Time to spend wisely

Written by: Amy Carroll Posted: 16/12/2019

Private equity illoWith record levels of dry powder pushing valuations sky-high, can alternative asset managers avoid repeating the mistakes of the past?

There are few who now doubt we are teetering on the brink of an economic downturn after one of the longest bull runs in history. Indeed, just under two thirds of limited partners (LPs) in market intelligence firm Preqin’s Investor Outlook: Alternative Assets H1 2019 think we have reached the peak of the market.

Deal volumes finally surpassed 2007 highs last year, according to McKinsey. And while fundraising has eased slightly over the past 18 months, in historical terms we remain in rarefied air. 

Dry powder, meanwhile, hit an incredible $2.4trn by the half-way mark this year. Unsurprisingly, this mountain of unspent capital, combined with a top-of-the-cycle ‘use it or lose it’ mentality, means valuations have hit superlative levels. Average private equity entry multiples across Europe and the US topped 11 times Ebitda over the past 12 months, exceeding the previous pre-crisis record.

“If you consider the level of capital raised across alternative investment funds in the past two to three years, the amount of undeployed capital chasing opportunities has never been higher,” says Mike Byrne, Partner at PwC in Jersey. “There has been no equivalent increase in the supply of quality assets to satisfy this investor demand, however, so there’s no doubt that there is significant competition for deals.”

“An awful lot of capital has been thrown at the alternatives industry in the years since the global financial crisis,” adds Nick Stevens, a Partner and private equity specialist at KPMG in the Channel Islands. “Investors love private equity, they love infrastructure and real estate, because of the solid returns they have delivered. 

“But there is now so much money washing around, which managers have to somehow deploy. They are entering into bidding wars with each other and in some cases paying over the odds.”

Investor exuberance

The reality is that, in a protracted low interest rate environment, the returns promised by alternatives have proved too great a lure for institutional investors, even as they recognise that their own enthusiasm for the asset classes is creating a bubble. 

“The continuation of low interest rates is still pushing inexperienced investors towards higher risk areas,” says Tony Gardner-Hillman, proprietor of Gardner Hillman, which specialises in resolving asset-related problems in the funds industry. “The urgency to deploy all of this dry powder means there is still a likelihood that assets are being bought at prices history will show to have been inflated.”

PJ Thibault, Head of Private Equity at CBRE, meanwhile, believes that investors are naïve to think that these asset classes can deliver on their promises without dramatically escalating risk. 

“I think the biggest fault lies with institutional investors expecting to achieve 15% to 20% IRRs [internal rates of return] in a zero to negative risk-free interest rate environment,” he says. “The reality is they are having to take ever increasing amounts of risk.”

In the real estate world, for example, investors are now taking planning risk and letting risk in addition to development risk. 

“But in a five-year fund, time is your enemy. If planning is appealed, or a downturn means you suddenly have an empty building in the city, that can really hurt,” Thibault explains. 

Private equity illo2And it isn’t just the weight of equity in the market that’s troubling. While the alternative asset classes have a rich tradition of finding opportunity in adversity, the sheer volume of debt in the system is also cause for concern. 

Global leverage loan issuance surpassed pre-crisis levels for the first time in 2017, with somewhere in the region of $1.6trn of loans currently outstanding, according to S&P Global Market Intelligence. Fitch, meanwhile, puts the leveraged loan default rate at the peak of the last recession at 10.5%. The numbers alone show the potential for fallout.

Add in unprecedented borrower-friendly terms, driven by the proliferation of private debt funds – 85% of global leverage loan issuance in 2018 was covenant-light, compared with 26% in the run-up to the financial crisis – and the situation becomes more worrying still. It appears that the early warning system has been disabled. 

Lessons learnt

But it is not all doom and gloom. There are reasons to believe that the alternative asset classes are now better positioned to weather a change in economic fortunes than they were a little over a decade ago. 

While the level of dry powder has continued to rise, private markets are now double the size they were in 2007, average deal sizes are smaller, deals are less levered and the mega clubs associated with the worst excesses and implosions are no more. 

Institutional investors – many of which were newcomers to the alternatives space prior to the financial crisis – have now developed pacing plans that should give them greater staying power this time around. 

The secondaries sector has also matured exponentially, creating sophisticated options for both LPs and managers, which should prevent fund valuations from plummeting. 

General partners, meanwhile, have learnt some lessons as well. Most now have a more nuanced approach towards portfolio construction and vintage risk. And while avoiding competitive auction situations is all but impossible in today’s highly intermediated market, managers are taking a more thorough approach to pre-deal analysis. 

“Conducting a full suite of due diligence is really important. Rather than just focusing on the financial information and market diligence, private equity funds are now looking in depth at the political environment and the technology in the business. They are going the extra mile to make sure their diligence on the deal is watertight,” says Marcus Archer, Partner at Clearwater International. 

Managers have also significantly evolved their strategies for identifying and delivering on value creation. True sector specialisation – as opposed to mere marketing spiel – has become increasingly common, enabling funds to speak the same language as management teams and to gain a competitive edge. And most firms have ramped up their operational resources dramatically.

“In the years running up to the financial crisis, private equity investors could make money for their investors relatively easily by buying at 8x profit and selling at 10x profit, with leverage multiples increasing along the way,” Archer says. 

“A number of private equity managers came out of that thinking that financial engineering was the route to stellar returns, but had forgotten that private equity’s core skill is adding real value to businesses they back and making good businesses great.”

We now see alternative managers with rosters of operating partners, dedicated digital expertise, international networks focused on growing an asset’s global footprint, and specialist teams focused on talent management. 

“Operational improvement is the name of the game,” says KPMG’s Stevens. “Managers recognise that their job is to generate value by actually improving the way that a business works.”

An opportunity?

There is little doubt the market has become perilously heated and that managers are struggling to maintain investment discipline under the sheer weight of dry powder in the system. But, at the same time, those managers are also working hard to play a transformative role in the assets they back. 

As central banks ease monetary policy still further in expectation of tough times ahead, the quest for yield will only intensify, making alternative assets more popular than ever. 

If both LPs and GPs heed the lessons of the global financial crisis and hold their nerve, there is every chance they will reap the rewards of a market correction.

“Alternative assets actually performed very well during the crisis for those that stayed the course,” says Stevens. “On balance, an end to this protracted bull run, and a softening of pricing, could prove a good thing.” 

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