I was reading over the Bain and Company Private Equity report over the weekend, and there was a key line that stood out for me. The report mentioned that “Resilient PE markets have provided a floor on sellers’ price expectations. Acquisition multiples reached record or near-record highs across the US and Europe, at more than ten times EBITDA in both regions at the start of 2016. In a recent Preqin survey, buyout GPs overwhelmingly cited deal pricing as the biggest challenge facing the industry.” Assets are getting expensive, and it is tough to get deals done at a reasonable price.”
Bain analysts added “And there’s a new wrinkle: Every month brings us closer to what many consider an inevitable next recession. Assumptions that GPs now build into any deal model for market beta—future multiple expansion, GDP expansion, leverage—have turned more bearish. GPs find it increasingly difficult to pencil out how assets bought at prices today will achieve targeted returns.” It is going to be tough to get money to work at prices that will allow private equity firms to get the returns their Limited Partners expect.
The report goes on to outline way firms may search for deals that offer adequate returns but the truth it is going to be difficult to get large sums of money to work. PE firms continue dot do a lot of selling in 2016. While not quite up to the record setting pace of 4014-2015 2016 was still one of the biggest years in PE exits with about $300 billion of assets sold in one form or another. Combine this with strong fundraising in a return starved world and cash is piling up at PE firms. There is currently about $1.47 trillion in dry powder waiting to be invested. $534 billion of that is earmarked for traditional buyout funds.
Private equity fund managers are going to have to cut back on their expectations or begin to look for riskier deals with higher potential returns The Bain reports notes that “As a result, GPs who aspire to generate the strong returns that a “2-and-20” model demands will have to take on more risk or get more creative in putting money to work. The standard formula for GPs cannot accommodate the prices paid in the middle of the fairway. PE funds are getting pushed into the rough and the sand traps, where the higher-risk deals live.” The private equity firms that reach too far will fare poorly in my opinion. Those who sit on their cash and wait for their deal at their price will do very well, but patience is a difficult chore in a world dominated by short-term thinking.
The tone of the report is optimistic about the PE industry but suggests that high valuation will make it harder to find deals that yield the returns investors have come to expect from private equity funds. PE funds are selling a lot of assets and cash is piling up as they wait for better pricing to deploy the money.
Compare the cautious tone of the private equity folks to this weekend’s front page headline in the Weekend WSJ. Just above the fold was an article titled Small Investors Run to ETFs. $124 billion has gone into ETFs so far in 2017, and retail investors have accounted for about 85% of that volume at Blackrock according to the article. Nine years after the market bottom investors are finally getting excited about stocks. A lot of the money has gone onto S&P 500 ETFs but here has been a lot of buying in sectors investors think will fare well under President Trump. The Financial Select Sector SPDR ETF has attracted more than $8 billion in assets since the election. Given that the fund has about $26 billion in assets that is a huge asset build.
When retail investors are rushing to throw money at the market, it is a good time to rethink your portfolio. As Mark Twain since suggested, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
Last week I put hedges in place for the first time in 8 years.