For investors facing unrelentingly low interest rates, private equity has been one of the best performing asset classes in the last six to seven years. According to Bain & Co’s most recent annual report on private equity, on a worldwide basis, private equity fund distributions have exceeded contributions every year since 2011; on average, investors have received $2 back for every $1 paid in since 2013.
After the global financial crisis, a decade of loose monetary policy, in the form of quantitative easing and sustained low interest rates, stopped the world economy from slipping into a second Great Depression. It also had a particular booster effect on the private equity model, which has fuelled the boom.
For LPs, low interest rates created a pressing need for yield, which made them more willing to increase their allocations to alternative asset classes like LBOs, real estate and infrastructure. For GPs, it became easier to engineer buyouts using low-cost debt.
This benevolent environment could easily be unwound by central bankers at long last putting words into action by tightening monetary policy. Refinancing old deals and leveraging new acquisitions will then become more expensive; companies and investments which rely on cheap debt will become less profitable. That said, most economists expect the current relatively easy borrowing conditions to persist a while yet, with interest rates edging upwards only gradually. That should allow finance and industry time and space to adjust.
Dry powder and asset prices
Capital commitments are flowing into the latest generation of funds at record rates. In a recent Preqin investor survey, 63% of investors said that they had a positive perception of private equity; 53% planned to increase their long-term allocation to the asset class. According to Bain, private equity funds’ uncalled capital reached an all-time high of $1.7 trillion at the end of 2017.
This “dry powder”, built up over years, has prompted intense competition in transactions and driven deal prices steadily upwards. Bain reports that LBO acquisition price multiples hit a record high of 11.2x average EBITDA in 2017. This is a good time to be selling assets, but a hard one to find bargains.
And GPs are not only competing against each other when bidding for target companies. Big institutional investors often co-invest alongside their PE funds, or, in a few notable cases, are managing their own direct investments. Cash-rich big companies are major players in the acquisitions market, as they seek to achieve or defend market dominance by consolidating their industries.
A GP needs to call and invest most of the fund’s capital before its investment period expires, so it is under pressure to find deals. The challenge of deployment is most pressing for the biggest funds. The bigger the fund, the more deals that the GP has to originate; or else fewer deals with much bigger ticket sizes. High-priced investments are generally more difficult to exit at a high IRR.
Private equity investment horizons do stretch out several years, so it will be some time before these issues, if they do occur, have a material impact on distributions. And even with the record accumulation of dry powder, the industry is currently managing to deploy capital with reasonable speed – $1.18 trillion worldwide in 2017, up from $1.13 trillion the previous year, according to a recent report by The Boston Consulting Group.
The industry is increasingly dominated by an elite circle of big managers. Of the $453 billion raised by PE funds in 2017, 42% was secured by the largest 20 funds which closed in that year. The aggregate number of funds closed in 2017 fell a bit compared to 2016, even as the number of mega-funds surged. We see this reflected in the average size of a private equity fund, which grew from $384 million in 2016 to $535 million in 2017.
The concentration of cash in the industry has happened in part because many institutional investors, in the past couple of years, are actively setting out to prune and deepen their GP relationships. As a consequence, first time fund managers are finding it tougher to attract capital. The total capital committed to first time funds fell from 9% in 2016 to 6% in 2017, and the number of first time funds reaching final close in the past year was at its lowest since 2009.
The concentration of cash in the biggest funds is thought to be contributing to a funding gap for SMEs, a traditional target for private equity investment. But, at the same time, it opens up marginal deal opportunities for small-cap or specialist managers who do have a successful fundraise.
It would be foolish to think that we can abolish the business cycle, as others have claimed during previous economic booms. But, for the moment, notwithstanding rising headwinds, investor appetite for the private equity asset class remains strong.