For the private equity industry, it’s the best of times and the worst of times.
The best, because private equity firms have plenty of ammunition to put to work, and they have opportunities to invest more in young, growing companies. The worst, because high valuations have put a dent in the number of deals being done and started to crimp returns for the asset class.
Valuations of private equity targets have averaged about ten times earnings before interest, taxes, depreciation and amortization, probably the highest level in ten years, says Stephen Ellis, director of financial services equity research at Morningstar in Chicago.
“All of the publicly traded alternative-asset managers are struggling to put money to work,” Ellis says. At Apollo Global Management in New York, for example, undeployed capital currently stands at 32 percent of assets under management, compared with a common level of about 20 percent.
And why have valuations soared? “The big reason is that interest rates are so low that a lot of people are chasing alternative investments, looking for yield,” Ellis says. In addition, the stock market’s bull run of the past six and a half years has raised the value of public companies’ shares, giving them valuable currency to use in bidding against private equity firms for acquisitions, says David Erickson, a senior fellow in finance at the Wharton School of the University of Pennsylvania and a former investment banker.
Another factor holding down private equity buyouts is regulators’ crackdown on leveraged lending. “That makes it difficult for non–brand names to acquire debt,” Ellis says. Leveraged lending to private equity managers has dropped about 50 percent in the 18 months leading to October, he says.
The high valuations and lending constraints have reduced the number of global private equity deals announced this year to 1,527 as of November 10, a six-year low and down from 1,742 in 2014, according to research firm Dealogic. But the value of these deals rose to $230.7 billion, an eight-year high for the period and up from $223.4 billion last year.
The divergence shows the dominance of the biggest private equity players, analysts say. They are outperforming their smaller competitors “because of their ability to source large deals and raise larger funds where capital is a potential constraint, either due to market turmoil or skittish limited partners,” Ellis says. In the past two years, big-name managers such as Blackstone Group, Apollo and Carlyle Group raised jumbo funds of well over $10 billion each, he points out.
As for the drop in the number of deals, “I don’t see anything to convince me this is secular rather than cyclical,” says Ellis. “At some point, valuations have to come down, so these private equity managers will be able to invest.”
Whether they can generate the same high level of returns as in the past is less clear, says Gustavo Schwed, a clinical professor of finance at New York University’s Stern School of Business who previously worked in private equity. Investors have been willing to take a risk on private equity because the industry has historically generated much higher returns than publicly traded stocks. “For any long period of time, private equity has dramatically outperformed public markets,” Schwed says. “But not in the years after the 2008 financial crisis.”
In the five years through 2014, U.S. private equity funds provided an annualized return of 15.8 percent, barely beating the 15.5 percent return of the Standard & Poor’s 500 index and trailing the Nasdaq Composite index’s return of 15.9 percent, according to research and advisory firm Cambridge Associates.
“We’re keeping a close eye on this,” says Schwed, who helps oversee a college endowment, which invests in private equity. “It’s hard to judge over a short period of time. We’re a ways away from saying this isn’t a good asset class, but we do feel it must continue to outperform public indexes.”
Still, Schwed and others say private equity managers may soon find very profitable investments. “It’d difficult to outperform like they have the past 25 years, but these are smart people who are good at reinventing themselves.”
The slips in Asian markets and in energy companies may provide investment opportunities, Wharton’s Erickson says. Already, private equity managers are shifting their focus from large buyouts to growth-oriented investments, Schwed says. “A lot of firms have built in-house operating teams, which is what’s necessary to create value in companies outside of financial engineering.”
Examples of growth investments include KKR & Co.’s $35 million commitment to Australian ultrasound technology company Signostics, announced Monday, and Carlyle Group’s August agreement to buy McLean, Virginia–based cybersecurity data firm Novetta for an undisclosed sum.
Private equity is cyclical like anything else, Ellis says. “At some point, interest rates will go up and valuations will come down in the stock market,” he says, creating a positive environment for private equity investment.
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