The Changing Landscape of Private Equity: Pros and Cons
Written by Sloan Smith, CAIA, CPWA®
Sloan is a Vice President at Innovest Portfolio Solutions
The private equity investing environment has witnessed major changes in the last dozen years. Valuations, dry powder (i.e. unused capital), and fundraising all have increased to levels not seen since the years leading up to the Global Financial Crisis of 2008. From 2006 to 2007, the private equity asset class invested large amounts of capital at high asset prices, which led to lower returns in subsequent years. Some investors worry that we may be experiencing a similar situation today. However, it is important to take a deeper look at how the current private equity investment environment compares to that of a dozen years ago. An assessment of the advantages and disadvantages of the current environment will help investors to make prudent decisions for their long-term portfolios.
Advantages of the current private equity environment:
1. Less leverage
In 2008, the average U.S. private equity transaction was levered at 7.5x debt-to-earnings before income, taxes, depreciation and amortization (EBITDA).1 In 2018, the average private equity deal was levered at 6.2x Debt-to-EBITDA.2 Also, the ratio of debt to equity is more moderate today than ten years ago. In 2009 the average percentage of equity that private equity managers were committing to their deals reached a low of 30%, meaning they had a lot less skin in the game. Today, private equity firms are investing, on average, close to 50% of equity into their transactions, which is a significant improvement.3
2. Prudent and cautious investment process
Private equity investment activity is running at a significantly lower level than that of 2006 and 2007. Private equity deal volume was close to 40 percent lower in 2017 than its peak in 2007.4 Volume has been mainly from larger funds and their significant deal sizes. However, the greater private equity space has been cautious in a higher valuation environment and has been more thoughtful in identifying opportunities and investing capital.
3. Avoidance of club deals
A club deal is when numerous funds work together to make a large private equity transaction. In 2006 club deals made up more than 50% of private equity purchases that were greater than $1 billion.5 However, during the Global Financial Crisis of 2008, private equity managers were faced with joint control hindering prompt decision making, especially in the board room. The size of these deals also made it difficult to complete the transactions. Though club deals still exist, they recently represented only $50 billion of the aggregate private equity deal value, versus $300 billion in 2007.6 Currently, private equity firms tend to favor institutional limited partners eager to potentially co-invest on deals, or corporations providing some strategic value.
Disadvantages of the current private equity environment:
In 2018 the median private equity EBITDA multiple was 11.1x .7 This multiple is the highest level in the last eleven years (see Chart 1). One reason for these expensive valuations is that private equity strategies value their deals based on valuations in the public markets, which have risen significantly since 2008. Additional reasons for the valuations are low interest rates and the cost of debt. Access to cheap financing has encouraged some private equity firms to make aggressive purchases at higher prices.
2. Dry Powder
Dry powder is the amount of capital that is sitting in cash or similar securities waiting to be invested by private equity managers. Private equity dry powder has grown, on average, about 20% a year since 2012, accumulating to $1.2 trillion as of mid-20188 (see Chart 2). This growth is due to heavy amounts of fundraising and investors becoming increasingly interested in private equity for its return potential.
Growing competition for private deals has been pushing up prices in private equity, particularly in competitive auctions. This trend may tempt private equity strategies to reduce their due diligence criteria in order to invest capital and keep up their pace of calling capital. Private equity firms are not paid large management and incentive fees to sit on the sidelines. Their limited partners expect them to allocate capital and could grow impatient if their committed dollars are not invested.
Over the past 15 years private equity has outperformed the S&P 500 by an average of 400 basis points per year.9 There are mixed reviews of today’s private equity environment and whether investment returns will be as strong in the future. Some investors are not only worried about valuations, but about the flood of capital is waiting to be invested. Others point to reduced deal volume and fewer club deals as positive indicators. It is essential that investors understand the asset class’s current environment when considering its merits for their long-term portfolios.