Monday, May 11, 2015

Private Equity: Aging Cyclical Business Model?

Private equity is a mature asset class that is enjoying an excellent fund raising cycle. According to Prequin, 1Q15 fund raising topped $104B just $7B shy of a very robust 1Q14. Continued strong equity and IPO markets allowed PE funds to liquidate portfolio holdings at attractive prices and return substantial capital to their limited partner investors. These investors may be chasing yield based on past performance by reinvesting in new funds. For example, they committed $17B to Blacksone's latest fund in just 7 months, among others.

Strong fund raising combined with weak investing prospects have raised the level of PE dry powder to over $1.2T (that is in trillion not billion). PE investments both in number and dollars (excluding the hybrid 3G-Berkshire Hathaway Heinz-Kraft $40B deal) have fallen to their lowest level since the crisis year 0f 2009. PE is being out-bid by strategic acquirers in a buoyant M&A market. Thomson Reuters  reports that domestic M&A is up by over 30% 1Q15 to over $415B-heavily skewed towards larger $5B+ deals. Furthermore average purchase price multiples top 12.5X EBITDA with premiums in excess of 37% in an already frothy stock market.

Remember, PE adds value in one of 4 ways:

1)     Buying Right (i.e. not over paying): this is difficult when strategic acquirers are offering such high premiums.
2)     Financial Engineering (i.e. high leverage): complicated by bank regulator guidance frowning upon FD/EBITDA leverage levels above 6X. Current new deal leverage is stuck at around 6X. The PE math (not risk adjusted) is difficult when you pay 12X and can only leverage lever up 6X.
3)     Multiple Expansion (i.e. sell high): little room for multiple arbitrage (buying cheap in the public market and subsequently selling higher in the M&A takeout market) at current price levels.
4)     Operating Improvements (i.e. grow EBITDA): the easy stuff has already been done; the big payoff requires some special strategic sauce like 3G is doing with Kraft-combining it 3G’s prior Heinz acquisition. This is both difficult and rare for PE.

PE is a mature asset class experiencing a cyclical recovery. GPs will have a difficult time profitably investing. Make no mistake, however, invest it they will (otherwise they forgo substantial fees) leading to some unhappy returns for current LPs. This is just the nature of the pro cyclical boom and bust PE cycle. There is just too much capital to deliver superior risk adjusted performance across the market cycles thru differentiated strategies. The former persistence of superior returns in certain top tier funds has disappeared suggesting just competitive the market has become. LPs should beware of investing at this point of the fund raising cycle.


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