PE Outlook over the next decade
Wanted to see if anyone can weigh in on the future of PE over the next decade or so
I've identified a couple of headwinds and tailwinds and was curious if anyone could piece them together to provide more clarity about where PE as an industry is headed
Dry Powder: Record amount of money needing to be deployed could increase competition for potential targets but could also drive up the value of existing portcos leading to hire returns based on multiple expansion
Improving Operational Efficiencies: Seems like it's getting much more difficult for sponsors to create value by improving companies, and there was a Bain report suggesting that multiple expansion rather than operational expansion is contributing to returns more so than ever. Obviously safer to improve operations to generate returns rather than relying on multiple expansion which is subject to sentiment. It seems like this is happening because lots of portcos have already been passed around by multiple sponsors, making it more difficult to squeeze out efficiencies.
Poor Stock Market Outlook: It doesn't seem like stocks are recovering anytime soon, and pundits have stated that we're headed into a potential "lost decade" on public markets. I imagine this would increase interest in private markets which are inherently less volatile. Ie. PE returns during the gfc vastly outperformed public markets. However, the circumstances are different: the gfc was relatively isolated and fed policy created more opportunities for PE, but virtually all investors suffer from higher interest rates
Higher Interest Rates: Given the amount of HY debt needed, I imagine that returns are extremely sensitive to interest rates. A lot of the tech buyouts we're seeing are obv going to be undoable, but will there be enough of an appetite for HY debt to support the deployment of more dry powder, or will sponsors need to put up more cash?
Regulation: Read something about more government scrutiny over megadeal buyouts and seems like gensler's pushing for more transparency over performance in the private market. I've heard a lot of sponsors can sort of cook their books to make their IRRs look better than their cash returns because of subjectivity in portfolio valuations. Will increased transparency impact the way pensions and institutions view the "benefits" of PE as an asset class?
Public Perception: It seems almost inevitable that a lot of the underperforming funds will be exposed and potentially fail given interest rate pressures. I have to imagine it's a matter of time until we start seeing a couple PE funds implode (re: archegos, melvin), and since PE funds are primarily investing pension money, wouldn't this cause extreme public outrage given the optics of PE execs paying themselves millions while burning through retirement money that teachers and firefighters have saved? But then again, is this a legitimate concern since the PE investors are fairly sophisticated?
Compensation Outlook: Will it become more difficult for funds to meet their hurdles, or will they be able to adjust their hurdle on account of the underperforming broader market? Is there a risk that carry won't materialize?
Any opinions/commentary from people with insights/experience in the industry greatly appreciated!
Intern in IB - Cov, sorry there are no responses yet. Maybe one of these topics can point you in the right direction:
More suggestions...
You're welcome.
Bump
Although PE firms “technically” outperformed public equities during the financial crisis, it is incorrect to expect interest in the private markets to ramp up during a falling publicly market.
The whole reason PE “outperformed” in 2007-10 was because of self-cooked return smoothing where funds valued their own assets. This creates an incredible upward bias that will always leave PE’s portco’s looking more insulated to the public markets — when in reality private markets are actually much riskier than public markets.
This means the private markets should have a beta greater than 1 and during a volatile public market period, you can expect private firms to be even more volatile in reality.
David Swenson of Yale Endowment wrote “Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to-marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86 percent annual return. The risk-adjusted marketable security result exceeded the buyout result of 36 percent per year by an astounding 50 percentage points per year.”
The heightened amount of dry powder is likely to cause a bubble in the future where prices deviate from true value. We have seen this with funds holding longer on to portco’s than they expect (holding for 10 years instead of 7 because nobody is interested in buying at your 20x EV/EBITDA multiple)
Jeff Hooke has a great video on YouTube about this
Great analysis! Out of curiosity, has the impact of the “bubble” created from excess dry powder materialized? Doesn’t more money chasing a finite amount of assets mean multiples will continue to expand until there’s not enough dry powder to sustain the growth? So is your view that PE can hold up in the short run but will experience more issues in the long run exiting investments later?
Precisely.
More dry powder makes it harder to invest all of it into positive NPV deals. Harder to gain a 20% return on $5 bn of capital than $250 million.
We will likely see returns go down in the future as interest rates rise. PE firms will not be make the same returns as they have in the past due to higher borrowing costs and limited number of undervalued firms
"Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to-marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86 percent annual return. The risk-adjusted marketable security result exceeded the buyout result of 36 percent per year by an astounding 50 percentage points per year."
Buying companies with debt of 6x EBITDA at the company balance sheet level is really not the same as investing in a 6x leveraged S&P 500 tracker...
Right, the S&P 500 will smoke PE on risk-adjusted and leverage-adjusted basis lol
Depends... LMM will have some pressure. Lot of recent deals had a ton of leverage on them given low interest rates. Obviously rate increases are are going to drive down valuations.
MM/MF will be fine.
This seems slightly counterintuitive. From what I've been taught, larger buyouts tend to generate smaller returns (because firms are willing to accept smaller returns if it means being able to deploy larger amounts of capital. Additionally, wouldn't it stand to reason that a $1B+ company is already substantially more efficient than a ~$100mm company, so it would be harder to generate returns from operational efficiencies for the $1B+ company? Is there some mechanism or principle involving debt that makes MM/MF more resilient that I'm missing?
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