Letter #130: Matt Nord and Torsten Sløk (2023)
Co-head of Private Equity at Apollo and Partner & Chief Economist at Apollo | Private Equity Investing Amid Market Dislocation
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Today’s letter is the transcript of a conversation between Apollo Co-Head of Private Equity Matt Nord and Apollo Chief Economist Dr. Torsten Sløk. In this conversation, the pair discuss the current private equity investment landscape and how capital markets dislocations have helped create an attractive entry point into the asset class. Matt starts off with an overview of the private equity landscape, dives into his view of rates, pontificates on the transition away from a low-rate, low low-inflation environment, discusses the macro environment, and shares his views on investing in a volatile market. He then goes into how he assess the profile of companies’ capital structures and if he thinks there’s a problem, dealing with higher financing costs, what 2023 PE vintages will look like from a historical perspective, how investors should think about generating sustainable alpha in private equity now and going forward, and general trends in the PE industry.
Matt Nord is a Partner and Co-Head of Private Equity at Apollo, where he oversees the Firm’s private equity strategy and has led numerous investments across technology, healthcare and business services. He is on the board of directors of TD Synnex, West Technology Group, Lifepoint Health, ScionHealth and Tenneco. Prior to joining Apollo in 2003, Matt was a member of the Investment Banking division of Salomon Smith Barney Inc.
Torsten Slok is Partner and Chief Economist at Apollo. Prior to joining in 2020, Torsten worked for 15 years on the sell-side, where his team was top-ranked by Institutional Investor in fixed income and equities for ten years. Previously, he worked at the OECD in Paris in the Money and Finance Division and the Structural Policy Analysis Division. Before joining the OECD, Torsten was with the IMF in the division responsible for writing the World Economic Outlook, and the division responsible for China, Hong Kong, and Mongolia.
I hope you enjoy this letter as much as I do!
(Transcript and any errors are mine.)
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Transcript
Torsten Sløk: Hello, everyone, I'm your host Torsten Sløk, Chief Economist here at Apollo. And you're listening to the view from Apollo podcast. My guest today is my good friend and colleague, Matt Nord. He is Partner and Cohead of Private Equity here at Apollo. And I'm excited to have Matt with me today to discuss the investment landscape for private equity. We have a lot of ground to cover from how to invest in times of dislocation, to areas of focus, this scarce financing environment, and much more. So without further ado, let's get right to it, Matt. Welcome to the show.
Matt Nord: Great. Thanks for having me, Torsten.
Torsten Sløk: Great to have you. So let's start with a simple question... can you give us an overview of where is private equity today? And how did we get here?
Matt Nord: Sure. I'm not sure this is the perfect analogy, but it's probably a lot like waking up with a hangover. You're a little disoriented, and you probably regret some of the decisions you made. Thinking about where the industry has been the last couple of years, really, for a while, just a tremendous amount of excess. There was a 40 year bull market in rates, the Fed printed $8 trillion dollars in capital and liquidity. And so we experienced that everything bubble, not only in the public markets, but in the private markets as well. And so if you look at where the industry has bought assets over the last 10 or 15 years, really post the financial crisis, valuations just continue to tick up higher and higher. So if historically, the average multiple for a business, in private equity, it was about nine times cashflow, people were paying 12, 15, 20 times cash flow. And a lot of that was supported by cheap debt. So leverage levels increased across the industry as well. This is all changing now. Money has a cost, as you well know. And so what we're experiencing right now across the industry is navigating this pivot. So what is the economic outlook gonna look like, what's financing going to look like? And that uncertainty is really having a significant impact on deal volumes this year.
Torsten Sløk: Yeah, and the environment we've had, with very low rates for a very long time is obviously very critical also for thinking about the macro outlook. And so looking ahead, what does it mean when the cost of capital now is permanently higher. And inflation, as you and I talk about frequently, is much more stubborn and sticky. And it's gonna take quite some time before we get inflation back to the Feds 2% target. As we know, inflation at the moment is running at a rate around 5%. And getting that back to 2% could take several years. So talk to us about what does this reversal mean, from your perspective, as a private equity investor?
Matt Nord: It's interesting how much has changed, and how quickly it's changed. So even if you compare where we are today, to a year or so ago, on any consideration, any metric, whether it was inflation being low and stable, now high, as you mentioned. Valuations have come down, the cost of financing is significantly higher, if it's available at all. So availability of financing is a huge issue across the industry right now. The amount of potential distressed and distressed companies across the economy and markets, there's been this wholesale shift. And so I think the bigger point is that the strategies that really outperformed over the last five or 10 years are not going to be the strategies that perform in this environment, and the next couple of years. So what worked over the last 10 years or so, it was really a momentum trade. Purchase price did not matter. And we talk about purchase price matters. I think for the industry, for a long time, it was less relevant. You could buy a company, any sort of good company, as long as it was growing, and you could pay up and fully lever that business. And so you bought high, but you were able to sell even higher. And a lot of your value was created with multiple expansion. And if you think about an environment today with structurally higher rates, a higher cost of capital, a lot of uncertainty, whether that's economic uncertainty, geopolitical uncertainty, it's going to favor investors who have a more flexible toolkit and who really have the ability to drive alpha across all market environments.
Torsten Sløk: And that process, that regime change that we've been through, including on the inflation side, where we, for literally decades, inflation was not a problem to now suddenly inflation is a problem and rates are structurally higher and it is very unlikely that we're going back to zero interest rates anytime soon again. I mean, do you think the markets are done correcting here? Or do you still see imbalances in the system? In other words, how do you look at the transition from the low rate, low inflation environment that we had before, to this new world, a new regime that we have entered?
Matt Nord: I guess I would separate sponsors' existing portfolios, and then kind of the new deal environment. I think for existing portfolios, the capital that was put out over the last couple of years at peak prices is really going to struggle to generate an attractive rate of return. And it's really just math. So much of valuation was driven by the availability of financing. So rather than sponsor saying this is the appropriate price for an asset, now let me figure out how I want to finance it. Private equity firms are really approaching valuation more from the perspective of I could put this amount of debt on a business and then my equity on top of that. And so the valuation really drove higher overall purchase prices. But those capital structures were not sustainable. Because if you're levering a business at seven or eight times in a low rate environment, and then rates are up three, four or 500 basis points, structurally, that business cannot support the same level of financing. And so this is going to play out over some period of time. But there's going to need to be a massive deleveraging across the industry. And at higher rates, if a company was levered at seven or eight times, just to have the same interest coverage ratios, it's probably now going to be five or six times. That two to three turn reduction in leverage levels is either going to have to come from lower valuations, sponsors putting in more equity, or ultimately, the deleveraging of balance sheets. So for existing portfolios, that hurdle around needing to transact at a more reasonable value means that there's going to be a longer period of time before you find that overlap or intersection between buyers and sellers. I think sellers are going to hold on to that prior environment for as long as they can, whereas buyers are going to think about the higher cost of financing, and they're going to think about uncertainty, and want to get paid for that risk. And so that's why you've already seen a slowdown in deal volumes this year. That can't last forever. But as we go through this regime change, it's just going to create a real challenge for sellers to achieve the valuations that they need, and buyers to be able to pay for those assets.
Torsten Sløk: So the conclusion is really that it is not today that's unusual. It was actually the environment leading up to today that was unusual. In other words, we have had a number of episodes before, haven't we, where we have had bubbles in everything from gold to the tech sector to the US housing market. I mean, how do you, from a very long perspective, look at where we are today, relative to a number of these episodes, like the one that we have just exited?
Matt Nord: You raise a great point. History doesn't repeat itself, but it rhymes. And so if you've been in the industry long enough, you've seen multiple bubbles, and asset classes, really get disconnected from fundamentals, and you mentioned a number of them. I think the strategy for private equity should be strong absolute returns and strong risk adjusted returns across all market environments. And so, that's the question. Some sponsors will try and chase that trend. And that works for a while. What you've always seen across the industry is that commitments and allocations and investments are somewhat procyclical, and a lot investors put a lot of capital to work at the peak of the market, whereas other investors really try and hold onto their discipline: focus on purchase price, focus on well structured companies, a lot of downside protection, and not get caught up in some of those excesses. If you look across the industry, there has been an enormous amount of concentration in a handful of sectors. Right now, tech has about 35% of all private equity deal volumes. Pretty similar to the amount of tech in the S&P. And tech and healthcare have been about half of all private equity deal volumes the last couple of years. And so this exposure to higher multiple sectors, long duration equities, really become a derivative bet on the rate environment. For all the reasons that we've been talking about, these higher multiple sectors are the ones that are most interest rate sensitive, most valuation sensitive. And so if you're an investor, and you're allocating capital, you just need to think through the underlying exposures in these portfolios, and if you're looking to private equity as a source of differentiation or diversification, make sure you're choosing the right manager that will help you achieve that, because if a sponsor is doing the same sorts of deals and investments that the broader market is, then just because you're allocating to a different asset class, you haven't diversified your underlying exposure.
Torsten Sløk: And you have done this for decades, and your entire career, and you've been through many different cycles. As you now look at it from the long perspective that you have, how do you then prepare, if there is a risk that we may have recession, say in the next few quarters, and we may have heightened market volatility, and we may have permanently higher cost of capital than we've had before we got into this new regime, how are you preparing for the investments that you're making on the private equity side?
Matt Nord: Your question is something that we think about quite a lot. And I'd say, before I address some of the specific strategies, we just have sort of a different point of view than most. Anytime you talk to a private equity firm, a sponsor, they love to talk about their winners. And my view, and our view towards portfolio construction has been: the best pathway to great PE performance is just to avoid your losers. Avoid mistakes, focus on that downside protection. Or if you'll allow me to use a baseball analogy, lots of singles and doubles, a couple of homeruns, but no strikeouts. If you can do that, you're going to generate outstanding private equity performance. And so your question around how do we anticipate risk? How do we protect our companies? is really foundational to what we do. So clearly, buying, not overpaying for assets is a critical first step, because one of the benefits, among many, of buying well is just using less leverage. So if you head into a period of volatility or distress, starting with less leverage, all else being equal, you're going to have a lot more sustainability for your business. But then there are other tools that we have employed to help protect our companies across different cycles: making sure that they have ample liquidity, making sure that there's sufficient duration on capital structures, making sure that covenants are sufficiently flexible so we can invest in our businesses. And then more sophisticated strategies around buying back debt at a discount. If we own the equity and we feel good about the long term prospects of the business, then being able to buy back portfolio company debt at a discount just helps to deleverage that company and create incremental profit dollars for us as sponsors. Or maybe it's doing add-on acquisitions when others are retrenching, this notion of playing offense when others are playing defense. So you're right, these are strategies that we've honed for several decades. And I think it's a real differentiator, that ability to lean in when others pull back. But it all starts with that discipline on the buy and just positioning your companies for success.
Torsten Sløk: So in other words, making the investments as little sensitive to whatever the business side may bring you. Is that a fair description?
Matt Nord: Yeah, I mean, no one has a crystal ball, obviously, and us included. The way that we've thought about generating returns, you can kind of approach it bottoms up or top down. Our view is if you buy a good asset at a reasonable price, and it's reasonably capitalized, and you have a good management team, then you can achieve really very strong returns just through operational improvements and free cash flow generation. So levers that are far more controllable, far more tangible, in my view. And that would leave us a lot less exposed to overall growth of the market and changes in the valuation environment. I think that is the right--through the cycle strategy. Now, the opposite has worked really well the last couple of years. Buying these higher multiple businesses with a lot of leverage. Maybe there's still some operational improvement, but there's definitely no cashflow. But the market bailed out these deals, the multiple expansion bailed out these deals, but just circling back to where we started the conversation, those strategies are not going to work in this environment. You're not going to see multiple expansion, given the increase in rates. And if anything, you could see multiple contraction depending upon where you bought some of these assets.
Torsten Sløk: From your perspective, why should investors then consider deploying into private equity today?
Matt Nord: If you look at the history, generally speaking, the best performing vintages are the vintages that have been invested post a recession and into a recovery. There is variability in performance. So really finding the right partner or the right manager who knows how to take advantage of that opportunity set is important, but generally speaking, the vintages that were deployed coming out of post recessionary periods have performed the best. So the challenge for most investors is that they think about targeting a certain allocation to the asset class. And so what happens is, as other parts of their portfolios increase in value, they increase their allocation, but then they're increasing and deploying capital at the peak of the market. And then you have a correction, and you have the denominator effect. And people start to question how much they should allocate to the industry to private equity during an environment that's more akin to the one that we're in now. And so rather than leaning in, because this is actually the best time, in my view, to deploy capital to the private equity industry, they start to pull back. So I do think it's really important for investors not to try and time the market, but to have a consistent plan, a consistent allocation across vintages, because you do want to make sure that you're capturing the value that's going to be created when investments are made in an environment like today.
Torsten Sløk: Let's now turn to the potential for distressed transactions. How are you assessing the profile of companies' capital structures today? And if you think there's a problem, how big is it?
Matt Nord: I mean, the size of the leverage finance market's about three times what it was in the financial crisis. So there's a significant amount of opportunity. Our view of distress for control... first, it's really just a deleveraging transaction. These are good companies with bad balance sheets. But they're fundamentally good companies. They're companies that we know in sectors that we know. And by buying the debt, you're able to convert it into the equity, deleverage the business, it's just a pathway. At the end of the day, it's a good company, good balance sheet. But the reason why I think distressed debt investing is such a powerful tool is that you can really create a heads I win, tails I win dynamic. So if you're buying debt at a discount, first, you're higher in the capital structure and so you have that downside protection. But if the company is able to refinance you, either because the market rebounds or the sponsor contributes more equity, then you're generating a very attractive rate of return. And if not, then you're perfectly happy to own that company. And so it really starts with companies and sectors that we know. You have to do your work in advance. If you think about periods of dislocation, whether it was the financial crisis, or the first quarter of 2020, you can't wait for that environment to start doing your work. You really need to do your work in advance so that you can capture those opportunities when those windows present themselves.
Torsten Sløk: And you mentioned financing costs are higher. As we talk about that structurally, the cost of capital is going to be more expensive, how do you deal with this issue?
Matt Nord: I think one, as a value oriented investor, purchase price matters. If we're just buying assets at lower multiples, and we're using less leverage, it's less of an issue. That's sort of obvious. But I think there's a related point, that financing is temporary, purchase price is permanent. So what I mean by that: we are all too happy to make a trade if we can buy a company at a lower multiple of cash flow at a cheaper price, even if it means more expensive financing. And that is the environment that we're operating in right now. The cost of financing is higher, it's more difficult to get and it's higher, but we can find very compelling value. And the reason why that's a good trade is because as the company performs, as it deleverages, as it pays down debt, we'll have an opportunity to refinance that capital structure at some point during the course of our ownership. And at that point, you not only have bought, but you have a cost of capital across your balance sheet that's lower as well. And so it starts with just using less debt, which has always been a hallmark of our business. But again, I'm all too happy to make that trade around purchase price and cost of financing.
Torsten Sløk: And you mentioned that it matters a lot, of course, that over time to have the same consistent approach. And we of course, also looking at this from a vintage perspective, and vintages matter in private equity, and that return dispersion is of course high in the asset class. So maybe can you contextualize this for our listeners and elaborate a bit more on your views for 2023? What will the 2023 vintages look like from a historical perspective when you and I sit down and do this podcast again in five years time?
Matt Nord: I hope it's sooner than five years. I think it's going to be a very strong vintage, generally speaking. Again, selecting the right manager, and someone that has a flexible toolkit, is clearly going to outperform. And someone who can do more creative transactions and capture different opportunities that volatility presents is going to outperform. But generally speaking, investing on the other side of the correction during the recovery has been the time when private equity has generated its best performance as an industry.
Torsten Sløk: So how should investors think about generating sustainable alpha in private equity now and going forward?
Matt Nord: I am massively bullish on the prospects for the private equity industry. If you think about what private equity is all about, it's about helping companies and people achieve their full potential. That's my view. I think this industry is about good corporate governance, it's about alignment of interests, and it's about speed of decision-making. That toolkit, that approach, is going to generate outsized returns. And there's going to be a role for that approach in all market environments. So my view is that the industry will continue to grow. My hope is that additional investors come into the industry because we've generated outperformance for decades. Now, with that framework, and particularly for us, we're not trying to chase trends. We are trying to generate strong absolute returns and strong risk adjusted returns across all market environments. And I think to do that, to position yourself to be successful in that regard, it does start with purchase price. Purchase price matters. It's embracing complexity and creativity to do differentiated deals. It's well capitalizing your companies so that they have that flexibility to be able to invest in their businesses across all market cycles. No one can fully anticipate the risks, but you can give yourself a cushion, so you can withstand those risks. And then focus on operational improvements. And that is also a big shift in the industry. And I think that's going to continue to become a larger and larger source of value creation. It's the operational improvements and the way that entire process gets institutionalized within private equity firms so that the consistency around delivering that operational uplift, company to company, fund to fund, generation to generation, vintage to vintage, is something that is reliable and will grow over time.
Torsten Sløk: Okay, so we're coming up on our allotted time here, and I know how busy you are, I greatly appreciate that you have taken the time to talk to me here today. But I'd just like to ask you just one more question. If we just zoom out a little bit and look at the private equity industry more generally, what trends are you seeing in the industry today?
Matt Nord: Generally speaking, right now, we're seeing good resiliency across the portfolio. So a lot of the correction in valuations, and you know this better than I do, has really been the reassessment of the cost of capital. And so it's been more of a financial markets correction than a real underlying economic correction. That varies a little bit by sector, but generally speaking, I think people's portfolios are in pretty good shape. You're starting to see cracks--and so I do think as we head into the back half of this year and into next year, you are going to see some more stress across people's portfolios because you're going to have the double impact of higher rates plus companies starting to miss their plan, some economic weakness, companies missing their budgets. And so that's going to be something that the industry will have to navigate. And it's another reason why I believe that deal volumes are going to be lower this year, because financing is tough and sponsors are going to need to turn inward to really focus on protecting their portfolio of companies. But in time, as we get through that, I would expect there to be a little bit more balance across sectors again. I think sponsors got overexposed to higher multiple sectors: tech and healthcare. And given the change in the valuation environment, you'll probably see better diversification and something that's more in line with historical averages across sectors.
Torsten Sløk: Thanks so much, Matt. This has been fascinating. I know you and I have a lot of meetings together and we run into each other in the hallways often, but I really appreciate that. I have learned a lot here from spending this time with you, and really hearing your clear thoughts about what you think is going on at the moment. So thanks very much, Matt, for taking the time to be with us here today. And thanks very much to everyone for listening.
Matt Nord: Torsten, thanks so much. Always a pleasure to spend time with you. I really enjoyed it.
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