Thoughts on the State of the Private Equity Industry, 2016

It is now the second week of 2016. 2016. It seemed so far away, when I left the industry to begin my MBA at Wharton.

I’ve recently had the pleasure of discussing the state of the private equity industry with a few industry participants whose opinions I respect. These discussions have crystalized a number of thoughts on the state of the private equity industry as we enter 2016.1

Fundraising: It’s Complicated

Based on what Preqin has reported, 2015 was a strong year for private equity, private debt, private real estate, private infrastructure and private natural resources fundraising, with approximately $550 billion in capital commitments raised during this period.2

Yet, based on the discussions I’ve had with people in the industry, the story is somewhat more nuanced than those numbers imply.

Firstly, there are indications that fundraising in certain regions is more constrained than in other regions. Notably, in the Middle East and North Africa, it seems that fundraising can be a significantly more difficult process, with several industry participants noting that for many fund sponsors, the only way to raise funds is to do so on a deal-by-deal basis, as investors are reluctant to commit to blind pool investment funds.

I’ve heard similar skepticism towards blind pool investment funds in other regions of the world, though none as pronounced as what I encountered while in the Middle East recently. Notably, in the United Kingdom, according to the Wall Street Journal, PSP Investments decided to wait to commit capital to Terra Firma Capital Partners’ renewables fund until the fund sponsor had found at least one deal that would be part of that fund. Terra Firma Capital Partners is also investing on a deal-by-deal basis with investors after it failed to raise a new private equity buyout fund, according to Bloomberg.

Secondly, many institutional investors are consolidating their portfolio of fund investments. There are several reasons for this:

Many fund sponsors do not consistently generate alpha. Indeed, the vintage year of a fund can often be the most statistically significant determinant of fund returns for many fund sponsors. It makes sense to allocate more capital to those fund sponsors that consistently generate alpha.
Monitoring and evaluating a large number of fund sponsors is complex and costly. In an era when institutional investors are under pressure to justify the cost of an actively managed portfolio, most are taking steps to reduce the number of fund sponsors to whom they allocate in order to reduce the cost of monitoring their portfolio.
Consolidating the institutional investor’s allocations to a smaller number of fund sponsors will often allow institutional investors to negotiate for rebates or discounts on the management fees payable to the fund sponsor.3
As secondary transactions among private equity fund sponsors become more common,4 institutional investors are finding that they can be invested in funds on both sides of the secondary transaction, i.e. in both the selling fund and the buying fund, and thus have exposure to an underlying portfolio company for a significantly longer period of time. Such insitutional investors may also have reason to question whether any value obtained by the selling fund is being extracted from the buying fund and depressing returns for the buying fund.

This consolidation will undoubtedly benefit the large fund sponsors such as Kohlberg Kravis Roberts & Co. L.P., The Blackstone Group, The Carlyle Group and TPG. These fund sponsors have an enviable track record and the deal flow necessary to continue securing top quality investments. Moreover, they are able to absorbe large capital commitments from institutional investors given the size of their flagship private equity funds.

It will also benefit small specialist fund sponsors that offer access to highly specialized skillsets that cannot be replicated in-house or by the large generalist fund sponsors.5

This consolidation is likely to be detrimental to fund-of-fund sponsors, as institutional investors seek to reduce their costs by eliminating an additional layer of fees from investing in fund-of-funds. We can see this in the statement by CalPERS that its commitments to funds-of-funds has been a drag on its portfolio, with 10 of the 22 fund-of-funds that it has return data for in the red and none with an IRR in the double-digits.6

It is also likely to hurt mid-market generalist fund sponsors that cannot demonstrate a clear competitive edge relative to their peers, and have not consistently delivered above average returns relative to competitors from the same vintage year. These fund sponsors may still be able to survive on allocations from less sophisticated institutional investors that lack the access to top tier fund sponsors but must nevertheless allocate to private equity. It is, however, a precarious existence and not one that I think offers a sustainable long-term business. Mid-market specialists, with a clearly differentiated strategy and demonstrated alpha, will likely see continued interest given that valuations for large buyouts have been rising.

For 2016, a Probitas Partners survey suggests that at least 20% of the 104 institutional investors surveyed are planning to commit more than $1 billion in new capital commitments to private equity funds in 2016. This, of course, is likely to further increase the massive amount of dry powder that must be deployed by fund sponsors, and drive up valuations. Moreover, the distribution of capital commitments is likely to benefit incumbent fund sponsors that have built up relationships with institutional investors, given that the majority of institutional investors are not actively pursuing new fund sponsor relationships.

Valuation: Be Afraid, Be Very Afraid

In 2014, according to Preqin, fund sponsors raised approximately $590 billion for private equity investments. In 2015, fund sponsors raised $550 billion, with more than $256 billion raised in the U.S. alone.

My overall impression, at least in North America, is that the unprecedented low interest rates occasioned by programs such as the U.S. Federal Reserve’s quantitative easing has driven many institutional investors to allocate more capital to private equity and other alternative assets. This has resulted in a buildup of “dry powder” among private equity fund sponsors, who are now under pressure to deploy it before the expiration of their fund’s investment period.

I have noted, in the past, that valuations were a concern of mine in 2014 for Asian private equity. It is a concern of mine generally for most regions of the world now, as funds raised in 2014 and 2015 are pursuing deals before their investment periods end. There is simply too much money chasing too few good deals.

Indeed, some industry reports I have read suggest that transaction valuations were unusually high, with multiples in the range of 13 to 15 times EBITDA for middle market technology companies in 2014, and in the range of 9 to 12 times EBITDA for deals valued at more than $250 million in 2014.

While precise data for 2015 is not yet available, the anecdotal evidence I have heard suggests that transaction valuations have remained at least as high as the valuations in 2014.

In 2016, I do not expect to see transaction valuations come down significantly: there is still too much dry powder chasing too few good deals. Indeed, a recent Preqin report suggest that there is more than $1.32 trillion in dry powder that must be deployed within the next three to four years. I remain pessimistic about returns from 2013, 2014, and 2015 vintage year funds; there is likely to be some measure of multiple compression at exit due to the high multiples being paid at present.

Sovereign Wealth Funds: No more “Big Friendly Giants”?

I have mentioned my concerns with the rise of direct investing arms at several of the more sophisticated sovereign wealth funds before, and I remain convinced that this trend will have a substantial impact on the private equity industry.

Historically, many fund sponsors have viewed sovereign wealth funds and large pension funds as “big friendly giants”, or BFGs for short. The BFGs provided capital through capital commitments to investment funds sponsored by fund sponsors, and were often considered a stable source of funding. They were also an ideal source of co-investment funding for those times when a fund sponsor had a transaction that was too large for its fund and did not wish to form a syndicate with other fund sponsors.

This has started to change. Pension funds such as CPPIB and sovereign wealth funds such as Temasek have built direct investment arms that lead transactions in their own right. These direct investment arms have made some significant investments, notably CPPIB’s acquisition of Antares Capital from GE Capital in a management buyout in 2015, and CPPIB’s acquisition of Wilton Re in a management buyout in 2014. (Indeed, a Middle Eastern institutional investor whom I met with recently has noted that certain pension funds like CPPIB and Ontario Teachers’ Pension Plan are among the most sophisticated and bold institutional investors and often serve as a barometer of where things might go for sovereign wealth funds and pension plans.)

While other sovereign wealth funds and pension funds have not yet begun leading deals in their own right, it stands to reason that as they grow more sophisticated and more confident, they will begin to evaluate the potential benefits of building direct investment arms to handle at least part of their allocation to private equity. These include the reduction in fees and carried interest payable to a fund sponsor, and the flexibility to adopt investment horizons that differ from the typical investment horizon of a private equity fund.

I would expect that for the nonce most sovereign wealth funds will remain BFGs. It will take time for them to develop the confidence and the skillset to successfully make direct investments without an experienced fund sponsor.

Asia: Diversifying Opportunities

I could not leave this blog post without at least touching briefly on Asia. In January 2015, I noted that control deals were likely to become more common as family businesses experienced succession issues and conglomerates divested themselves of non-core assets.

While I do not have statistics for the number of control deals that are being done in Asia, the anecdotal evidence I have from conversations with industry professionals and their professional advisers suggests that minority ownership and growth equity investments are no longer the principal type of private equity investment in Asia.

China’s stock market gyrations and ham-fisted government responses have had some impact on institutional investors’ appetite for investments in Asia, but for investors with a long-term investment horizon and the ability to weather short-term volatility (such as CPPIB), China remains attractive. I would say that the gyrations are likely to impact the private equity industry in three ways. First, price multiples may decrease as sellers and buyers adjust their expectations. Second, fund sponsors with existing Chinese investments and plans to exit by way of a listing on the mainland Chinese stock exchanges will find that door partly closed given the volatility of the market and the lock-up periods for existing substantial shareholders. Third, the volatility of the Chinese yuan is likely to increase the risk for fund sponsors with funds denominated in currencies such as the U.S. dollar or Euro.

Speaking of currency volatility, one should note that many Asian currencies have fallen in connection with moves by the Chinese government to devalue the Chinese yuan. For funds denominated in currencies such as the U.S. dollar or Euro, this offers some potential for profitable investments as the price of portfolio companies has fallen in U.S. dollar or Euro terms, even if they may have stayed constant in the local currency.7

Asian fund sponsors are finding it harder to raise funds, though, with the Wall Street Journal reporting in September 2015 that Asia-focused private equity funds had raised $20 billion, significantly less than the $72 billion raised in 2014. It suggests, as mentioned above, that fundraising is complicated.

Conclusion

One phrase seems to sum up most of what I have been observing in the private equity industry: It’s complicated.

On the fundraising side, I do expect to see the allocations by institutional investors change towards a more barbell strategy, with less funds allocated to mid-market fund sponsors. I also expect that some skeptical investors may even prefer to shift more of their investments into deal-by-deal investments alongside a fund sponsor, as is currently happening in the Middle East. Fundraising is likely to be more difficult in Asia and the Middle East, as institutional investors become more cautious about allocating to these regions given their economic and geopolitical risks.

On valuations, I expect the same story to be true in 2016 as was true for 2014 and 2015: the enormous reserves of dry powder amassed by fund sponsors will put upward pressure on transaction valuations, and will demand that fund sponsors adopt a disciplined approach to deal sourcing and be willing to walk away from expensive deals.

Sovereign wealth funds are unlikely to massively change their approach from 2015 to 2016: the majority of them as yet do not have the infrastructure to lead investments without an experienced fund sponsor. They are likely to become more selective in their allocations to private equity funds, and more likely to concentrate their commitments with a smaller number of fund sponsors to reduce complexity, obtain fee rebates or discounts, and maximize co-investment opportunities.

Finally, investors in Asia must adapt to a new balance of risk and returns, as currency volatility, geopolitical risk, and the prospect of a real economic downturn in China become more likely. This does not mean that Asia will be an unattractive destination for foreign investment, but it does mean that fund sponsors and institutional investors will become more discerning, and diversify beyond the traditional growth capital and minority ownership style of investing into distressed and special situations investing and buyouts.