July 09, 2014
Driven by the strong bull market in stocks and facilitated by low interest rates, private equity firms have been heeding the advice of Apollo Global Management head Leon Black to sell everything that isn’t nailed down. It was slow going for PE exits in 2009-2012 and many funds were stuck holding mature investments in their portfolios far longer than their preferred three to five years. But exit activity finally picked up in the second quarter of 2013 as PE firms that needed to divest portfolio companies took advantage of a rising stock market to sell these companies and return capital to investors.
Exits from private equity investments continued at a good clip in the first half of 2014. According to PitchBook data, private equity funds exited $91 billion of capital worldwide in the second quarter of 2014, $44 billion in the US alone. A large number of exits were via initial public offerings (IPOs) that returned portfolio companies acquired by private equity funds to the public markets. The 60 IPOs of PE-owned portfolio companies in the U.S. in the second quarter of 2014 was the highest number since the fourth quarter of 2006. And there is no sign that IPO activity is slowing down. Private Equity Law 360 (behind a paywall) reports that the initial public offering pipeline is ‘jam-packed.’ The result is that limited partners in PE funds – including the public and private pension funds that are the largest investors in private equity – can expect to continue to see large payouts.
High prices are great for older PE funds that have portfolio companies they want to sell, but they make it difficult for newly launched funds to find companies to buy. As a result, PE funds are sitting on a record-high overhang of ‘dry powder’ – capital committed by investors that PE funds have not yet invested – estimated to be between $1.1 and $1.2 trillion. Despite this, however, private equity firms continue to launch new funds. They want to recruit investors now, while pension funds and other investors are flush with cash from recent sales of portfolio companies. For investors, however, this may not be the best time to invest in private equity.
As we discussed in detail in an earlier post, judging private equity returns requires that the money received as PE funds cash out of portfolio investments be compared to investments in the stock market using the public market equivalent. Yes, PE investments are returning lots of cash to investors, but the stock market has been on a tear, and many PE funds are not beating investments in index funds that track the market.
Fund raising is cyclical and easiest for private equity firms when the stock market is booming. Dan Primack in his July 1 post in Term Sheet reminds the private market that “the current funding environment is a moment in time….” It’s not just fund raising that is cyclical, however. Academic studies (see here, here, and especially here) have shown that private equity returns are also highly cyclical. Funds launched at or near stock market peaks tend to perform poorly. Those launched in the current environment are unlikely to achieve returns in subsequent years that beat the market and justify the added risk and illiquidity.
With private equity exits at post-crisis highs, PE firms are eager to encourage investors to plough their money back into newly launched PE funds, despite the fact that the industry can’t find attractive investment opportunities for more than a trillion dollars that it has already raised. And investors – whose understanding of financial markets may not be as sophisticated as is usually assumed – seem willing to oblige.