There is more money in the global private equity (PE) industry today than at any other point in its history but challenges may lie ahead on the PE horizon.
Key insights
- A significant influx of capital and new players in global private equity is driving concerns of an overheated market, making it difficult for PE firms to source good opportunities
- Multiple expansion and cost cutting, conditions that have historically formed the basis of future value projection in the PE industry, look increasingly fragile
- New long-term approaches to value generation in the PE industry could see a growing number of firms adopt top-line growth strategies in portfolio companies, explore creative uses of technology and pursue more add-on investments
Private equity - facts and trends
Private equity is booming. Global PE fundraising totaled an unprecedented USD 453 billion in 2017, topping the previous record set in 2007 of USD 414 billion.1 The global PE industry now has more than USD 2.8 trillion in assets under management, higher than at any other time in its history. This is a significant rebound from the doldrums the industry found itself in following the financial crisis in 2008. In a persistently low-interest rate environment, the appeal of PE is clear. PE funds returned 17.3 percent in the 12 months through June 2017, a slight increase on the 15.4 percent annual gains registered for the five years through June 2017.2 With the post-crisis bull market in public equities moderating and valuations in both equities and bonds starting to look stretched, institutional investors have begun to allocate more illiquid alternative investments into their portfolios.
As money pours in, however, PE finds itself at a crossroads. The challenges facing the industry are a combination of medium-term and cyclical, as well as long-term and structural.
Medium-term challenges: more competition, less value
In the medium term, the flood of institutional capital entering the asset class and increased competition are driving deal multiples higher. The number of PE firms chasing deals has risen steadily each year for decades and now totals 7,775 globally.3 In addition, high-net-worth individuals and family offices are entering the field and the number of multi-asset class direct investors has also increased. Several sovereign wealth funds and pension funds have begun exploring direct private investments on top of their allocations to PE managers. The California Public Employees' Retirement System, for example, has said it will invest USD 13 billion in PE directly every year in addition to its existing USD 27 billion PE allocation.4 Corporate buyers are more present in the market today than they were a decade ago and they look to capitalize on several advantages that improve their odds when bidding against PE firms, including a lower cost of capital and a willingness to bid higher for assets of synergistic value to their core businesses.
As money pours in, PE finds itself at a crossroads
At the same time, however, the number of deals being done is essentially static. According to data from Dealogic, the number of annual buyout deals has remained range-bound between 3,000 and 4,000 since 2010.5 More investors and money chasing the same number of deals means that valuations are rising. Buyout multiples climbed to a record 10.2 times Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) in 2017, according to S&P Global Market Intelligence, and remain elevated this year at an average of 9.5 times. This is a level that has surpassed the 2007 peak of the pre-crisis buyout boom.6
Dry powder (i.e., money promised by investors that PE managers have not yet spent), reached its highest level ever at USD 1.7 trillion in 2017, which underscores the degree to which suitably priced valuations have become increasingly difficult to find.7 However, as dry powder accumulates the pressure to do deals continues to build. This will test the PE industry's ability to maintain discipline in the years ahead.
Long-term structural challenges: time for a new model?
As dry powder accumulates the pressure to do deals continues to build
Debt continues to be a preferred source of financing for many PE deals, particularly buyouts. S&P Global Market Intelligence estimates that buyout debt levels averaged about 5.7 times EBITDA for the year to date, up from as low as 3.7 times in 2009, and not far from the pre-crisis peak of 6.0 times.8 The end of easy money in the United States and the tapering of the European Central Bank's quantitative easing program present medium-term growth challenges for buyout companies that have debt. An uncertain macroeconomic outlook in both the United States and Europe compounds this cyclical stress that is likely to weigh upon the PE industry in the medium term.
Amid increased competition for deals, rising valuations and the likelihood of an economic downturn over the next five to 10 years, the long-term structural challenge for PE is to figure out a new model that can continue to generate superior returns for investors. For decades the fee structure, a 2 percent annual management fee and 20 percent carry on investment returns, and the operational approach of PE managers have remained largely unchanged. Future value projections have rested on a combination of multiple expansion and cost cutting. Neither footing looks particularly sure today so a new model may be needed.
The disruptors
While the future state of the PE industry remains unclear, several elements of the industry's current approach are already being disrupted and may intensify in the years ahead.
Firms are looking to become more competitive on fees, and many are shifting the emphasis of operational turnarounds in portfolio companies from cost cutting to top-line growth generation, a potentially decisive shift for an industry that has long seen restructuring as the key to value generation. In addition, firms are exploring ways to integrate technology and data, for example blockchain, into portfolio management as a way to increase efficiencies in custodianship and compliance. Finally, add-on investments, such as synergistic opportunities “added on" to a primary “platform" investment, are growing in importance. Add-ons represented 24 percent of total global buyout deal flow in 2017 by value, up from 10 percent in 2007.9 Greater pooling of add- on investments and smarter sectoral specialization could become an important competitive edge for PE firms in the years ahead.