An Ocean of Capital: Saturation in Private Equity

I'd like to revive this discussion from 2012.....

http://www.wallstreetoasis.com/blog/an-ocean-of-c…

It seems particularly pertinent given the PE recruiting cycle. I've attached some charts from a presentation given by the CIO at a firm in the 75th percentile of the PEI 300. The last two slides are from another source and attempt to critique the "conventional wisdom" tenets as to why LBOs produce solid returns as they apply in the current environment.

The LBO private equity industry has become incredibly saturated. The PEI 300 was the PEI 50 in 2007. The abundance of "dry powder", competition from other investment platforms and new LBO shops has driven up LBO purchase price multiples. Can the returns of the past really be replicated in this new, wildly more competitive (and expensive), environment?

I am at a boutique industrials M&A shop and, while my experience may be anecdotal, we are seeing a significant disconnect between the supply and demand for new opportunities. We regularly get inbound requests from shops all across the PEI 300 spectrum (I'm talking like from the very top) to source new opportunities. While M&A activity in my sector, which has historically seen significant LBO activity, remains relatively high (>90 deals closed in 2016), the LBO share of those deals is extremely low (

Attachment Size
Challenges Facing Private Equity 220.85 KB 220.85 KB
 

In my opinion Private Equity is cyclical like any other area in finance. Prices and LBO volume will ebb and flow just as the equity and M&A markets ebb and flow. Although there is a build up of many PE firms and "dry powder", if these firms are unable to make investments that provide good returns they will be weeded out. In time competition will reduce the number of PE firms and how much dry powder they possess, but a dry powder buildup will happen again in the future because it is just a phase in the cycle of the PE industry. Therefore I believe that PE is still a good industry to work in as long as you are at a strong firm.

 

I agree that many of the firms will be weeded out as they fail to provide competitive returns. However, I believe that there has been a structural change in the space due to the build up of dry powder and the entry of many new shops. Valuations of good private equity targets have been inflated by the dollar value of "dry powder" available. Even if a number of shops fold, that capital will just be redistributed among a smaller number of shops. This will likely put even more pressure on those shops to do deals which will likely reduce the quality of the deals done, eating into the LBO returns.

 

I think the last slide of the deck has a lot of merit. There's a solid argument for the value components of traditional LBO either getting competed away or priced accurately, either way reducing the upside for those doing the buying.

I was talking with the partners at a middle-market PE shop earlier this week, and I think they're indicative of an investor type that is always going to have a competitive edge. A couple elements have to come into play:

--the target is at a growth stage where some strategy & operations formalization is a value-add (which means the PE firm has to have enough sector & operations expertise to achieve that value over and above what another owner could, and I think that's pretty tough for a generalist to accomplish anymore)

--there's a risk disconnect between ownership & future owners, like when it's a closely held business and the owner wants to cash out to protect the value that's been created

--bonus for buying the asset outside of a process, so you capture the value that would have been auctioned away by using a competent banker

--extra bonus for information asymmetry between this investor and others, where some network of contacts gives them insight into a rollup thesis that someone outside the sector wouldn't or couldn't capitalize on

I think this kind of PE setup is always going to exist to some extent, and it'll always be profitable because participation in it is capped by the scarcity of sector and operational execution expertise. But that's a fairly minor segment of the greater world of PE, and I have a hard time believing that a lot of the bigger generalist shops (especially ones that rely on PE-to-PE handoffs) will continue to exist to the extent they do today.

"Son, life is hard. But it's harder if you're stupid." - my dad
 

In the sectors I cover, which are fairly mature spaces

--companies with any real top-line growth are snapped up by strategic buyers who can outbid the PE shops because of synergies

--the universe of closely held businesses is dwindling further and further with LBO shops popping up on every street corner....."is there a point at which all (or a vast majority) of attractive LBO candidates have already been taken out by a shop with "sector & operations expertise?" How many family-owned iron ore mining companies are there left?"

--access to company information has never been easier thanks to the internet, CapIQ, Factset etc....which closely held company hasn't heard from an investment banker pitching the merits of an auction?

--information asymmetry that results in a thesis is definitely an advantage but I would think that bigger LBO shops with the most resources (i.e. networks, data, consultants etc.) have the upper hand there

Maybe I'm underestimating the universe of private, non-sponsor backed companies or I'm looking at this through the limited lens of very mature sectors and it's a different situation for less mature spaces (i.e. enterprise software, IT services). However, I would think the returns in those sectors are less attractive because of the leverage limitations in asset-light industries.

I agree that the bigger generalist shops will not continue to the extent they do today because they will diversify their strategies to fit the mold you described..."an investor type that is always going to have a competitive edge." KKR just announced a $650-800 million healthcare growth equity fund (I know not exactly the same as what you were talking about, but indicative of fund diversification).

What I want to know is......does it really make sense to be chasing PE associate roles when the industry will face significant contraction? Might it be better to stick with banking and really learn the nuances, build a network and find an under served space where you can effectively compete?

 
Best Response

I am in CF at an acquisitive industrial company and I often wonder how PE companies compete. The short answer is that they likely have different targets than we do, but realistically, if it's even close to any of our markets we'll take a look at the company.

When I look at our models and the synergies that a PE company could never achieve (and a decent chance we won't either), our relatively low cost of capital, our industry knowledge, the growth we're chasing, and the multiples we're ultimately willing to pay, it just doesn't make sense to me.

Obviously, if the PE company gets to an owner before we do and seals the deal, there could be tremendous upside (when they sell to us in 4 years). However, I have to assume that this is fairly rare. Any owner who has thought about selling their business will do some homework and try to maximize their returns.

The other thing that makes me laugh is that rarely does a PE or IB have better information than the people operating in the market. We had a BB in here pitching our president a month or so ago on a few ideas. The ideas weren't bad at all, but we are so far ahead of them and what they think is "coming" that their "insight" was useless. We already know that their biggest pitch to us is useless (for reasons you can imagine).

I truly believe that PE and IB are full of very sharp people and have their place, but the future is contraction rather than expansion. Not exactly the same, but I happen to have similar thoughts for consulting. Companies are getting smarter, cheaper and thus, handling more things in-house. It's just getting less likely that we need a BB to advise us on buying a company for 10x or MBB to tell us how to sell to our distribution network.

twitter: @CorpFin_Guy
 

The reality is that returns are being compressed across all asset classes. PE is attracting a lot of dry powder since its still a good way to generate return, and is certainly the case when compared vs low interest rates. Returns in PE are/will be coming down, see below -

GPs have been softening up LPs for a lower-return reality in recent vintages that have operated in a high-priced environment. This is a theme we've heard about for some time and expect to continue through this year, barring a downturn.

The high-priced environment, combined with near-record levels of fundraising, makes LPs and their consultants nervous. Andrea Auerbach, Cambridge Associates' global head of private investment research, said last year she had had some awkward conversations with fundraising GPs touting return targets of 2x or 2.5x and 20 or 25 percent internal rate of return. The median return for all U.S. PE deals in 2014 was estimated at that time at about 10 percent gross, Cambridge found last year.

"We use this to have fairly meaningful discussions with managers we're thinking of working with or performing due diligence on," Auerbach said at the time. "This is the market, not 2x or 2.5x. This was surprising to me. I was ... not happy with managers that keep coming in and telling me what their return target is because I know they're not hitting it."

 

To be fair, a lot of funds have raised or are currently fundraising lower return / longer hold type fund and I think this is the future for the industry, especially the longer term hold due to the large costs / leakage that happens when buying / selling businesses. Deal fees, financing fees, make-whole, etc can run as much as 5% of EV so assuming equal annual performance, you're much better off buying a business and holding for 10 years than buying 2 businesses that you hold for 5 years each.

 

Ehhhh, maybe. Although as an LP I think this is kind of a cop out. A 10 year time horizon is a very long time and exposes you to multiple economic cycles. 10 years is also an eternity for a deal leads/ppl running a company - think about the amount of turnover at PE funds; the chances of the same people doing the deal being there when the company is eventually sold is quite low. The thought of paying full management fees for 10 years is frightening.

10 years also doesn't match up with Fund of Funds, which already have 15-16 year life spans for a 5 year target investment. Are we saying now that if I invest in a fund of funds that I'll be monitoring it for 20 or 25 years? No thanks. I don't think the industry dynamics match up well for 10 year target holds.

Although as a Secondary guy, I kinda like it - there would be a ton of trades in these types of funds...

 

h3dgehog You're right on the money. The private equity secondary market is currently expanding at a massive rate right now. There are firms like W Capital Partners and Coller Capital that trade in PE secondaries that are growing fast. Startups like SharesPost and Equidate are trying to hit different niches in the industry (I think Equidate only does large tech companies).

I was talking to an asset manager who handles only PE secondaries for a $100B+ shop that's $10B in on them right now. He's picking up the low hanging fruit that's getting sold for pennies on the dollar by LPs looking for liquidity 10+ years in from the crap PE firms they invested in. I think that low hanging fruit's only going to increase as well.

 

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