Cracks in the PE Bubble Beginning to Show?

In a previous thread, there was a lot of speculation around PE being the next high finance sector to follow the growing trend of squeezed margins and lower frequency of transactions.

An FT article from February 2017 mentioned how analysis from Bain showed that buyout groups' share of deals has fallen to its lowest point since 2009 (can't post links since I'm a new user).

"The research found that just 4.2 per cent of deals ended up with private equity buyers in 2016, down from 5.4 per cent in 2014. PE’s share of deals peaked in 2006 at 7.9 per cent.
Recent examples of private equity groups being outbid by corporations include the purchase of Yahoo by Verizon after several buyout groups bid for the California internet search company.
Likewise, the share of total mergers and acquisition activity by value involving buyout group purchasers has fallen from 9.1 per cent in 2014 to 8 per cent in 2016, Bain found in research released ahead of SuperReturn in Berlin, private equity’s main annual gathering.
Buyout groups are continuing to be priced out in 2017. Consumer groups Weetabix and Continental Foods are each up for sale, and people briefed on both processes say they are largely being fought over by corporate buyers."

What are your thoughts on this? The beginning of a long-term trend or just a temporary drought?

 

Well, your article also mentions that recent PE funds are significantly oversubscribed. I would imagine that fundraising success (or failure) is a better metric for the health of the PE world, as it is a direct reflection of how institutional LPs (who are putting their money where their mouth is) view PE from an investment allocation perspective.

 

Good point. If PE firms are oversubscribed by LP's, would you say that this implies a healthier PE environment as opposed to the negative points described in the article?

There has been a lot of discussion around private capital advisory and capital distribution from banks recently. I guess this could mean a lot more liquid for alternative investment managers to utilise?

 

I don't think the article is actually that negative. All it says is that big corporate buyers are winning out on some blockbuster deals and that corporate buyers are becoming a relatively larger part of the buyer universe. None of that is actually negative for PE per se, because that metric is not really a good barometer for the health of the PE world.

" If PE firms are oversubscribed by LP's, would you say that this implies a healthier PE environment as opposed to the negative points described in the article?"

Close not but not exactly IMO - I would argue it suggests that LPs perceive the PE environment to be healthier, at least relative to other options. Whether LPs are correct or not, I don't know, but they're the ones putting real dollars to work.

 

The lower percentage of PE deals is simply due to high valuations in the market, which favors corporate buyers that can pay a premium for strategic value or synergies. I don't think anyone expects that this environment to persist - we should be due for a recession in the next couple years. More dry powder might end up being a good thing as more PE capital can be deployed during a recession when there are lower valuations. A lot of 2008-2010 vintage funds had fantastic returns for that reason.

 
Best Response

It's a good question, but if corporate buyers could always beat out PE firms on price regardless of the environment, then PE as a business model would be significantly less successful. In reality, a recession would generally mean (though there may be some exceptions):

  1. The stock prices of corporates would be lower, so they would be less able to raise as much new financing to directly or indirectly pay for acquisitions
  2. Corporates would have less excess cash because profits would be lower. And if their capital structures are optimized to higher profit levels, then they would need to spend a relatively higher percent of their cash flow on interest for outstanding debt
  3. Corporations may be more risk averse to spending money on acquisitions in an uncertain environment, and may rather focus internally to improve/maintain operations whereas a PE firm would be more able to take advantage and find good opportunities
  4. A PE firm's opportunity set of potential deals increases just by virtue of lower purchase prices, making it easier to hit a minimum IRR requirement (assuming the company you invest in can perform reasonably well during/after the recession)
 

I personally agree with you conclusion (that PE is at the top of a bubble, even if just a local one), but the reasons you, and this article, offer in support are totally wrong. I'll explain my reasoning on both points (not just because I'm a dick, but also the info might be valuable to you/others).

Why the reasons you offered don't support your conclusion: 1) All else equal, a strategic buyer should always win in an auction, due to the strategic benefits/synergies (think other posters have already said this). 2) Beyond that, as someone who invests as an LP, it is NEVER a good thing if your manager is winning every auction (if they really have proprietary deal flow, it's a little different, but that's not what's was said by you/the article). If we were willing to pay whatever the 2nd highest bidder did + 5% on every PE deals in a the market / a sector, I could do it myself and have the added benefit of telling the girls at NYC bars that I work in private equity.

The reasons I agree with you conclusion: 1) Private deals have become insanely expensive relative to historical ratios. 2) Lots of allocators want PE for non-economic (in the long term anyway) reasons, such as their ability to smooth returns, which has provided PE guys a lot of dry powder (which will almost certainly lead to lower returns). 3) Unlike hedge funds, where you can pivot pretty easily in a changing market, PE firms (even the great ones) essentially just deliver levered equity returns (albeit in a very pretty, well marketed package). Said another way, if, like me, you think the risks of a general downturn in equity markets have increased over the last 18 months, this is one of the worst places you could put your money.

Life's is a tale told by an idiot, full of sound and fury, signifying nothing.
 

agreed. Just to add one point to those who point to the increased fundraising/allocation as a signal of LP's confidence in the sector's health - institutional investors are behind every asset bubble.

One other thing - if you assume an increasing rates environment then the increased cost to service debt combined with lower profits would offset the impact from reduced valuations.

 

One of the guys in the PE division of our firm said that leverage is actually back to 2007 levels. This may not be true at all firms but in general debt is much more accessible than 1-2 years ago. If you look at the history of PE, the use of leverage and structure of deals always change with the times, and PE may take on a different form in the future than now. But it definitely won't go away.

 

I agree that it won't go completely away but with relatively no growth domestically, would you agree that the PE industry might thrive elsewhere?

PE needs capital and I just cant foresee it when the US is in the shape it is in.

 

There isn't less capital. There isn't enough lending. As far as opportunities, wouldn't a bad economy create more situations for PE firms to take advantage of since they generally hold for a long period?

I think the biggest potential threat to PE (and even VC and to some extent HF) is regulation. Regulators are still trying to asses the systemic risk caused by PE firms. They may not pose direct risks as commercial banks, but holding hundreds of billions levered is causing the increased oversight. Whether this may manifest into actions by the government is anyones guess.

 

This is like the ideal situation for PE. Cheap ass credit but looming inflation. You can lever yourself to death and buy hard assets. As long as you're not a moron buying consumer goods or healthcare companies or other shit facing headwinds, you'll do very well.

If I were a PE firm, I would borrow hand over fist right now and buy energy/natural resource assets.

If you're in it just for the money (which I assume most of you guys are), you should be aiming to go work for somoene like First Reserve or Riverstone, rather than Bain or KKR.

 

Leverage is extremely available right now in the middle market. We're all shocked in my shop at just how many groups are okay with lending to mediocre companies.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

I read the WSJ article among many others, but I'm surprised at some of the comments. I feel the only real opportunity in PE especially mid markets are value plays. Seems a bit one dimensional and continuing to dry.

I'm wondering whats next after everything is bought up ... Will there be opportunity for the new up and coming 10-15 years from now...

 
carbon:
I read the WSJ article among many others, but I'm surprised at some of the comments. I feel the only real opportunity in PE especially mid markets are value plays. Seems a bit one dimensional and continuing to dry.

I'm wondering whats next after everything is bought up ... Will there be opportunity for the new up and coming 10-15 years from now...

Do you even work in finance? You sound naive.

1) markets are extremely hot (but who knows for how long) 2) sponsors can sell to sponsors (different sponsors view industries and companies in different ways, thus sponsors play in different parts of the growth of companies) 3) PE does not rely on pure financial engineering.

 

guys it's simple question of where is your return coming from. If you're a growth equity buyout firm (summit, general atlantic and many others), you will use significantly less leverage than KKR, because 1. growth needs capex, hence no fcf to pay debt remains, or if it does it will be very little, hence less debt capacity and 2. your return will come mostly from ebitda growth. It doesn't take a genius to figure out that you can still make money with 0 debt, if your ebitda grows 50%/year. Mature companies on the other hand grow less, have plenty of predictable fcf=high debt capacity, hence you generate returns through a combination of leverage and modest growth.

 

Yes, I work in MM M&A. I'll PM you the name of 1 PE firm that operates with little to no leverage as an example.

Actually, in the last few years, it was relatively common for PE firms to buy out companies themselves, then refinance after the closing by having a competitive process between lenders. Today, that's not really necessary as leverage is readily available again, as are favorable terms. I wasn't speaking to that before, though, I was referring to firms that will operate with little leverage throughout the entire investment.

 

PE is a cyclical industry. it comes and it goes.

Right now is a pretty good time for business. Not necessarily a good time for buying stuff on the cheap, but a good time for deal shops to complete deals. Tons of deals are coming to market right now because valuations are up for sellers and debt is cheap for buyers.

 

Who the fuck would want to buy Yahoo? That garbage can fire can't even manage to do a useable job with search let alone any of the other bullshit they do.

Follow the shit your fellow monkeys say @shitWSOsays Life is hard, it's even harder when you're stupid - John Wayne
 

they are basically just leveraging against the S&P. If interest rates shoot up and the stock market hits some trouble they will have a hard time finding new deals and liquidating their current holdings.

 
Sabrine:

Have provided the perfect storm for PE. Such a storm doesn't always happen.

...

Basically, it's all driven by cost of capital. Everything else you've heard is bullshit.

Well put.

@"ratul" All industries are cyclical. As an industry they deliver excellent returns.

 

um, that doesn't make any sense - it seems to be about cash flow and leverage - if you can't maintain a decent cash flow in a downturn, the economic model for a buyout collapses - doesn't it? I can't wait until "h07 to find out what actually happens.

 

and the weasels go pop. Seriously, with PE firms trying to IPO, things seem rather bubblicious.

There are always undervalued gems to be found out there, you just need to find them.

For example, Cerberus could swing for the fences with the Chrysler deal, if they restructure to better target current auto-buyer needs. Compared to the buy price years ago, this was a surprisingly cheap deal.

 
researchmonkeyboy:

and the weasels go pop. Seriously, with PE firms trying to IPO, things seem rather bubblicious.

There are always undervalued gems to be found out there, you just need to find them.

For example, Cerberus could swing for the fences with the Chrysler deal, if they restructure to better target current auto-buyer needs. Compared to the buy price years ago, this was a surprisingly cheap deal.

Good calls.

"'In summary, people are morons and who cares. Make a shit ton of money. I've never seen a Ferrari paid for by what people think.' - ANT" -rufiolove
 

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