Few would have predicted 10 years ago the meteoric rise of private equity. In 2017, US private equity firms raised $621 billion, the most in a decade. However, this ‘wave of liquidity’ has led to concerns that heightened competition for deals is driving up valuations and exerting downward pressure on returns. Given the asset class’s relatively illiquid nature – and factoring in rising interest rates, macroeconomic concerns and the threat of a global trade war – it is therefore reasonable to ask: is private equity worth the risk?
End of the golden age?
This first thing to say is commentators have been predicting the decline of private equity for the last 25 years or more. And yet, despite a few bumps along the way, the industry has thrived. The current ‘golden age’ of private equity is due to a number of factors. For private equity firms (GPs), low levels of interest rates have made it easier to borrow at lower costs to buyout deals or refinance old deals on better terms. At the same time, fundraising levels have soared as yield-hungry investors – both institutional and retail – have turned to more unconventional sections of the market in search of better returns. And private equity has certainly delivered on that front. According to a study by the Association of Investment Companies, the median annualised return for the past 10 years from private equity was 8.6% (net of fees), outperforming public equity (6.1%), fixed income (5.3%) and total return strategies (5.3%).
But, as we are often told, past performance is not a guide to future returns. So, can private equity continue to deliver this stellar outperformance?
Paying a premium
As we highlighted, private equity fundraising is at its highest in 10 years. This, however, has left global GPs holding around $1.7 trillion of unallocated capital (or ‘dry powder’). With more money at their disposal, managers are under increasing pressure to deploy that capital, leading many to pay a premium to secure their targets. According to consultancy firm Preqin, private equity managers were paying up to 11/12X average EBITDA in 2017, while leveraged deals were 6X EBITDA. These are the highest multiples since the peak in 2007. Elevated prices will naturally affect the returns investors can expect.
However, these prices tend to be focused in the upper end of the market, where many large GPs deploy their capital. By contrast, there is much stronger return potential from buying at lesser entry multiples at the lower mid-market. Here, leverage is typically capped below 5X EBITDA and companies have strong debt-to-equity ratios. It also means debt is less of a driver of valuation in this segment.
Additionally, the supply/demand dynamics of companies-to-GPs in the mid-market space is less competitive. According to the Boston Consulting Group, only 17% of midsized US companies ($500 million to $1 billion in annual revenue) are owned by private equity firms. Were US GPs to spend all their ‘dry powder’ ($628 billion at the end of 2017), this would see this increase to only 27%. This means there are numerous attractive companies that can still be acquired for sensible prices.
There are also numerous early-stage opportunities in the tech space. While the so-called ‘unicorns’ – $1billion-plus start-ups such as Air BnB, Uber, Pintrest – continue to garner much of the attention, there are also many early-stage opportunities in Big Data, A.I., automation and the cloud. While not traditionally the realm of GPs, many are tapping into this market through strategic partners, who can nurture growth ahead of a profitable exit further down the line.
Further, GPs are increasingly looking at new and expanding markets. This includes China, where private market returns better reflect the nation’s strong GDP growth than their public market counterparts. Sectors such as consumer, healthcare and services – which all benefit from China’s growing consumption – are rich in private market opportunities. The reduction in China’s capital controls and the opening of its markets are also positive for private equity exits, both in terms of offshore-to-onshore capital inflows, as well as international exits to Chinese purchasers.
So, while valuations are undoubtedly elevated at the upper end of the market, there are still plenty of opportunities elsewhere that should enable GPs to continue to deliver superior returns.
Watch out for bears
Of course, one cannot ignore the current macroeconomic climate and the headwinds markets are facing. For one thing, major central banks have started to unwind QE and raise interest rates. This includes the Federal Reserve (Fed), which has hiked rates four times over the last year, with four more expected in 2019. However, some have argued that the Fed was too slow to start tightening and will have to hike more aggressively should inflation rise rapidly. The US government’s $1trillion tax cut at a time when the economy is at its strongest in 40 years could certainly manifest itself in rising prices, necessitating the Fed to act.
As for the wider economy, higher rates and inflation fears could also push up costs for consumers and businesses, curtailing spending and business investment. Then there is President Trump and his trade war. The tetchy rhetoric is now translating into real world tariffs, which is hurting business around the world. Geopolitics also remain a factor, notably around the oil price, which is sensitive to any new confabulation. It is these factors that could ultimately lead to a US recession in the next few years.
Bumpy times ahead
As for markets, we are now in the ninth year of bull-market run and the S&P 500 is up 300% since early 2009. However, with central banks tightening policy, this liquidity-fuelled run might not have much further to go. The likelihood of a market reversal increases as we move into 2019, especially given the unpredictable nature of the factors at play.
This would obviously have implications for GPs. Indeed, elevated interest rates could make it potentially difficult for highly leveraged firms to meet their obligations. However, any downtown will also create opportunities for GPs, who can use their huge stockpiles of dormant capital to buy companies at discounted prices. So, perversely, a market slump may prove a boon for many private equity firms.
In the interim, markets are therefore likely to be volatile for the remainder of 2018. This will no doubt impact valuations and the performance of private-equity-backed companies. That said, private equity funds have traditionally performed well in volatile markets because managers focus on long-term value and are able to look through short-term noise and market disruption. In particular, sector-focused funds have also grown in popularity during volatile times, with GPs able to capitalise on favourable trends amid wider macroeconomic concerns.
What are the risks for retail investors?
With large minimum investment thresholds, private equity funds are usually too expensive for the average retail investor. However, investors can access the market through investment trusts. These tend to be ‘fund of funds’ (FoFs), whereby mangers invest in private equity funds (for a management fee) and reap the benefits of the manager’s investment decisions. These FoFs suffered during the financial crisis, but have rebounded strongly, beating the MSCI World index by 560 basis points over the past 20 years. One of the major risks of such investment is that they are long-term in nature – typically 8-10 years – which means retail investors must be prepared to lock their cash away for an extended period of time before making any meaningful returns.
So, while risks exist, there are reasons to believe that private equity will continue to stand the test of time. As we have shown, elevated valuations will no doubt weigh on returns, but there are opportunities in the lower mid-market, tech space, growth capital and geographies like China that will allow GPs to continue to create value. Rising interest rates and the threat of recession also remain to the fore, while the former will no doubt pose challenges for overly leveraged GPs. However, any market downturn will also create opportunities, notably for those that have chosen to keep their powder dry.
Column by Graham McDonald, Global Head of Private Equity, Aberdeen Standard Investments