Is Private Equity a victim of its own success?

Private Equity has been part of the investment landscape since the middle of the 20th century. It consists in investing in non-listed companies or in public ones to then delist them. It is a complex industry that has several unique characteristics: It invests in non-listed companies, is not market-correlated and has performed consistently in the last thirty years; Funds have several participations, which makes them diversified assets; Investments last between 5 to 7 years and investors commit money to a fund that lasts in average 12 years which makes the asset illiquid; Debt is often used in structuring a deal, to increase the profitability and thus, it increases the risk of the investment; There are various counterparts at stake: limited partners (investors), general partners (fund manager), company executives, banks&hellip; While Private Equity has always been a niche in the investment world, it has gained ground significantly in the recent years, in the context of low interest rates and cheap debt. Indeed, it has managed to seduce new investors to put money in these alternative assets by consistently providing them with double digits returns. But the industry has a limited capacity and this liquidity is as much of an opportunity as a challenge for the professionals, who fight to deliver the historical profitability. An unprecedented amount of capital available On July 26th 2017, Apollo Global Management announced its new fund: Apollo Investment Fund IX, which raised $24.7 billion, making it the largest Private Equity fund ever raised. It tops Blackstone&rsquo;s $21.7 billion fund raised in 2007, before the Subprime crisis. Moreover, it only took seven months for Apollo to raise that amount of money, which shows investors&rsquo; will to invest in the Private Equity asset class as well as the liquidity present in the market. Indeed, Private Equity is currently a very attractive asset class to investors for several reasons: first, the industry has delivered very strong performances in average for the last twenty years, even during the crisis, with a median internal rate of return (IRR) ranging between 28% and 12% (See Figure 1). Second, in the context of low interest rates, this performance is even more attractive to investors in comparison to any other asset class. As investors need a certain return, they will often look to reallocate towards Private Equity to boost their own performance since loans and bonds&rsquo; yields are poor. Third, it is weakly correlated to financial markets as it is a private investment and thus it allows investors to diversify their portfolio. And fourth, in a market in which liquidity is tremendous, the illiquid aspect of Private Equity is not as an obstacle as it was before: investors have cash available to reorganize their portfolio without touching to their PE assets. For these reasons, the amounts raised by PE firms have increased massively since 2011, returning to the pre-crisis heights: in 2016, according to Preqin, $347 billion have been raised by PE firms, making it the third most successful year in Private Equity history. Thus, the capital currently available for investment in the market is very important as more than $300 billion has been raised each year in the last 4 years. Another element can explain the amounts raised in the last years: the megafunds (several billion funds) launched pre-crisis, such as Blackstone $21 billion fund, have now been completely exited and the median returns for the vintage (the year in which the fund was raised) from 2004 to 2006 have been over 8% according to Preqin, which is a robust performance in that context. Therefore, investors are looking to reinvest their Private Equity distributions in the industry, since it has over-performed any other investment (See Figure 2). On top of this capital raised in the last few years, other sources of cash have fuelled the funds&rsquo; capacity to invest. Indeed, an important source of financing for Private Equity deals is the debt. In a paper published in 2013, Axelson, Jenkinson, Str&ouml;mberg and Weisbach, after studying 1157 PE deals, have put forward that the cheaper the debt is, the more used it is in deals. The use of debt mostly depends on the economic context and its price rather than the opportunity itself. The current market conditions for debt users are extremely positive: due to the monetary policies of both the ECB and the Federal Reserve, borrowing money has been historically cheap in the last years as the interest rates of both central banks are very low. According to S&amp;P Capital IQ, the average debt/EBITDA ratio multiple on US LBO transactions in 2015 was 5.6x, while the average EBITDA purchase price for these LBO operations were 10.3x: debt financed in average 54% of the operation. Therefore, cheap debt has had a direct impact on the capacity of funds to finance an operation and on the quantity of money available for PE investments. In the meantime, new ways to put money to work in Private Equity have been developed, known as shadow capital: some funds offer to their investors the opportunity to directly invest or co-invest in the acquisitions. In 2015, shadow capital amounted to $161 billion according to Triago, a Private Equity advisor firm. This source of cash is not included in reports as capital raised by funds but still is a direct source of capital available for investments. A challenging environment As a result, the current liquidity in the Private Equity market is tremendous and the capital raised has increased significantly. Capital raised, debt and shadow capital have been fuelling the dry powder, which is the cash available for investments, committed by investors, which has not been used yet. According to Preqin, the Global PE dry powder amounted to $1,466 billion in 2016 against $952 billion in 2012, an increase of 54%. The dry powder present in the market is a sign that funds are not able to use their full investment capacities: they raise more than they can invest, considering that they also use debt to finance their acquisitions and boost their performance. However, a fund has a limited lifetime (between 10 to 12 years) and investors expect the capital committed to be put to work in that period of time. Thus, in order to satisfy their investors and to be able to raise future funds, GPs need to invest in a certain period of time and they are under pressure to realise deals. Therefore, investing in the current market is complicated because competition between funds is tougher than ever. According to a Preqin survey in late 2016, 42% of the survey respondents consider that competition has increased compared to 2015. The funds face a necessity to invest capital committed but all funds in the market have cash. On the other hand, Private Equity backed deals have remained stable in the last four years (See Figure 3). Big funds have set up specific teams to enter new industries and enhance the investment capabilities but the vast majority of GPs still fight for the same targets. Profitability called into question Already in 2009, Kaplan and Str&ouml;mberg had published a paper pinpointing that there is a positive correlation between performance of the industry and the amount invested in it: the better it performs, the more investors will put money in Private Equity. However, they have also put forward a negative correlation between the amount of money invested in PE and the performance of the industry: the more money is invested in PE, the worse the industry performs. Axelson, Jenkinson, Str&ouml;mberg and Weisbach, still in their paper of 2013, have also found out that the more debt is used, the worse the fund will perform. The competition between funds has triggered inflation in deals pricing. Because of the cash available and cheap debt that can boost the performance of a deal (reducing the capital invested thus maximizing the IRR), GPs are willing to pay an expensive price for assets, in comparison to what was done before in the industry. According to S&amp;P Capital IQ, the average EBITDA multiple of an LBO deal in the US was 10.3x in 2015 against 8.8x in 2013, an increase of 17%. Private Equity is a cyclic industry in which a vintage, and the price paid at that time, has a big impact on the performance of fund itself. Indeed, there are three ways to create value for a deal: deleveraging, increase the operating profit (EBITDA) and sell to a higher EBITDA multiple than what was bought. Since the current pricing is very high in comparison to historical data, it is very likely that the deals realised in the last two years will undergo a downside during their exit on their EBITDA multiple. The deals might need to create even more operating value (increase EBITDA) and improve their capital structure (reduce debt) in order to be profitable for the funds. Even with a company performing well, the performance of the funds will still depend on the economic context when they exit their participations. So this massive amount of capital puts pressure on pricing in the market and the question is whether the industry will be able to deal with this amount of cash. Megafunds and lasting changes? Indeed, the situation calls into question the way Private Equity has been working in the last decades, as the industry needs to evolve in order to deal with the incoming capital. Several changes can be witnessed already in the market. First, as we have seen above, a decrease of the industry&rsquo;s profitability is likely to happen in the next years. The question here is whether this decrease is just part of a Private Equity cycle or if it is something that will be lasting. Looking at the numbers, especially historical PE IRR produced by Preqin, we can see that the median IRR has been pretty stable in the last years. As a result, it is too early to have a definite view about the industry&rsquo;s future. The second evolution is the fact that the gap between large caps funds and the other PE actors is increasing on several aspects. First of all, the large caps are getting bigger and bigger (See Figure 4). The new Apollo fund is another example that bigger funds are the one taking advantage of the liquidity in the market. The power balance between these GPs and their LPs has changed with the fund managers being the ones choosing their LPs. They manage to raise money extremely fast (seven months for Apollo). Moreover, they manage to impose their terms when raising the money: in 2016, Advent dropped the preferred return rate (hurdle rate) for its investors for its new $13 billion flagship. This means that the fund does not have to reach a certain performance in order to get its carried interest working. It only took Advent seven months to raise such a fund and it has been oversubscribed up to $20 billion by investors. Last, GPs can propose direct investment opportunities to LPs, putting shadow capital to work, and this increase their power over their investors. On the other hand, raising a new fund for small &amp; mid-caps GPs is still hard and the terms have not significantly changed for them with the standard being 2% management fees and 8% hurdle rate. Likewise, the pricing spread between large caps and small &amp; mid-caps is increasing as pinpointed by Pitchbook: while the average Enterprise Value/EBITDA for mid-cap ($25-250M) deals was 7x in Q2 2013 and 9 for large caps (more than $250M), it was 6x and 11x in Q2 2015 and is expected to be even large in 2016. Lastly, large caps have more means to develop specific teams in certain areas (healthcare for instance), and they are able to diversify their portfolio. Small &amp; mid-caps have limited resources and therefore cannot internalize a specific savoir-faire in order to broaden their intervention scope and increase their numbers of potential targets. Future will tell whether Private Equity has managed to deal with this significant capital increase without suffering in its performances or if the industry has a limited capacity and is still not mature enough to deal with new money. However, one thing is sure: the current situation is an interesting test for the industry and it could be a crucial moment in Private Equity history.

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