Will Private Equity Continue With the Amazing Returns?

opaquet's picture
Rank: Baboon | 146

Private Equity has been a solid investment plan for the last few years. There is a huge cash flow going into the private equity industry. There is concern that these returns will diminish as more competition is entering the field.

"Private equity managers, on average, are unlikely to deliver net returns after fees that are better than the global equity market and, as a result, offer no meaningful diversification benefits. But it is still possible to build portfolios of specialised managers and strategies than will deliver outperformance and diversification," says Mr Calnan.

My question to you guys will the huge inflow of investors and competition make alternative investments no longer worth it and why?

Comments (11)

Sep 10, 2017

Think competition will drive prices hirer in auctions and returns lower in PE. The days of easy wins are over.

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Sep 12, 2017

"The days of the easy wins are over"

People have been saying this for 25 years. It has been true for 25 years. The average PE Fund has had mediocre returns in general for the last 20 years. The real question is whether a particular firm has a strategy that can effective in the "new" more competitive environment.

Sep 13, 2017

That's spot on! I think everybody would agree that the plain vanilla LBO market is becoming less inefficient. Almost all deals nowadays involve a competitive auction process led by some M&A advisory where the highest price most likely will make sure you win the deal (some strong counter examples but I am talking about the average deal).

If you have a strategy where you can't differentiate yourself, bad alignment of interests (inside the fund as well as with management teams) and/or your sourcing sucks, then you will have mediocre returns at best (just to name a few factors). For example, I personally very strongly believe that a MM buy-and-build strategy can lead to superior returns. That said, you need to identify the correct sectors/companies to use as a platform, have/hire the correct management team for this and then spent most of your time sourcing proprietary add-ons. These are a lot of factors to get right and only a few funds are capable of getting them right repeatedly. The same is true for P2P transactions. Great returns IF you are aware of the deal dynamics, can execute swiftly (sometimes outside of your control) and can actually drive the value of the firm(s) in the future.

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Sep 13, 2017
Best Response
Sep 14, 2017

I think rather than answer yes or no to your question, it makes more sense to examine some of the structural peculiarities that have emerged in the past decade, and what this means for Private Equity.

In my mind, the situation today is the product of mainly four forces which are acting in tandem: (1) The post-crisis regulation of traditional lending institutions, (2) prolonged periods of low interest rates as part of QE, (3) institutonal investors, and (4) the tech economy.

Let's start with (2). As I'm sure you know, the world has been more awash in capital than ever before in the past decade due to the cheapness of credit, thanks to QE. In my view, this has resulted in a few things:

  • Investors who, in other times, would maintain a more even-handed composition of stocks and bonds in their portfolio are chasing returns by being more heavily invested in the equities markets. This is saturating the markets for public equities, pushing valuations to all-time highs. With rate increases looming, investors are ironically less inclined to swing back to bonds despite equity markets being so highly valued.
  • I would argue that as the proverbial lifeboats fill up in the public markets, hedge funds and other actors that make money in those public markets will see their profitability suffer. This has been happening, and while inflows have increased, the industry is consolidating. Between PE and HF, PE is seen as the better bet nowadays, and I think it has something to do with how crowded the playing field is for HFs.

Moving on - let's examine (4). Unlike previous market eras, there is something remarkable happening currently to tech. The advent of AI, but more significantly, the revolution that is occurring in the field of data analysis is going to be like a second industrial revolution. Rightly so, investors coming out of their fallout shelters after '08 began to flock to the tech giants we have today, because these companies are actually producing staggeringly profitable new enterprises based upon revolutionary technology. The issue now, in light of my points above on (2), is that tech is a bubble within a bubble - that is to say, not only are investors crowding the equity markets, but they are crowding the equity markets for tech, largely because tech is cannibalizing the other sectors - look at what is happening to grocers, automobile manufacturers, retailers, etc., and the way that these age old forms of business are being co-opted by Amazon et al.

So, we have a lot of retail level investors cramming themselves into one compartment of one part of the economy. Why does this matter for PE?

This brings us to (3). I would argue that institutional investors nowadays, facing overly crowded equity markets, have increasingly turned to PE, and to a lesser degree HF, as these managers have historically been regarded as able to outperform the market with their expertise. PE assets have hit an all-time high this year, with the largest PE fund in history having been raised this past summer. This is exacerbated by the fact that many of these institutional investors are state pension plans, which are beginning to wake up to the reality that they are on the hook for grossly more pension payouts than their returns can sustain. Their response has been to funnel even more resources to the biggest names in PE/HF to try to eke out higher percentages in the face of pressure from the politicians that monitor their quarterly reports.

Before going on, want to note that I think the subject of retirement is a whole issue unto itself. If you want to read more on that, I did a more thorough write-up here.

So, PE and HF have become crowded as well by dint of their being the last refuge for huge players that can't seem to find enough space outside of private markets. I would argue that the huge amount of private capital out there right now, mixed with the general attitude that tech is the only sector worth investing in, has produced increasingly dubious investments from PE. Think of Theranos, Snapchat, and any number of other businesses that run the gamut from unprofitable to fraudulent, yet have at some point (or currently) sustained "unicorn" status of $1bn+ valuations. I would argue that there are several engines out there in the economy right now that are running on borrowed fuel - hemorrhaging money from quarter to quarter, and sustaining themselves with sucessive rounds of equity financing from managers that are desperately trying to find the next source of double digit returns. I cannot help but wonder at what point the managers' investors will need to see profitability. Perhaps it will be when they get greedy. Perhaps it will be when the staggering number of boomers without savings start to retire and need pension checks to cash.

Finally, I want to touch on (1). Since '08, many forms of riskier, middle market lending have been curtailed by the post-crisis regulations forced on the newly minted bank holding companies. The role of commercial banks on the fringes of the credit market has therefore been largely assumed by PE managers engaging in forms of direct lending that I would argue they are not experienced in. These are people whose bread and butter is buying companies, and now they're foraying into the business of writing loans as well. Aside from the fact that this is not their domain of expertise, these entities are also not banks. They are not huge entities with a global presence and a balance sheet to fall back on. They are restricted by fairly complex and rigid agreements with their limited partners. In other words, I don't think they are prepared to weather a downturn in their investments the same way that a bank might be able to.

Getting back to the question at hand - will PE continue to show amazing returns? I'd wager that their returns will still probably outstrip the market. But more interesting to me is the question of what the effects will be in the coming downturn of PE's dramatically larger presence in a weirdly concentrated economy, performing services that are historically out of their wheelhouse.

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Sep 15, 2017

1) More capital and same opportunity set -> lower returns, ceterus paribus. Nobody contest the first part of that so, unless you're gonna try and disprove the law of supply and demand, you need to explain why the 'ceterus paribus' part is wrong. I haven't come up with a compelling one.

2) "are unlikely to deliver net returns after fees that are better than the global equity market and, as a result, offer no meaningful diversification benefits" This shows a basic lack of understanding of portfolio theory, so I'm choosing to believe the article's author is an idiot and misunderstood Calnan, or Calnan is intentionally being misleading for competitive reasons (the alternative belief, that you can become an MD at Tower Watson and misunderstand basic tenets of investing, would just depress me).

3) Alternative investments - which, as it happens, doesn't just consist of PE and VC - will always be 'worth it', though the structure of those investments will evolve (as they should) to be more investor friendly.

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Sep 15, 2017

I don't want to argue with you because I don't take issue with your points - but to play devil's advocate, I think there's some reason to suspect that ceteris paribus might actually be an incorrect assumption.

Fact of the matter is that private capital is wading into a gap in the credit markets that they haven't occupied historically. There are a plethora of new funds out there whose investment philosophy has gone beyond buying and developing enterprises, into the realm of funding revolver facilities, issuing mezz debt, direct lending, etc. The acute and exotic ways that private capital is being deployed in today's global economy are fascinating, but also very different from the thesis of "Let me buy this company, grow it, and sell it as a platform/m&a exit, etc."

PE guys are not bankers - remains to be seen what the ramifications of this will be. But as far as ceteris paribus goes, I don't think all else remains the same. Fact of the matter is that the "opportunity set" has grown hugely since the financial crisis because banks have been regulated out of the fringes of the credit markets by Dodd-Frank/Basel, etc.

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Sep 18, 2017

The global financial wave will crest at some point between 2020 and 2024. Between now and 2019, Poland and Russia will join Japan in the ranks of the demographically impoverished. Between 2020 and 2024, thirteen of the world's top twenty-five economies3 will be in the ranks of the financially distressed. The new arrivals will include Canada, Germany, the Netherlands, South Korea, Switzerland, the United Kingdom, and of course the United States. With over 90 percent of the developed world in that unfortunate basket, the availability of capital and credit for all will plummet.
Pair the coming demographic dearth with the end of the free trade era, and the future is as bleak as it is readily visible.
Aging demographies will sharply and suddenly contract credit availability to a level that has not been witnessed since the 1970s--in the best case. Interest and mortgage rates will climb into the teens in the developed world, and higher in the developing world. Consumer activity will plunge, due both to the lower volume of twenty-and thirty-somethings as well as sharply higher credit costs.

The answer is that PE is in its twilight days -- sorry if this isn't palatable for most of you on this website.

Sep 18, 2017

Not only pussy, but insights galore as well.

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Sep 20, 2017