Monday, August 11, 2014

Texas Pacific Group: The Curse of Too Much Money

Private Equity is mature, large, global multi-trillion dollar industry with over 5000 firms. It is subject to booms and busts - experiencing 4 such cycles since the appearance of the modern industry in the 1980s. The last cycle ended with financial crisis in 2008. Activity, investments, exits and fund raising, dried up, and the industry became a shadow of its former self. The post crisis Fed induced a liquidity flood that rescued the industry by inflating the prices of some, but not all, portfolio firms. Sponsors capitalized on this development to liquidate their holdings at a profit. They returned the realized gains to Limited Partners, and began new fund raising efforts. Currently, the industry has over $1.1T in dry powder - committed un-invested capital. As previously discussed this places an incentive (AKA conflict) on sponsors to invest before the investment period ends and the unused commitments expire. This provides the context for the current TPG fund raising effort. It also sets up the introduction of a structural industry change in additional to cyclicality.

TPG is a large private equity firm with over $60B in AUM. It suffered several problem investments in its $19B 2007 fund including among others, TXU, WaMu, and Harrah's. Limited partner returns suffered. They are now seeking to raise a new $10B Fund and are experiencing some difficulties with investors. TPG is seeking to allay investor concerns by stating they identified the problem with the 2007 fund investment and will not repeat the error. They claim the problem was investing in large deals. The new fund’s focus is on smaller middle market investments. TPG is a fine firm and I wish them well. Nonetheless, I think they, and possibly new investors, misunderstand the nature of the problem.

The problem, just like with banking, is one of industry overcapacity with too much capital chasing too few quality deals. Some of TPG’s competitors recognized this problem and diversified into other activities like real estate and debt products. For example, Blackstone's $266B AUM has only about $66B in is PE.

The real issue is an insufficient number of quality deals, not deal size. Middle market deals are unlikely to be any less competitive than other private equity sectors. Also, do you need a $10B fund for smaller middle market deals? What is needed is as follows:

1)     Avoid overpriced deals: my belief is that double digit purchase price multiples (greater 10X trailing EBITDA) are presumptively overpriced. 1H14 PPX are again at the 10X level.
2)     Leverage: overpriced deals require high leverage to achieve nominal return targets which leaves little room for error. 1H14 FD leverage levels are approaching 2007 6X levels.
3)     Deal types: poor quality deal types have returned. This includes sponsor-to-sponsor (e.g. pass the parcel STS) transactions. These involve one sponsor selling to another sponsor. These deals typically experience lower returns as the low hanging fruit has been picked by the original sponsor. STS have dramatically ramped up in 1H14. Another problematic deal type, public to private transactions, have yet to recover.

TPG should recognize the industry shift to overcapacity with reduced return opportunities and adapt. This implies reduced commitments to traditional private equity investments and fund raising and shifting into other areas. Real estate and debt products may already be taken by other competitors like Blackstone, so something else will be needed. Absent this, TPG and its prospective investors may want to scale back.


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