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KKR bats for thoughtful allocations, distressed theme in 2019 as valuation corrections unfold

Deal Street Asia 2019-01-10 16:58:31

A valuation correction is “now unfolding” in the growth/venture capital markets, according to a 2019 outlook report by private equity major .

“Deals priced in the second half of 2018 will now see lower valuation marks in 2019 in areas where deal teams stretched on valuation metrics amidst ebullient market conditions,” notes 2019 Global Macro Outlook: The Game Has Changed, a report prepared by Henry McVey, Head of Global Macro and Asset Allocation (GMAA) at KKR, and a market guru in his own right.

Funds that were relying primarily on unrealized gains on an IRR basis are likely to see the maximum impact, it added. “Given the carnage of late, however, we do want to highlight that this is an investment area that we intend to revisit for an upgrade in the first half of 2019,” it pointed out.

The firm maintains a 300 basis point overweight position in Traditional Private Equity and 500 basis point underweight in Growth/VC/Other.

Explaining how the game has indeed changed, McVey said, “We are entering a sustained period when the performance of capital markets will – at best – be on par with the performance of the global economy in nominal terms. So, we also expect lower returns with wider dispersions and higher volatility over the next few years.”

However, there are still pockets of hope. While return per unit of risk is headed lower, investors with a long-term game plan and the ability to buy complexity amidst uncertainty will continue to see significant opportunities in 2019, KKR said.

McVey’s advice is to stay invested, especially in areas of dislocation that participants could immediately lean into with increased positions. “In particular, we are moving to a tactical overweight position in Global Equities for the first time in three years. We also believe that… parts of Liquid Credit, Infrastructure, and Special Situations/Distressed now appear quite attractive too,” the report added.

Bullish on Distressed/Special Situations

Continuing a migratory pattern KKR started last year, the firm is adding another 1 per cent to distressed/special situations (4 per cent compared to 3 per cent previously and a benchmark weighting of zero). “To be sure, this call is a walk, not run idea, but if we are right about increasing volatility and late cycle behavior, we think our logic directionally makes sense,” it added.

In terms of the specific opportunity set, McVey said distressed/special situations managers may have success buying positions from lower quartile direct lending managers and banks that provided leverage to fund these investments during the “recent periods of excess”.

“We also expect more fallen angels from the traditional Investment Grade market. Finally, we are already seeing quality positions in liquid credit that might be a touch too ‘spicy’ for our Actively Managed Opportunistic Credit account (i.e., either too illiquid or may require some active management) but would be well suited for the Distressed/Special Situations arena,” he added.

Favour more complex realty bets

The KKR market guru, however, lowered the Opportunistic Real Estate Equity allocation to 2 per cent versus 3 per cent and a benchmark of 2 per cent.

“…Real Estate Credit appears to be a more efficient vehicle for playing our nominal GDP-linked theme at current levels. Also, we note that there is a lot of money sloshing around in Core Real Estate. So, within Real Estate Equity we prefer more complex situations where there is less cap rate risk,” McVey said.