• High valuations mean private equity investors need to be more disciplined than ever
• ‘Dry powder’, or uninvested capital, has grown significantly
• Investors need to scrutinise managers’ strategies, particularly as fund sizes increase
• Investment in secondaries can deliver returns more quickly

Private equity has outperformed the public markets for the past five years, and institutional investors of all kinds have been ramping up allocations. But valuations are high and investors are understandably nervous. With low expected returns in public markets, the question whether this is time to buy or sell private equity holdings should be on every investor’s mind.

“There is no doubt that this is a good time to sell,” says Anthony Tutrone, global head of NB Alternatives, Neuberger Berman’s alternative business. The firm has managed over $50bn (€42bn) of commitments from private equity investors since inception.

“Valuations in private equity deals are at an all-time high,” says Tutrone.  

American private equity adviser Murray Devine reported in August that deal valuations in the US had reached multiples of 13.7 times EBITDA (earnings before interest, tax, depreciation and amortisation), a common private equity valuation metric. This is far higher than the multiples recorded in 2007 when the market had peaked on the eve of the financial crisis.

But the more disconcerting sign, according to the firm, is the relationship between capital raised and the number of deals closed. The aggregate number of deals closed in the US during the first half of the year fell 15% compared with the same period last year. “Deal volume and valuation trend lines have begun to diverge, a tendency that’s typically more common near the end of a market cycle,” said Murray Devine’s report.

At the same time, the amount of capital committed by investors but yet to be deployed, known as ‘dry powder’, is growing. Alternative asset data provider Preqin reported that dry powder had reached the record level of $906bn in May.

The growing size of private equity funds is also a sign that the market is approaching the end of the cycle. According to Preqin, at the end of April the 10 largest private equity funds were targeting a combined $203bn, 32% of the total assets sought by the industry.

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Investors appear to have mixed feelings about the situation. Recent surveys by Preqin show investors’ appetite is increasing and they are maintaining a generally positive perception of the asset class, despite concerns about valuations.

“There are still good investments to be made. It is still a very attractive asset class. Performance of private equity funds has been better than listed equities. That is the case for the average, not just the best funds. One must not forget that prices are high in virtually every asset class,” says Tutrone.

One important point to note about the asset class, according to Tutrone, is that, since the financial crisis, deals have become much more conservative. Investors have put more equity in deals compared with before the crisis. Low interest rates mean balance sheets are stronger, due to higher interest cover. This means deals dating from after the crisis are more resilient to harsher economic conditions.

However, concerns about fund size are valid, says Tutrone. The alarm bell warning investors that a manager may be reaching critical mass is changes in management style or focus. “We dig in very deeply into the funds that are growing a lot in size, and try to determine whether or not they are changing their strategy, which would be a negative for us. We have said no to managers who have become too aggressive and started meandering away from the strategy that gave them the results,” he says.

Dan Aylott, private investment specialist at Cambridge Associates, agrees, and adds that investors should ask managers how the increase in fund size affects fee income and incentives. But investors should still be able to earn returns from the asset class, as long as they increase discipline in due diligence. “Being highly selective, based on thorough due diligence, is key to maximising the potential of achieving returns expected from private equity. Returns have come down over time as the market has become more efficient, but we believe it is still possible to outperform public markets in a meaningful way that makes allocating to the private equity asset class attractive,” says Aylott.

Cambridge advises first-time investors in private equity to consider secondary funds – those that buy assets at a discount from funds that are already active – instead of fund-of-funds. A report published by the firm argues that secondary funds can start generating returns much faster. “A secondary transaction can begin generating distributions as early as day one of the investment, accelerating the cash distributions within a private investment programme, and mitigating the J-curve effects of private investing,” says the report. In this sense, secondaries may be the best option for investors who approach the asset class amid high levels of dry powder.

Experienced private equity investors with existing portfolios may also be wise to consider standalone secondary transactions. The secondaries market has grown significantly since the financial crisis, exceeding the $40bn mark in terms of annual trading flows, according to Maulik Patel, senior broker at Tullett Prebon Alternative Investments, a brokerage firm focused on illiquid assets. At the same time, the way investors use the secondaries market has changed, and the visibility of pricing for funds or assets has improved.

Patel says: “The secondaries market has evolved from one where investors would be selling top-tier funds at a significant discount for liquidity, to one where investors trade for portfolio management and regulatory reasons. More investors today actively trade the market to bolster returns, and top-tier funds are often trading at a premium.”

Pricing for secondaries is as high as it has ever been and there is plenty of capital committed for secondaries, Patel adds. However, general partners can still acquire assets at better prices compared with the primary market, allowing them to meet their return profile.

As Neuberger Berman’s Tutrone points out, trying to exit the private equity market at the right time is unlikely to be a successful strategy. And demand remains strong, despite high valuations. Pension funds that are reducing their private equity allocation are hard to come by.

The ASGA Pensionskasse, a Swiss multi-employer, multi-sector pension fund, is planning to raise its strategic allocation to private equity from the current 2.5% to 4% over the next three years. The CHF14.8bn (€13bn) fund has invested in the asset class since 2003, according to Lars Bollhalder, portfolio manager for alternatives investment. Over the past five years, the fund has increased its allocation to secondaries and co-investments.

Bollhalder recognises that private equity assets are trading at high multiples, but points out that this is the case for virtually every asset class. He says: “Private equity valuations continue to exhibit a persistent discount versus public markets. Private equity vintage years during market peaks, or shortly after, are typically very strong vintage years for private equity. As a pension fund, we are a long-term investor and we do no market timing.”  

Inarcassa, the €10bn Italian first-pillar pension scheme for architects and engineers, is also planning to increase its commitments, mainly to domestic private equity investments. Until two-and-a-half years ago, the scheme focused on global private equity assets. The portfolio consisted of buyout funds investing in small and medium-sized companies located primarily in the US but also Europe and Asia.

The scheme then started investing more heavily in Italy, says Alfredo Granata, Inarcassa’s CIO. “We were confident that the domestic economic environment was improving, and that such improvement would positively affect the valuation of unlisted small and medium enterprises (SMEs). Fiscal incentives created by the government also contributed to the SME sector,” says Granata.

Inarcassa has committed to various initiatives, including Fondo 4R, a fund investing in firms that need financial restructuring. To bolster its private capabilities, the scheme has hired specialists focusing on investment due diligence, as well as fiscal aspects. “One of the most challenging tasks is to make sure our global private equity investments comply with the domestic fiscal framework,” Granata says.

After running a private equity programme for several years, the scheme no longer has fund-of-funds investments, except for a small venture-capital portfolio.

The value of Inarcassa’s real asset portfolio, which includes private equity, private debt and infrastructure, is around €1bn. “The real assets portfolio is one of the main return engines for us at the moment, along with domestic and emerging market equities,” says Granata. For that reason, he adds, the scheme will continue to reinvest proceeds from current positions. This is despite the strong possibility that the lag between commitments and deployment of capital will widen as the cycle reaches its peak.