European PE Firms: Moaty and Profitable, But Expensive

We initiate coverage with narrow moat ratings on all three major European-based private market firms: CVC Capital Partners PLC (CVC), EQT AB (EQT), and Partners Group Holdings (PGHN) AG. We expect all three firms to remain highly profitable, and the private market industry benefits from established secular growth trends.

However, the eye-watering mid-20s EV/EBITDA multiples the firms trade at currently suggest that the market already prices in these strong fundamentals. We do not believe that higher interest rates mark a structural change in the industry, but we expect near-term dealmaking to remain muted.

Key Morningstar Metrics for CVC, EQT and Partners Group

The high switching costs the investors in its funds face and the intangible assets the firms developed over time underpin our narrow moat ratings for the three firms. We expect high excess returns, even if we exclude the contribution from volatile carried interest to revenue. We do not, however, have sufficient conviction that excess returns will persist for the next 20 years—the threshold for a wide moat rating.

Most private market investors are contractually locked into funds for anywhere from five to 20 years, making switching fund managers impossible. The high costs of fresh due diligence on new managers lead to limited-partner investors reinvesting in successor funds. All three of the European managers have seen substantial reinvestment from existing clients.

CVC has climbed over 15% since its IPO in April

The dispersion of private capital returns is far wider than that of public market returns. We therefore view the stellar long-term track records of CVC, EQT, and Partners Group as material intangible assets. Most limited-partner mandates will constrain their ability to invest in fund managers with limited track records. Access to attractive investment opportunities before others is vital to outperformance in private markets. Some deals take years to come to fruition. An attractive target might not yet be ready to sell or does not yet require capital. Private market firms spend significant time and money to source and cultivate relationships with potential targets.

A Challenge to Maintain High Fees

While it is not our base case, we are concerned about the risk of fee margin erosion in the long term. The outperformance of private markets over public markets is narrowing, making it harder to justify its significantly higher fees. Regulators will also take a keener interest in private market fees as the asset class opens up for more retail investors. The demand for private market firms with an extended track record exceeds supply. As demand stabilizes, this would improve the bargaining position of limited-partner investors.

Higher interest rates have constrained dealmaking in private markets globally. Still, we agree with the three firms’ rosy, longer-term assessments of the industry’s growth prospects. Institutional limited-partner investors, lured by the promise of higher performance and increased diversification from private markets, continue expanding their allocation to this asset class.

The high compliance and monitoring costs of having a multitude of firms managing their private market investments have motivated many limited partners to cut their roster of managers. With track records of outperformance and entrenched client relationships, we think the firms we cover will be among the biggest winners from industry consolidation. Private market investing is also gradually opening up to individual investors, which opens up a potentially vast pool of fresh capital for private market managers.

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