November 10, 2014
Have private equity investors begun to experience buyer’s remorse? That’s the question Private Equity International ([email protected] to subscribe to newsletter) poses in its November 7 Friday Letter. Apparently, the answer is yes.
Limited partners have “voiced growing concerns over how GPs plan to make back the high multiples they paid for companies this year,” according to the Friday Letter. And endowments and foundations are increasingly concerned about prospective returns in light of the high current valuations for companies the PE funds are acquiring.
We identified the possibility of low returns for funds launched in the current environment back in May and again in July. In our May report, we noted that:
The cyclical nature of private equity returns does not bode well for pension funds and other investors who are currently piling into private equity funds. … PE buyout funds have lots of cash on hand … and they are competing for a limited number of attractive companies. … [T]his competition among PE funds for desirable acquisitions has led PE funds to pay prices that are close to historic highs. This year U.S. PE funds have paid an average price equivalent to 9.2 times ebitda – close to the 2007 peak of 9.7 times. … Acquiring companies at these high prices will make it difficult to exit these investments at a profit.
We warned of this danger again in July:
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.
The Friday Letter notes that many LPs – notably wealthy individuals who invest via family offices – still believe private equity is an attractive investment. But noting the “frothy pricing environment,” PEI finds it reasonable to question “how current vintages are likely to be faring.” The big exits some investors have realized, in their view, have “more to do with competition than skill.”
Coming as it does from Private Equity International, this is a warning that LPs – especially pension funds, which are entrusted with the retirement savings or working men and women, should heed.