Sep 2017 by Caroline Rasmussen
Most readers of the financial press will have noticed a steady drip of commentary "sounding the alarm" about private equity over the past year. These commentators' concerns center around the amount of dry powder held by PE firms - buyout funds have over $540 billion in capital to deploy, the highest on record. 1 Including other private asset types such as real estate, venture capital and mezzanine debt brings the sum to nearly $1.5 trillion, as shown in Figure 1.
These levels of dry powder should certainly give investors pause. However, it would be overly simplistic in our view to consider headline dry powder numbers in isolation and conclude that private equity as an asset class should be avoided. The most glaring weakness of this approach is the fact that “private equity” encompasses a wide range of investment strategies focused on very different asset types and parts of the corporate capital structure. There are indeed areas that we would consider relatively less attractive today in light of secular industry trends, valuations, dry powder amounts, and the actual fund opportunities coming to market over the next 12 months. For instance, late stage venture capital, certain segments of the private real estate market, generalist secondary private equity, and large buyout are currently dealing with a confluence of factors, including meaningful capital overhang, that may challenge returns.
In contrast, we would single out specialty finance, opportunistic, deep value special situations, and small to middle market sector-focused buyout as examples of attractive private strategies in today’s environment. Asset based and structured lending offers an appealing combination of current income derived from floating rate, short duration assets and downside protection via collateralization and self-amortizing structures. (As discussed further in our full piece, the key with this, and indeed all, private capital strategies is manager selection – within specialty finance we would advocate seeking experienced credit managers with low realized loss ratios through cycles, and a predominantly senior secured risk profile.) With respect to special situations strategies, the high yield market today is almost double the size it was eight years ago ($2.2 trillion compared to approximately $1.1 trillion in 2009).2 As a result, the opportunity set has effectively doubled, regardless of whether the default rate increases (from $22 billion to $44 billion annually, assuming a constant 2% default rate).
Finally, the advantages enjoyed by smaller and more specialized buyout managers in spotting pockets of opportunity where they might realistically generate alpha even in hypercompetitive markets make this segment very interesting in today’s environment. These managers may be able to add differentiated operating value by virtue of industry expertise and more robust, relevant networks that enable them to better identify and execute on investment themes, potential assets and high-quality management teams. Smarter sourcing that not only covers a broader set of companies but also informs deal theses and imparts due diligence insights is more critical than ever, and provides a real edge in a market where the typical firm only sees 18% of intermediated deals that might be relevant to them.3 We were not surprised to see that 58% of institutional investors surveyed by Preqin earlier this year pointed to small and midmarket buyout as the most attractive private equity strategy over the next 12 months.4
Read our full analysis of the private equity dry powder argument here.
(1) Ernst & Young April 2017 Private Equity Capital Briefing.
(2) Bank of America Merrill Lynch, April 2017.
(3) 2016 Sutton Place Strategies analysis of 110 PE firms, Bain 2017 Global Private Equity Report.
(4) Preqin March 2017 Private Equity and Venture Capital Spotlight
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