I have been fortunate that, since I moved into private equity search three years ago, the alternatives industry has been riding on the wave of a bull market. Despite some temporary knocks, it continues to surprise its doubters’ expectations. I have been told by some of my more senior colleagues, who have experienced recruiting through a recession, that it is a particularly exciting time to be working in private equity; and it is not just my fellow colleagues. The huge volume of candidates that I meet who are eager to move into this area from investment banking is at least somewhat indicative of a thriving market.
The industry’s success has been due to a combination of reasons.
First of all, favourable economic conditions have made it easier for private equity funds to take on large amounts of cheap debt, thus allowing them to make larger bids for businesses. This was exemplified most recently by Blackstone, which, along with GIC and CPPIB, completed its largest deal since the financial crisis when it bought Thomson Reuters for $17.3Bn. This was secured through a $13.5Bn loan and bond financing package, the hefty amount of debt packed into the deal highlighting the easy availability of said debt.
In addition, private equity has continued to generate strong returns, outperforming other asset classes. In 2017, LBO funds delivered their best performance in a decade, with multiples on invested capital reaching an all-time high. Equity capital markets have also been extremely active, and funds are taking advantage of this by choosing to float a number of their investments, especially before the looming uncertainty of Brexit. Last year, combined buyout-backed exit value came in at $366Bn, the third best year ever. According to research published by law firm Pinsent Masons, the number of private equity backed IPOs increased by more than a third last year.
What has been most noticeable has been the record-breaking amounts of capital raised. Private Equity firms raised more than $700Bn globally last year. Furthermore, GPs are returning to the market quicker than usual to capitalise on the huge demand for the asset class. According to Bain & Co’s private equity report, growing investor demand for the asset class has resulted in the largest buyout funds ever raised in the Asia, Europe and the US. A case in point has been Apollo Capital Management raising a $24.6Bn fund, the largest buyout fund ever. It is not only the scale though, but also the incredible speed at which funds have managed to raise capital, such as Advent International which only took six months to reach a final close for its latest fund of $13Bn.
All rosy in the world of private equity then? Or is the state of the market too good to last? Somewhat alarmingly, there has been a growing consensus that all these factors are similar to conditions seen in the years leading up to the Financial Crisis. The challenge for fund managers today is not raising capital but deploying it. Funds are anxious to spend, and this has led to them paying huge multiples for assets. Whilst this is synonymous with a buoyant market, it is also creating more pressure to generate high returns. I recently discussed this with a Principal at a large cap private equity fund, who noted that, “there is a question of whether you buy now and assume you are going to sell at an elevated valuation or hold out and wait for the market to turn”. Funds have had to come up with creative ways to continue to invest, but at the same time not compress their future returns. The Principal added, “One way we try to reduce our risk is through looking at deals where you can do add-ons. Let’s say you buy a business for 12X EBITDA and then you can start buying individual practices for 6X EBTIDA, it means you can blend down your multiple”. It seems that the real beneficiaries of these economic conditions are the sellers, specifically of larger assets, who are enjoying funds’ need to look at bigger deals, so they can deploy their capital quicker. However, given the huge valuations being traded, it will be difficult to generate the same returns to which investors have become accustomed. Another challenge occurring due to high valuations has been where private equity funds are now having to compete with the public market. A number of private companies have chosen to IPO instead of selling to private equity, which is a challenge that has not been seen that much in past years.
Another theme that has been circulating the industry has been the growing competitiveness from longer-term funds and pension funds. Buoyant market conditions have seen them to be much more active than seen in recent years. This was noted by the same Principal, to whom I referred earlier, who observed, “a lot of the pension funds and family offices have become a lot more aggressive and are taking more of a direct approach, versus a co-investing role”. A growing number of pension funds, which were previously happy to invest their capital through private equity firms, are now cutting out the middle man, as it were, and setting up their own direct investment teams. This increased competition, combined with record quantities of dry powder, has led to funds chasing too few deals, and those at inflated prices, or taking bigger risks when buying assets. You would hope that the experience of the Financial Crisis would mean that this would not happen again, however, with such huge amounts of debt available and high investor demand, this could be wishful thinking.
In the future, investors may struggle to hit the returns seen in recent years, and it is hard to predict how the private equity industry will react to this. Given the market has been so flooded with capital, that now has to be put to work, fund managers will need to come up with more creative ways to invest, such as through bolt-on acquisitions, in order to cope with rising asset prices. Given the recent turbulence in the equity markets, we might see a sharp correction that would bring valuations and debt levels down to a more stable and sustainable level. Even with all of this taken into consideration, I would nevertheless reiterate that current sentiment regarding private equity as an asset class is still predominantly positive, as demonstrated through recent strong fund-raising and high returns on investments, but it remains to be seen what the future holds.
Author: Robert Cameron is a Consultant within Altus Partner’s Private Equity Practice. Robert.Cameron@altus-partners.com