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.
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 below, 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
In surveying the diverse landscape of “private equity”, it is also worth noting that recent fundraising numbers have been driven by large buyout vehicles, with the biggest buyout fund ever closing this summer at $24.6 billion.5 Investment activity has been driven by large deals as well; the first quarter of 2017 saw 23 megadeals (transactions valued at $1 billion or more), which accounted for 71% of total private equity acquisitions.6 As shown in Figure 2, while the value of PE deals has remained about steady since 2014, the number of deals has been trending lower, indicating that volume has been supported by larger funds while the broader private equity industry has been moderating its investment pace.
This observation highlights an important point: most private equity funds actually invest their committed capital over a five-year period, or three to four years in the case of private debt strategies. The fact that PE fund investments are not made in one lump sum but rather distributed over several years gives managers significant timing flexibility and makes it impossible, short of clairvoyance, to predict the predominant investment environment for a given fund. To put it another way, if one commits to a buyout fund today, unless the manager were to immediately deploy the majority of their dry powder (which would be highly unusual and certainly not what we would expect of a historically top quartile firm in this environment), one is effectively buying exposure to the next several years rather than to current market conditions.
Looking at the outlook for the next five years, it seems more likely than not that the long bull run we find ourselves in will finally turn the corner. In this context, it’s worth pointing out that private equity has historically outperformed in downturns, as shown in Figure 3. A recent Cliffwater report examining private equity investment programs at state pension plans over the 15-year period ending June 30, 2016 (a period which encompassed two bear markets and two bull markets) found not only that PE outperformed public equities by 4.4% per year on average for all pension plans studied, but that the return premium increased in times of low or negative growth in public markets.7 This is partially attributable simply to the illiquid nature of private equity, which precludes investors from selling on emotion and forces them to rely on the judgment of a professional manager in timing the exit, an often underappreciated benefit of the asset class.
Notably, the Cliffwater study also found significant variability in the performance of pensions’ PE programs; while all state pensions that operated private equity portfolios over the entire period outperformed public stocks, individual private equity returns ranged from 7.9% to 13.8%.8 As the study authors noted, this finding signals the "importance of implementation", i.e. manager selection. Rather than jumping in and out of the asset class, what most effective investors in private equity have found is that the best strategy is to focus one’s efforts on singling out experienced managers who can take advantage of favorable investment conditions if they do occur (effectively, buying low, selling higher and taking advantage of secular growth along the way), but who also have the networks, discipline and industry expertise to (i) avoid overpaying in frothy markets, (ii) develop and execute clear value creation plans, and (iii) identify the most accretive selling opportunities in any given market environment.
Fundamentally, manager selection and not vintage selection is what tends to drive PE returns. While this is clearly a truism for all asset classes, it is particularly the case in private equity, where the spread between mediocre and top quartile funds can exceed 1,000 basis points, as shown below.9
Taking a step back, the most basic counterpoint to "dry powder frenzy" and concern around PE valuations is that simple multiples do not necessarily have predictive power in terms of short (or long) term returns. Certain segments that we have seen trade at premiums are often expensive for good reason, while assets that are cheap are not always good bargains. Multiples on public-to-private tech deals, for example, have been high relative to those for non-tech deals over the past two years, but tech-focused companies tend to generate stronger revenue growth that is often more recurring, recession-resistant and actually cash generative in nature than their peers in other industries.10 It’s also important to note that overall private equity investment activity in terms of both deal number and deal value is only at about half the levels we saw in 2006 and 2007.11
It is interesting to speculate about what those preoccupied with crowding and valuations in the private markets must think about conditions in the public markets, where we now have more than $350 billion invested in the top two S&P 500 Index funds and over $7.8 trillion dollars benchmarked to the index.12 And while the universe of public companies in the US is shrinking, with delistings from stock exchanges outpacing IPOs and the number of public companies roughly half what it was in 1996, the private company universe continues to grow.13 As of the beginning of this year, there were only about 5,700 US-listed companies, compared to over 6 million private firms.14
Most investors have been disappointed at least once trying to time the public markets. Take recent history - if you didn’t act in real time during the Brexit vote, you missed the opportunity, while after the 2016 US election, the entry point that many anticipated never materialized. Timing the private markets, especially without accounting for the diversity of investment strategies available, is not any simpler. The last cycle peaked with KKR’s 2007 buyout of Texas energy group TXU for $45 billion, which went bankrupt in 2014. But even accounting for these big blowups, private equity has provided investors with better returns than public markets over the past decade, and is expected to continue to outperform.15 This is the basic reason why, despite the fact that dry powder levels may impact returns, 95% of institutional investors in Preqin’s H2 2017 survey plan to maintain or increase their private equity allocations over the long term. Regardless of where we are in the cycle or the general investing environment, there are always niche relative value opportunities to be found.
(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.
(5) Apollo raises $24.6 billion for largest private equity fund ever, Business Insider, Dasha Afanasieva, July 27, 2017.
(6) Ernst & Young April 2017 Private Equity Capital Briefing.
(7) An Examination of Private Equity Performance among State Pensions: Evidence for a Systemic Asset Allocation Underweight, Cliffwater, August 10, 2017.
(8) An Examination of Private Equity Performance among State Pensions: Evidence for a Systemic Asset Allocation Underweight, Cliffwater, August 10, 2017.
(9) The Ultra High Net Worth Investor: Coming of Age, May 2017, KKR.
(10) Bain 2017 Global Private Equity Report.
(11) Dealogic, Ernst & Young April 2017 Private Equity Capital Briefing.
(12) Ogg, Jon C. “Which Is the Best S&P 500 Index Mutual Fund or ETF for Investors Now?” 23 Feb 2017; Ogg, Jon C. "S&P 500 and US Debt Now Challenging $20 Trillion Each." 13 Feb 2017.
(13) Shrinking US Stock Market Opens Door Wider for Private Equity, WSJ Pro Private Equity, June 29, 2017, http://www.middlemarketcenter.org/ infographics/2q-2017-middle-market-indicator-infographic
(14) IPOs Are Dwindling, So Is the Number of Public Companies, Forbes, Anne VanderMey, January 20, 2017, US Census.
(15) Bain 2017 Global Private Equity Report, Cambridge Associates, An Examination of Private Equity Performance among State Pensions: Evidence for a Systemic Asset Allocation Underweight, Cliffwater, August 10, 2017.
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