Back to School: Is PE becoming the victim of its own success?

  • U.S. large and mega buyout funds show imbalance between capital raised and deployed
  • GPs buying smaller, cheaper add-ons or looking to “secondary LBOs”
  • LPs should select differentiated strategies like complex situations or corporate carve-outs

Private equity’s assets under management reached $2.48 trillion in 2016, a more than tripling from the year 2000. And that figure doesn’t capture all the money at work in the market, excluding so-called shadow capital used for co-investments and separate-account mandates.

As is well known, this AUM growth presents the prospect of lower returns, driven down by increased competition for deals. So how should GPs and LPs respond? A recent report by Cyril Demaria, head of private-markets research at Wellershoff & Partners in Zurich, tackles the question of whether PE is “becoming the victim of its own success” and offers some recommendations.

Looking at the data, Demaria found an excess of capital available for large and megabuyouts in the U.S. From 2012 to 2016, funds dedicated to these strategies “raised a stunning $572 billion while deploying on average only $111 billion. Assuming no further capital is raised, it would take over four years to clear the current amount available to funds for these types of investments.”

Demaria discusses two options for managers confronting this money glut: buying smaller assets at cheaper valuations as add-ons and targeting the portfolio companies of peer firms. (Returning commitments to investors is possible but highly undesirable, from reputational and logistical standpoints.)

The first approach “reflects the general corporate race to scale up and maintain or increase relative market power”; for portfolio managers, it can reduce risk while increasing value. The transfer of assets from one financial sponsor to another is a more dubious solution: “The question of whether these transactions are correctly priced and will generate good returns remains open.”

As for why so much available capital has accumulated in the sector, Demaria identified several contributing factors. Some investors may look at the strategy as a free lunch, offering higher returns with limited risks. But the traditional LBO approach has by now been commoditized, and cost-cutting measures are often taken preemptively by the management of targeted companies. The upshot: Good returns are going to require more work than they have historically.

Big-ticket buyouts are also able to accommodate large amounts of capital, and require no highly specialized knowledge to assess (unlike tech investments). LPs can decrease their workload by allocating to fewer managers with larger funds, and the biggest firms offer strong brands that can shield investors from blame if things go wrong.

But LPs should avoid the temptation to invest with megadeal makers turned multistrategy managers. Instead, Demaria advises backing first-time funds with experienced managers, who generally offer friendlier terms and better alignment. Portfolios should be “diversified in terms of vintage years and regional and strategic exposures,” including niche strategies that complement LBO exposure.

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