A significant growth in direct lending has helped boost the private equity market
- Valuations are high after a period of strong returns
- Returns for private equity investors look good on a like-for-like basis
- An explosion in direct lending has helped to finance acquisitions
- Fundraising has enjoyed a benign couple of years
The past couple of years have set records for private equity fundraising backed by an explosion in direct lending and what appears to be strong evidence of superior returns to public markets in private equity over long periods. For investors new to the market, though, current pricing and competition in deal sourcing poses challenges.
Last year there was over $1trn (€870bn) of uninvested private equity capital looking for a home, according to Hamilton Lane. The risk is that pricing gets inflated. But, as he adds, that has not just been driven by the amount of dry powder. Stockmarkets, until the correction in the final quarter of 2018, were also at historical highs. There has also been an abundance of debt capital with debt pricing at attractive levels. “It is a perfect storm, as there is a lot of liquidity with a significant amount of private equity capital and significant supply of debt able to be lent, and these two, by definition, will push prices up,” says Nikos Stathopoulos, a partner at private equity firm BC Partners.
For investors in private equity, that means they need to find general partners (GPs) who can not only find value when making acquisitions but also identify ways of adding value post-acquisition.
Comparing private equity returns with public markets has always been a difficult and controversial area, with private equity returns often characterised as being opaque and potentially misleading. Willis Towers Watson (WTW), which advises on both public and private markets, admits to higher returns being seen in private markets which justifies the growth in size of assets.
Hamilton Lane, an alternative investment management firm, claims to have the most comprehensive database of private equity information in the marketplace. Richard Hope, a managing director of the firm, attributes the firm’s access to detailed information to its being a direct investor in a large number of funds. Its comparison of private equity performance with public markets shown is based on an exact like-for-like comparison of cashflows. In most years, an investment in the private equity marketplace, as a whole, would have beaten an investment in the global equity index, while investing in the first and second quartiles of funds would have given substantial outperformance on top. Whether that will continue to be the case is the dilemma for investors.
“It is a perfect storm that will push prices up” Nikos Stathopoulos
The attractive performance, combined with a net distribution of funds for the past seven years, has supported a benign environment for fundraising in both 2017 and 2018, says Toni Vainio, a principal at Pantheon, a private equity firm. Given the success, there have been many new entrants to the marketplace. “We are also seeing GPs looking to capture limited partner demand so large-cap buyout firms may launch small-cap buyout funds,” he says. “In 2019, we expect GPs who have historically been managing a single fund may offer more alternatives to their LPs.”
Acquisitions have also been supported by a strong debt market which has seen an explosion in direct lending to finance acquisitions in the mid-market space, says Gregg Disdale, head of alternative credit at WTW. “Direct lending was a very small market in Europe pre-crisis with banks being the primary debt providers. Post-crisis, with banks reducing balance sheets, direct lending groups have grown dramatically and taken a lot of market share.”
What is also happening in the private debt markets has been a professionalisation and institutionalisation of the market, says Francesco di Valmarana, a partner at Pantheon. This emulates the transformation in infrastructure investment that happened in the mid-2000s. This can be seen in the growth of the secondary markets in private debt: “It was nascent in 2011-12. It grew in 2013 and reached $3.5bn (€3bn) in 2017 and well over $4bn in 2018”. While private debt fund of funds is a relatively low-margin business to be in, Pantheon does see more attractive potential in private debt secondary.
A lot of capital has been going to larger funds and in Europe in particular, many if not all, mega-cap fundraisings have hit their hard-cap limit. With the large amounts of dry powder going to larger funds, many investors including Pantheon see better value in the mid-market and lower mid-market. “Do you want to pay 12 times earnings for a business that’s growing at a double-digit rate or five times for a smaller business in the exact same space?” asks Andrew Brown, head of private equity research at WTW.
There are high valuations and high leverage in the upper end of the market, so while there is a case for including some upper-end funds for diversification, WTW, like Pantheon, tends to favour the mid-market. In terms of the opportunities, 92% of all deals in the past decade have been under $500m, says Brown. In contrast, mega buyout funds are only accessing a small universe with respect to the number of deals, with only 1% of all deals having an enterprise value greater than $1bn.
As Hope at Hamilton Lane also points out, the private equity marketplace has broadened considerably over the past decade into new geographies and more strategies beyond buyouts; new areas include private credit, infrastructure and natural resources.
Where the private equity model claims to be superior to public equities is in the possibility for GPs to add value. BC Partners, for example, is keen to find companies that offer not only market leadership and strong cash generation but also, says Stathopoulos, “where there are a number of levers we can pull to allow the assets to grow so we are not investing in one-trick ponies”.
As Stathopoulos goes on to explain, many GPs focus on having an operations group which helps investee companies in areas such as mergers and acquisitions (M&A), technology, improving cost cutting and salesforce effectiveness. “That has become a key element of PE at the moment. We pride ourselves in exiting a company that is better, stronger and bigger than when we bought it.”
While this approach works well in the mid-market, much of the investment in private equity is going to mega-funds targeting much larger companies. But even here, argues Stathopoulos, the thesis is the same and while the pace of growth of a mega-company is not going to be double-digit, the volatility is smaller. This results in an attractive risk/reward trade-off.
For new investors, the worry is whether there is too much dry powder in the marketplace. Only time will tell, says Vainio. Historical returns may be good but he admits that finding attractive investments currently has been more challenging, with high entry-level pricing and increased competition. Some would argue that when the private markets seek opportunities in the public markets with more public to private transactions happening, it is a sign of the top of the market for private equity. “Not necessarily,” says Vainio. “GPs get more creative when pricing is elevated and public to private is simply another avenue for deal sourcing.”
Private equity investors, however, may feel more comfortable with the idea that their general partners are growing companies to be able to eventually exit by floating on the stock markets, rather than using the listed markets for deal sourcing
Private equity: An expanding universe
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Private equity: An expanding universe