Melvin: Private Equity Firms Struggle to Deploy Capital – Now What?

It is very easy for private equity funds to raise money right now. That is going to be a big problem for the industry and its investors.

Fundraising by private equity funds will set a record in 2019.

As of last month,  PE funds have raised $248 billion of new commitments. There were still two months left in the year. Blackstone (BX) had the most substantial raise at $27 billion for its latest fund that closed in September. Advent International raised a $17.5 billion fund that closed in June. And Brookfield (BAM) just announced the closing of a $9 billion fund.

Private equity has outperformed every other asset class over the past few decades.

Pension funds and other large institutional investors are desperate for returns in a low-interest-rate environment. With that rate trend showing no signs of changing, these funds are turning to private equity. Research firm Prequin estimated in July that 4,000 funds are actively raising money targeting $1 trillion of new capital.

Too Much Fundraising By Private Equity Funds

This trend has quickly turned into a case of too much money chasing too few good deals.

Buyout funds now have $775 billion of Dry Powder to spend and very few opportunities available at attractive prices.

As a result, funds have been paying up for companies and assets, and historically that’s not something that has worked out well. The current Enterprise Value to EBITDA ratio for a buyout deal is now a little over 12. That’s twice the level that Leon Black of Apollo (APO)said his firm was targeting for deals with the potential for a high return on a conference call last year

If you look at the internal rate of returns from funds raised and invested in prior years where multiples had climbed near current levels, the long-term returns are a fraction of those funds that invested during times that lower multiples were available. Looking at the latest data from Cambridge Associates, I see that funds raised in 1997-98 and 2005-2006, when multiples in public and private markets were above average, the average PE fund had returns that were a fraction of the long-term average returns of private equity.

What Will Fund Managers Do?

PE fund managers have a choice to make. They can sit and wait until multiples correct-which would be the right thing to do in most cases- or they can pay up and hope it works out well. Many fund managers are doing exactly that and using additional leverage to juice returns. The credit rating agency Moodys recently expressed concern as private equity-owned companies have issued debt that weaker than those of non-PE owned similar companies.

Moody’s analyst, Julia Chursin, noted in a press release that “PE firms’ focus on shareholder returns and high leverage has translated to a weaker rating distribution for their sponsored companies than for spec-grade debt issuers without such sponsorship. 92% of companies owned by the top 16 PE firms are rated B2 or below, compared with 40% for companies without PE backing.”

All of this adds up to a world where private equity is likely to underperform its historical norm. This could be a horrendous outcome for pension funds who are hoping that private equity returns could offset what is likely to be low returns form the public equity and credit markets over the next decade.

How Will PE Perform In the Future?

If private equity is going to underperform, what can you do to earn higher returns over the next several years?

If you manage a large pension or endowment, I can’t help you.

However, if you are an advisor or individual who manages millions and not billions, there is a solution.

In 2015 two academic papers were released. Erik Stafford of Harvard wrote a paper titled “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting.” He found that buying small-cap stocks at low enterprise multiples and using portfolio margin produced returns equivalent those of private equity funds. Best of all, his approach eliminated the 2 and 20 fee structure that reduces the actual returns received by the investors in the fund.

Dan Rasmussen of Verdad partners and Brian Chingono then at the University of Chicago took a different approach to capture private equity returns. The found that buying small-capitalization companies at low multiples that were leveraged at the company level also replicated private equity returns. The companies in the portfolio had to be paying down the debt and showing improving asset turnover.

The difference was that their returns didn’t match the private equity indexes. However, they were more in line with the historical performance of the very best funds.

I have tested both strategies myself. I’ve discovered that both work very well to capture returns similar to those achieved by private equity funds over the last several decades. Large institutions cannot adopt these approaches, but individuals can capture PE returns without paying PE fees.

By: Tim Melvin

Recent: Hedge Funds Blink; Private Equity Firms Free to Take Control of Inmarsat

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December 6, 2019

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