity must not be wasted. To prevent fi-nance from being slammed once again, with surging populism and inequality, asset management must resist the temptation to maximize short term returns with too much leverage, too much complexity, too many short-term strategies and management that is too abstract and out of touch with the real economy. Patient capital and the alignment of interests are the keys to sustainable growth. Private equity can and should be part of this scheme. This is achievable, but the asset management industry must take such a position now.

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