The run-up in the stock market over the last two years has been good to private equity funds. The U.S. stock market has more than doubled from its 2009 lows, and the Dow and S&P 500 were both in record territory on Friday. High valuations commanded by publicly traded companies have enabled private equity firms at last to exit many of the ‘mature’ investments in companies acquired at heady prices in the 2005 -2007 boom years. Apollo CEO Leon Black told participants at a Milken Institute conference in April that the rising stock market has created “a fabulous environment to be selling.” Apollo, he noted, sold about $13 billion in assets since the beginning of 2013. “We’re selling everything that’s not nailed down,” he told the audience.
Private equity investors are flush with cash distributions. Now that money is finally rolling in, many seem blithely unaware that the typical PE fund launched since 2005 has failed to beat the stock market. Investors would have been better off putting their money in an index fund that tracked the market than in these PE funds – and would have had less risk and more liquidity to boot. Yet PE investors are ploughing cash back into new PE funds. According to private equity data research firm PitchBook, 2013 was the best year for private equity fundraising since the financial crisis struck in 2008, and the pace has continued into 2014 (behind a paywall). A survey of private equity investors (pension funds and other limited partners) conducted late last year by Prequin found that 90 percent planned to invest the same amount or more this year than last, and 92 percent planned to maintain or increase their allocation to private equity going forward.
But what will the PE funds do with all the cash commitments they’ve amassed? High prices may be good for PE funds with companies to sell. But high prices make it difficult for funds to buy companies cheaply enough to sell them later at a hefty profit. PE funds face a choice between acquiring companies at premium prices or sitting on hoards of unspent cash – so-called dry powder. They have been going both routes; but whether they sit on the funds or buy companies at inflated prices, investor returns are likely to suffer.
In a confusing, if not confused, analysis of the situation, Dan Primack seeks to reassure investors that the apocalypse is not nigh. Yes, Primack agrees, private equity fund raising has been quite robust. And he concedes Prequin’s point that dry powder at buyout funds is well above its average. But this, he claims, is hardly the problem it has been made out to be. Just forget what you learned in Econ 101. According to Primack, competition among PE firms for desirable companies as demand for good businesses exceeds supply is not driving up prices since PE funds that have been priced out of the market can just hold onto the funds they raised. Of course, sitting on the sidelines letting dry powder pile up rather than paying premium prices is also not a formula for success. Primack doesn’t want his reassurances to be taken to mean that
“returns from the 2014 vintage of private equity funds will outperform. Indeed, history shows that the best ROI comes from funds raised when the overall economy and financial markets are sluggish.”
So, does Primack think the willingness of investors to put scads of money into PE funds is a good thing or not? I’m confused.
Dry powder has certainly been piling up in PE funds. According to Prequin, the total of unspent funds raised globally by various types of private equity funds to acquire businesses, invest in real estate, and engage in a variety of financial activities reached a record $1.073 trillion at the end of 2013 and grew to $1,141 trillion globally by the beginning of June 2014. Private equity funds whose dedicated purpose is to buyout and acquire Main Street companies were sitting on $442 billion in June.
High prices may have translated into fewer deals, but the acquisitions that have been made commanded prices that are very high multiples of earnings (i.e., ebitda). In its 2Q 2014 U.S. PE Breakdown Report (behind a paywall), PitchBook reports that the median company in 2013 was bought at a price that was 10.0 times earnings, up from 8.4 times in 2012, with debt in 2013 that was 6.5 times earnings. These multiples increased further in the first quarter of 2014 to 11.6 and 6.8 times earnings respectively. By comparison, the previous peak in the price multiple occurred in 2008 and was 9.6 times earnings. The debt multiple that year was 5.7 times earnings. The ratio of debt to earnings was 14 percent higher in 2013 than in 2008.
It’s easy to see what is driving up prices. Companies with high profits and good growth prospects are holding out for premium prices. And they can get them (contra Primack) because of the competition among PE funds and between PE funds and strategic buyers for good companies. Low interest rates and easy access to credit make these acquisitions possible, even at such high prices.
How will these deals turn out? Jonathan Zucker, senior vice president and head of capital markets at Intrepid Investment Bankers reflected on this in a recent PitchBook interview:
“While leveraged loan volume and debt multiples have steadily been on the rise since 2010, default rates have remained very low by historical standards. More and more lenders have entered the middle-market space and buyers are taking advantage of the ample supply of capital. Obviously, we know what happened last time ratios where this high…a few years later we saw default rates rise. Hopefully that won’t be the case this time around.”
Many lenders got hurt in the years following the financial crisis. A new report from Moody’s focusing on mega deals found that a group of private-equity backed deals before the crisis in which companies took on more than $10 billion in debt defaulted at an average annual rate of 17.8 percent. This compared with 6.4 percent default rate for a similar group of companies with weak credit not owned by private equity.
The lenders that extend credit to private equity firms and the investors that provide most of the equity capital should be wary of investments made when stock markets are booming and companies available for purchase command rich prices. Publicly- traded and entrepreneur-owned businesses have opportunities in today’s market environment that were not available a few years ago. Lenders and investors in private equity would be wise to consider whether they want to be on the other side of these deals. The situation may not be apocalyptic, but the likely results for private equity investors are not reassuring.