Institutional investors and private equity: Cracks in the ice?

Is now a dangerous time to be a global private equity investor? Record levels of dry powder, sky-high EBITDA multiples paid for companies, credit still available on relatively easy terms, longer holding periods, and slower deployment of capital. While LPs appear increasingly keen to put money into the asset class, one wonders if it will end up in the right place, particularly for larger buyout strategies.

“As an LP I think my job is to try and get out of that flow as quickly as possible because it looks very top-of-the-cycle behavior. We are trying to find ways to differentiate ourselves, to be around the edges and find different things to do that are out of that flow as much as possible. We ask ourselves, ‘Are we doing that just because it’s top-of-the-cycle and that is typical top-of-the-cycle behavior?’” Steve Byrom, head of private equity at Australia’s Future Fund, told the recent AVCJ Australia & New Zealand Forum.

Given the number and variety of LPs actively seeking to ramp up their PE exposure, it is likely that a significant proportion do not have the internal resources or mandate to be differentiated. The danger is they flock into similar kinds of strategies – typically the ones that can accommodate large checks – and end up with sub-optimal returns.

“At the top of the market we are seeing more and more competition. It is harder for GPs to get deals done, but there is more money coming their way, so more dry powder is accumulating,” Michael Weaver, manager for private markets at Sunsuper, told the same forum. “US pension funds are doing what is right for them, but it is making it more challenging, particularly at the top end of the market for those sorts of deals to get the returns we would expect private equity to generate over time.”

The findings of Bain & Company’s 2016 Global Private Equity Report underline this perspective. Global buyout activity was down on 2015 as PE firms encountered more competition from their peers – dry powder reached a record $1.47 trillion, of which $534 billion was earmarked for buyouts – and from corporates. Fueled by cheap debt, acquisition multiples surpassed 10x EBITDA in the US and Europe in early 2016, once again at or close to record highs. Pricing is seen by many GPs as the single biggest challenge facing the industry.

Yet LPs are willing to add even more fuel to the fire. Preqin’s most recent survey found that 89% of LPs plan to commit the same or more capital to private equity over the next year as they have done in recent years, and 94% intend to maintain or increase their allocation in the long term. This is driven by distributions outstripping contributions for six years in a row and a low interest rate environment that makes private equity seem all the more attractive against other asset classes.

This phenomenon may abate as interest rates rise, but it’s hard to say when this will be or what damage might be done in the interim. The Bain report noted there was a surge in fundraising activity for mega buyout vehicles in 2016. “Investors broadly do not cite megafunds as the most attractive type of fund, but such funds hold great appeal to large institutional investors who want to put a massive amount of capital to work in the asset class. And LPs who want to contain the complexity of their holdings see them as a way to limit the number of funds and relationships they need to track and manage,” it added.

It is difficult to generalize about strategies across different geographies as evidenced by LP responses to KKR’s third Asian fund, which with an $8.5 billion institutional hard cap is likely to be significantly larger than its predecessor: some dismiss a vehicle of that size out of hand; others express caution, but are encouraged by previous performance and like the idea of pan-regional exposure; and still more want exposure to Asian growth in a big way and see no other way to get it.

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• Topics
• Buyout
• Buyouts
• Fundraising
• GPs
• LPs
• Performance
• USA
• Asia
• Europe