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The End of the Private Equity Era?

The End of the Private Equity Era?
– Why the ongoing regime change will also affect PE returns

A winter for private equity would be hugely disruptive to those businesses and for the workers, families and customers who rely on them

Nir Kaissar

What this research paper is about

The numbers are staggering.  According to Preqin, in 1980, there were 28 private equity (PE) funds worldwide, and those funds did one of three things – leveraged buyouts, growth equity or venture capital (VC).  Today, almost 40 years later, there are more than 9,200 PE funds worldwide, managing almost $7Tn across a myriad of different strategies (Exhibit 1).

Exhibit 1: Private equity assets under management worldwide
Note: Assets for 2021 through September.
Sources: Bloomberg, Preqin

Most regulators prohibit retail investors from investing in PE; however, amongst institutional investors, the asset class is immensely popular, and it is not difficult to understand why that is.  According to Cambridge Associates, the annualised return over the past 25 years (through 2021) has been no less than 14.3%.  In other words, PE has outperformed pretty much every other asset class on the planet.

In this paper, I will take a closer look at PE; why the golden days may be over (for now), and what the implications of that are, but let’s begin by defining “golden days”.  It is no coincidence that PE has performed so well over the last quarter of a century.  Two of the most important drivers of PE returns – interest rates and equity valuations – have both worked in favour, the latter going up and the former down, and that combination has created near ideal conditions for the asset class.  Quite simply, you could not have asked for a more favourable backdrop.

As a result of those conditions, PE funds have been able to buy companies at attractive multiples, finance those purchases cheaply, refinance them even more cheaply, only to sell them eventually at higher multiples.  It doesn’t get much more attractive than that.  Therefore, one shouldn’t be surprised how well PE has performed.  In Exhibit 2 below, you can see how much PE has outperformed listed equities which, themselves, have performed very robustly over the last few decades.  The big question now, with multiples on the decline and interest rates on the rise, how is PE likely to perform going forward?

Exhibit 2: Growth of $1, 2000-21
Source: Kaiser Privatbank AG

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Why the golden days may be over

With almost 10,000 PE funds in operation today, it has become a very crowded marketplace, and the first cracks have started to appear.  Start-up valuations are now lower than they were only a few months ago, and funding new deals has become trickier.  Over the last few decades, with the industry growing so rapidly, it hasn’t been too difficult to find a buyer and, with P/E multiples going up, nor has it been very challenging for the new owner to make a respectable return on investment.  That may be about to change, though.

Many of the companies coming to the last leg in existing PE portfolios will have been acquired sometime between 2017 and 2019, when multiples were higher, and there was macroeconomic stability.  As a result, distributions to investors will likely come under pressure.  The transaction activity in PE funds will also slow as a consequence, and all of this translates into lower IRRs for 2017-19 vintages.

As you can see in Exhibit 3 below, since 2019, companies held by PE funds that have been IPO’ed have been able to achieve very attractive valuations – in fact much higher valuations  than those companies which have been sold through one of the other channels.  There is one overriding reason for that – a high allocation to tech companies in recent years.  The strong investor appetite for tech has more often than not made it possible for PE funds to significantly mark up their  investments vis-à-vis the cost price.

Exhibit 3: Median EV/EBITDA multiple by deal type
Note: Data through September 2021.
Sources: Moonfare, Pitchbook

More recently, exits via public listings have probably contributed the most to the outstanding performance of PE; however, over the last 25 years as a whole, low,  and continuously falling, interest rates have probably been the most important driver of returns. “Cheap debt is a red rag to private-equity bulls” as the Economist noted in a recent article.  About 50% of the average buyout is debt-financed.  As interest rates have risen in response to rising inflation, buyout debt has become more expensive.  Therefore, unless interest rates begin to fall again relatively soon, it won’t be long before higher interest rates will begin to affect the buyout market, if it hasn’t already started.  

If both IPO and corporate M&A activity are slowing down to a trickle (as they are), selling the companies in a PE portfolio to another PE fund is the only option left on the table.  And, as you saw in Exhibit 3 above, selling to other PE funds (aka sponsor acquisitions) don’t achieve the same valuations, as public listings typically do.  Therefore, fewer public listings will most likely lead to lower IRRs on your PE portfolio.

Why has interest in PE not started to cool off yet?

With a crowded marketplace, rising interest rates, falling multiples and fewer exit options in place, you would expect the public’s interest in PE to be cooling off, but it hasn’t happened yet.  Why not?

Unlike publicly traded companies, private companies are not marked to market every day, i.e. their valuation don’t fluctuate with the whims of the stock market.  I have (qua my job) invested in PE for many years and have found that (i) falling multiples only affect PE valuations with 1-2 quarters’ delay and (ii), even then, PE valuations are steadier than valuations of publicly listed companies.  At least, they have been so in the past.

As far as the second point is concerned, allow me to make a footnote.  As you can see in Exhibit 4 below, over the last 25 years or so, PE distributions have recovered quite well, and quite quickly, from recessionary periods. I can’t prove this, but I suspect that PE investors look at charts like this and conclude that PE is more recession-proof than listed equities.  That may or may not be true, but one shouldn’t ignore the fact that the distribution pattern in Exhibit 4 is from a period of falling interest rates and rising equity valuations.

Exhibit 4: Private equity distributions as a % of NAV
Sources: Moonfare, Preqin

As we have only entered a bear market in public equities over the last few months, PE valuations have not really been affected yet, i.e. investors may not yet suspect that, perhaps, the businesses held in their PE portfolio may not be worth quite what the investment managers claim they are worth.  Should valuations in public equity markets improve over the next few months, this may never become an issue but, if not, I would expect investor demand to cool off somewhat.

Don’t drop PE from your portfolio but …

On the basis of the conclusions I have reached so far, you may be tempted to think I am advocating a complete exit from PE, but that isn’t the case.  The picture is more complex than that.  First and foremost, my overall conclusion: Going forward, PE returns may not be in the mid-teens, as we have grown accustomed to over the past 25 years or so, but they will most likely still be quite attractive when compared to the returns you are likely to earn on listed equities going forward.  Why is that?

Over the last 120 years, annual returns on listed equities have averaged 5-6%.  However, since the early 1980s, when the great bull market in bonds and equities took off, equity returns have annualised nearly 11%.  Going forward, we expect a very different environment for risk assets.  As per our models, until total wealth-to-GDP has reverted to its long-term mean value, listed equities will deliver annual returns of 0-5% at best.  This estimate is predicated on US wealth-to-GDP being dramatically out-of-line but European and Asian wealth-to-GDP less so.

By comparison, we expect PE to deliver annual returns of 7-10%.  A mix of operational enhancements and financial engineering will see to that.  I should also point out that, although not immune to adverse economic conditions, there can be no doubt that PE’s long investment horizons make the asset class better placed to weather the occasional shock than listed equities.  As mentioned earlier, as a PE investor, you can choose between buyout, growth equity and VC funds.  Having said that, there is effectively a fourth strategy too, but more about that in a moment.  Allow me to begin with buyout funds.

These types of PE funds have had a phenomenal run over the last 25 years, and there can be no doubt that the combination of declining interest rates and rising equity valuations have contributed quite considerably to those outstanding returns.  It is therefore tempting to write this strategy off as yesterday’s story, but it is not quite that simple.

If my analysis is correct, over the next few years, buyout funds will undoubtedly find it hard to repeat the outstanding performance of the last 25 years, but less will also do, particularly if PE continues to perform better than listed equities, as I expect.  That said, I would advise not to go all guns blazing until we can see how well they adapt to the new environment.  On the other hand, unlike growth equity and VC, there is a value component in most buyout transactions.  As value tends to outperform growth in adverse economic conditions, I would still dip my toes in the water at current levels.

Growth equity funds are often very long tech and typically do best when the economy fires on all cylinders.  This is not exactly the sort of macroeconomic environment I see in front of us and therefore suggest some (near-term) caution on this strategy – at least until the global economy is out of the woods again.

VC next, and I have an admission to make.  I have never made a decent return on any of the VC investments I have made.  Consequently, I have (half-heartedly) prohibited myself from touching this strategy.  By saying that, I am not suggesting all VC opportunities are bad.  Not at all, but I have learned that, to make respectable returns in the VC space, you need to be a specialist in the field you invest in, whether you invest in fusion energy, bakery chains or otherwise.

Now to strategy #4 – the somewhat overlooked PE strategy.  Every now and then, a secondary investment opportunity in PE is brought to the market.  Sometimes it is the PE manager who wants to sell the tail end of an existing PE fund and, sometimes, it is a PE investor who, for whatever reason, wants (or needs) to sell.  There may be many reasons why that is, but that is not my point.  Rather, I would argue that the overall volume of secondary PE transactions, and hence the opportunity set arising from those sales, is growing quite rapidly at the moment.

One recent example is the chaotic political conditions in the UK over the last month or two, which has forced many UK pension funds to sell risk assets to meet collateral requirements for their hedging programmes.  I have heard from a reliable source that, over the last few weeks, UK pension funds have sold risk assets worth well over £100Bn to raise the capital (collateral) required to support existing hedging programmes.  

Buyers can, as a result, make some very attractive acquisitions from time to time.  Therefore, in reality, there are not three but four underlying PE strategies to consider and, of those four, #4 is my undisputed favourite at the moment.  If I expect buyout funds to generate 7-10% returns annually over the next few years, I expect secondary PE investments to deliver more than that – probably returns in the low teens when measured annually.  This is predicated on the fact that the market for secondary PE funds is very much a buyer’s market at the moment.

Risks to be aware of

In my book, two of the biggest risks associated with PE investing are (i) forced selling, i.e. a PE manager being forced to sell a holding (for whatever reason) at a highly inopportune time, and (ii) re-financing risk, i.e. a PE manager not being able to re-finance existing deals at an attractive price or, even worse, not being able to re-finance them at all.  That said, unless the macro environment deteriorates substantially from current levels, I wouldn’t assign a particularly high probability to either of those two risks.

A point often raised by critics of the buyout model is the damage it does to corporate balance sheets.  Allow me to share a quote from the blogger, Matt Stoller:  “Why would American corporations systematically borrow more than they can service? The answer is that those who control [a growing number of] corporations are increasingly using them not as businesses that produce things, but as limited liability vessels useful mostly for transferring money from lenders to private equity firms. Note the timing of the upturn in this chart [Exhibit 5], which is right around when club deals became popular and the new LBO boom started.”

Stoller’s point is that buyout funds are turning more and more US companies into zombie firms, i.e. firms with an interest coverage ratio less than one.  The chart below supports Stoller’s argument.

Exhibit 5: Share of “zombie” firms in the US
Note: The share of listed firms that are more than ten years old with an interest coverage ratio less than one for three consecutive years.  
Source: Matt Stoller, Deutsche Bank Research

Overall conclusion

Going back to the question I raised earlier –  why has interest in PE not cooled off yet? – a couple of weeks ago, I came across the chart below (Exhibit 6).  As you can see, today, new PE funds do not spend more time fund raising (before the fund is closed) than they have done in recent years.  However, Exhibit 6 only includes the largest PE funds which all have a strong preference for large, institutional investors, and they continue to allocate to PE.

Exhibit 6: Time spent before closing new PE funds
Source: Numis Investment Companies Datasheet

Pension funds probably less so, but foundations and endowments continue to allocate billions of dollars to PE, and they have a preference for large, well-diversified PE funds like KKR, Blackstone, Carlyle, Apollo, Artes and TPG, i.e. the sorts of PE funds that Exhibit 6 is based on.  If you were to include smaller PE funds and all types of investors, a very different picture from the one in the chart above would probably emerge.  As a consequence, the only conclusion I can reach is that investor interest for certain types of PE funds aimed at certain types of investors has not cooled off yet.

Total transaction volumes are down this year when compared to 2021,  and I expect volumes to continue to shrink next year.  Having said that, the industry won’t roll over and die.  2021 was an outlier with PE transaction volumes reaching unheard of levels.  If you instead compare activities in 2022 year-to-date to pre-COVID levels, volumes this year haven’t been materially different.

Going forward, you will have to adjust your return expectations, though.  Mid-teens annual returns are highly unlikely in the sort of environment we are entering.  Having said that, if you can settle for less, PE will most likely continue to make solid contributions to your overall returns.  In that context, it is worth noting that the PE industry as a whole sits on massive amounts of dry powder.  Therefore, many mega funds (which have most of the dry powder) and late stage funds (which need to put their capital to work before it is too late) will still happily pay a meaningful premium, and that will benefit smaller PE funds.

Niels C. Jensen.

7 November 2022

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.