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Trouble ahead for PE investors?

Summary:
Buried in the latest issue of Bain & Company’s Global Private Equity Report are a few concerning nuggets for investors.First, buyout firms are paying extraordinarily high prices for their targets, even higher than during the last boom in 2007:Historically, the single best predictor of returns in private equity investing is the entry multiple. That shouldn’t be surprising since, in general, higher initial discount rates tend to produce higher returns across assets. Limited partners should therefore avoid using the performance of the recent past to justify their PE allocations, since future returns will likely be lower.As if that weren’t bad enough, Bain points out that the relatively strong performance of the past few years was itself caused by the same forces likely to depress future

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Buried in the latest issue of Bain & Company’s Global Private Equity Report are a few concerning nuggets for investors.

First, buyout firms are paying extraordinarily high prices for their targets, even higher than during the last boom in 2007:

Trouble ahead for PE investors?

Historically, the single best predictor of returns in private equity investing is the entry multiple. That shouldn’t be surprising since, in general, higher initial discount rates tend to produce higher returns across assets. Limited partners should therefore avoid using the performance of the recent past to justify their PE allocations, since future returns will likely be lower.

As if that weren’t bad enough, Bain points out that the relatively strong performance of the past few years was itself caused by the same forces likely to depress future returns (our emphasis):

For the subset of deals in Bain’s proprietary database invested after the global financial crisis, we compared deal model forecasts for revenue and EBITDA margin expansion with the results that each portfolio company actually achieved over the holding period. Most portfolio companies, we found, had relatively accurate projections of revenue growth. However, most did not attain the projected higher profit margins.

This breakdown in execution had not come to light sooner because it was masked by macroeconomic factors, notably multiple expansion. Since the global financial crisis, acquisition multiples have risen significantly around the world. That’s not what PE funds anticipated. In their deal models, funds penciled in restrained expectations for multiples upon exit.

For the sample of deals Bain analyzed, funds assumed an average multiple at exit of 8.8 times EBITDA, but the realized exit multiple turned out to be much higher, at 10.9 times EBITDA. GPs had the good fortune to make up the shortfall in margin expansion through unforeseen multiple expansion. PE funds will not be so lucky with future deal returns…Unless interest rates decline further, multiples likely will top out.

Had PE firms not benefited from the rising share prices and collapsing credit spreads of the past eight years, their inability to improve profitability would have cost their investors dearly, according to Bain:

Trouble ahead for PE investors?

Bain’s analysis implies part of the problem was the way private equity firms and their investors responded to the decline in real yields. The problem is that the universe of companies eligible for leveraged buyouts is relatively small, and PE firms use lots of debt to boost their purchasing power.

Scholars have found that when it gets easier to borrow, general partners become less disciplined and overpay. At the same time, the willingness of limited partners to commit capital to buyout strategies strongly affects future returns. The more money LPs throw at the same set of companies, the more prices rise and the less those investors earn. The effects compound each other because LPs are often motivated to invest more in private equity when their other assets offer lower yields.

So while Bain rightly highlights the favourable macro environment as one reason why recent returns were good and future returns might be in trouble, it’s also worth noting how the macro environment encouraged large inflows back into private equity after the crisis, which in turn has helped inflate valuations:

Trouble ahead for PE investors?

Perhaps even more worrying for limited partners is the extent to which PE firms have yet to spend much of the money of they’ve already raised. This so-called “dry powder”, most of which was accumulated since 2013, is at record highs, with about $534 billion in equity available for buyout funds alone as of 2016:

Trouble ahead for PE investors?

Presumably, the general partners are waiting for prices to drop before increasing their spending any further. That seems reasonable, although it means the limited partners are locking up their money for years without the benefit of actually investing in anything.

Should that dry powder ever be deployed, however, it could have a meaningful impact on purchase prices, and therefore future returns. These days, debt covers about half of the purchase price of the typical buyout, so $534 billion in dry powder for buyouts implies a little more than $1 trillion in total spending power. That is a meaningful proportion of the total enterprise value of global small-cap stocks.

The most reasonable best-case scenario for LPs is that a new downturn hits soon, quickly presenting general partners an opportunity to ramp up their spending without pushing purchase prices even higher than they are today. Whether this is the likeliest scenario is a different question.

Related links:
Getting private equity returns without the fees? — FT Alphaville

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Matthew C Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist. I have worked at the world’s largest hedge fund and read every FOMC transcript since May, 1987