Private equity is becoming an increasingly popular asset class. The latest Ernst & Young investor survey shows that private equity is the most likely asset class that institutional investors are going to allocate more capital to.
“And hedge is the least likely,” says EY partner Scott Zimmerman, the firm’s Private Equity Assurance leader, Americas. “So there is a movement from hedge to private equity.”
Private equity investors have to give up liquidity, but they also don’t have to deal with market volatility to the extent that they would if they invested in hedge funds or equities.
Since the recession, more investors are prepared to tie themselves up in the long term and face illiquidity costs in return for less volatility and better performance.
Zimmerman says that during the financial crisis liquidity was restricted even in the hedge world, so investors are now much more prepared to give up liquidity in return for more consistent returns.
But the financial crisis also altered the nature of many private equity firms. The largest firms have moved increasingly into credit and filled a void left by the banks when credit conditions tightened. The move to become shadow banks, or as private equity firms prefer to call them, market-based financiers, means that today private equity covers a continuum from pure private equity to banking.
“That trend at the top level is now cascading down; mid tiers are diversifying their types of investments,” says Zimmerman.
Firms are still going to invest in companies at all stages of their maturity, but they are always looking for long-term investments to match the long-term capital structure that they have. Investors like this different dynamic and its ability to diversify investment portfolios.
Just like the hedge fund market, private equity is becoming more institutionalized. However, even the big firms are now also looking to enter the retail space, as large public companies in the U.S. have to grow so fast that they have to diversify not only their products, but also their investor base. As a result, for instance, ETFs (Exchange-traded funds) with exposure to private equity have become widely available.
Plenty of capital but asset valuations are high
In contrast to hedge funds, private equity firms, especially the better performing ones, have no problem raising capital. An abundance of available capital and high asset valuations means it is an excellent time to be a seller in the current market environment, but finding attractive acquisition targets is proving challenging.
“[The PE firms’] problem is deploying capital as everybody is competing for the same assets,” Zimmerman notes. “Debt is so cheap. If you are doing pure private equity, we see valuations at or above where they were before the financial crisis. I think there is a concern in the market that prices are inflated.”
Recent statistics bear this out, too.
2014 was a record year for both the number and value of buyout-backed exits. More than 1,250 sales last year exceeded the previous peak of 1,219 transactions in 2007. And total exit value, at $456 billion, increased 67 percent, also beating the previous record of $354 billion in 2007, according to data provider Dealogic.
Private equity-backed buyouts, on the other hand, peaked before the financial crisis at $687 billion in 2006 and $673 billion in 2007. At the time, private equity buyers were prepared to pay top dollar for acquisitions with the average deal reaching 9.7 times earnings before interest, taxes, depreciation and amortization (EBITDA) in U.S. and European leveraged buyouts.
When the financial crisis hit the market, the aggregate value of buyout deals dropped to $110 billion in 2009. The market subsequently recovered gradually, but at $332 billion in 2014 it makes up only half of the peak deal value, Prequin data shows.
However, the surge in global liquidity and near-zero interest rates have inflated asset valuations, and both earnings multiples for buyout targets and leverage have returned to the pre-recession levels. Last year the purchase-price multiples for leveraged buyouts in the U.S. and in Europe averaged 9.6 times EBITDA and 10 times EBITDA, respectively, according to S&P Capital IQ.
With vast amounts of unused capital sitting on the sidelines, available cheap debt and asset valuations that might cause buyers to overpay, attractive deals are hard to come by.
Longer holding periods
The median holding period for buyouts exited in 2014 jumped to a record 5.7 years, up from 3.4 years in 2008. Given the underlying target for many acquirers to double the invested capital at internal rates of return of around 15 percent, more than half of private equity assets sold in 2014 had been in portfolios for more than five years, while only 11 percent had been held less than three years.
Before the financial crisis, private equity firms were considered to be very good at financial transactions. After buying into a company, recapitalizing it and making some changes, the company could be sold at a handsome profit after two to four years. “That changed,” says Zimmerman.
During and after the recession, firms had to hold these assets longer and “get in there and really change the operations to improve the metrics that are improving the price.”
Private equity firms more than ever have to focus on value creation, make more adjustments and more investments in their existing portfolios, he adds.
Rather than hope for positive market changes, so-called “beta,” private equity firms have to concentrate on deal sourcing and carry out more due diligence to identify the right targets. While some firms go against the market and focus on assets that are out of favor but may have hidden value, others hope to identify macro trends and corresponding mispricings in the market.
Meanwhile, private equity investors have to protect themselves from the risk that a potential asset bubble might pose.
The competition for deals will remain high as large institutional investors are looking to co-invest or even bypass private equity funds entirely. Canadian pension funds, for instance, have started to set up their own private equity arms.
And co-investments, where investors commit extra capital to a deal through a separate investment vehicle outside of the private equity fund’s structure, are growing and make up about 10 percent of private equity assets under management.
“Co-investments are a big deal,” confirms Zimmerman, as they give investors the opportunity to put more money into deals they like without having to commit to the entire portfolio of a fund.
But he believes it is very difficult for institutional investors to bypass the investment adviser and the manager entirely. “That means changing the model from an investor to an operator. The Canadian pension funds certainly have the wherewithal, but it is not a trend that I can see,” he says.
In Cayman, where Zimmerman led a roundtable with industry professionals, the interest of professional directors in private equity was naturally focused on governance issues.
But while investors have been migrating from hedge funds to private equity, he says, the governance structure and the role of directors that everyone is familiar with in the hedge fund world have not yet taken hold in private equity.