Will money chase deals or will it remain on the sidelines? Both scenarios create problems

The private equity industry has a problem. A big one.

Dry powder, or uninvested cash, at private equity firms, totaled $1.45 trillion at the end of 2019.

That figure is the highest ever, according to industry research firm Preqin. The figure is double what it was five years ago.

Private equity firms have been raising money at a record pace; however, there are fewer options to put that capital to work on attractive terms. The decade-long economic expansion and the equity bull market have driven valuations above 2007 levels. Too much money is now chasing too few deals.

The Private Equity Industry Problem

Private equity returns have exceeded public equity returns for decades. Now, with most institutional money managers expecting lower returns from public markets in the next decade compared to the 2010s, money has poured into private equity industry coffers.

More than $300 billion was committed to private equity funds in 2019 as pensions, endowments, and other large institutions looked for an alternative to traditional stocks and bonds.

Their success at fundraising creates an interesting dilemma for private equity managers. The competition for deals is getting intense as a result of all the cash piling up and deal multiples are getting high.

They are at a point where it will be challenging to show the type of returns that attracted all the cash in the first place. The choice is now put the money to work at unattractive terms and use more leverage to juice returns or leave the cash uncalled until pricing improves.

So far, it seems more leverage has been the choice of most managers. Total debt-to-EBITDA ratios are creeping higher as PE firms pay up to get deals done. We also see lax underwriting requirements in the leveraged lending market that could end badly.

Private equity has been the best performing asset class for several decades now, but when you invest does matter. Returns for funds that opened in 1999 and 2007 are much lower than the historical averages.

Paying too high a multiple and using too much leverage could mean that private equity returns for all the cash raised in 2019 will fall far short of expectations.

By: Tim Melvin

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