Monday, June 23, 2014

Private Equity Fund Raising: Embarrassment of Riches or Just an Embarrassment?

Ralph’s Post dealt with over capitalized corporate who may misuse their excess capital by making ill advised acquisitions. The same problem exists for private equity firms. Federal Reserve actions created favorable capital market conditions. Private equity capitalized on this development by unloading portfolio investments at attractive prices over the last few years. They returned the cash to their limited partner investors. The result was a reduction in assets under management (AUM) for the general partners. Since their fees depend on AUM general partners began planning on raising new funds. Limited partners saw their investment allocation to the private equity asset class fall post receipt of the distributions and were anxious to reestablish their prior investment allocation by investing in new private equity funds.

The result of these considerations was a strong rebound in private equity fund raising. According to Prequin, 1Q14 private equity fund raising totaled $95B a post crisis high. The pre crisis record was for 1Q08 was $173B so there is still quite a way to go. This follows the usual cycle reflected below:

The amount of private equity dry powder, commitments yet to be invested, has risen from around $940B YE12 to over $1.1T, which represents years of transaction volume. The normal investment period for most funds is around 5 years. Most funds use the traditional 2 and 20 compensation model. General partners receive an annual 2% fee on limited partner commitments for the first 5 years and a 20% carried interest on any realized investment profits. If they invest the commitments then their annual falls to around 1%.They must invest, however, the commitments within 5 years, or the commitments expire and they lose the commitment fee. This “use it or lose it” feature puts extreme pressure to deploy the funds within the investment period.

The problem is the same favorable capital market conditions allowing the funds to liquidate their investments at a profit have caused a raise in purchase price multiples for new investments. Purchase price multiples in terms of EBITDA have increased to over 12X from 8X a few years ago. This complicates the reinvestment process. In fact, the increase and amount of dry powder is inflating pricing multiples throughout the M&A market. The only way to make these deals work at that pricing level, especially when competing against strategic buyers, is for private equity buyers to increase leverage. As previously discussed in Fantasy Finance this option is becoming limited as leverage levels are approaching pre crisis highs of 6X EBITDA.

Just as we saw in the previous cycle, private equity is also searching for new, lower quality, deal sources to offset increasing pressure from strategic buyers. These include the following:

1)    Public-to-Private (P2P): these involve taking a public firm private. They usually involve larger targets. Their purchase prices are higher (priced to perfection?) given the usual competitive bidding requirement for public firms. They fueled the large growth in pre crisis LBO volume. They are also higher risk as illustrated by the two major problems of the last boom- First Data and TXU. As Steven Kaplan has noted, P2P deals are debt market driven-so we can expect a return of these deals.
2)    Sponsor-to Sponsor (S2S or pass the parcel): this is the incestuous practice of private equity buying/trading each others’ portfolio investments. The “juice” has most likely been squeezed out by the first buyer.
3)   Minority Interest Investments: this raises the issue of who is in charge when something goes wrong i.e. governance problems.
I am afraid the agency problem associated with excess cash and capital affects both corporate strategic acquirers and Private Equity.


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