When we talk of private equity (PE), we are referring to investment funds that are structured as limited partnerships. They are not publicly traded, and so are out of reach for traditional investors. Typical private equity players consist of large institutional investors and high net-worth individuals. But is this traditional form of investment running out of steam?
The standard vehicle used by private equity funds is debt financing that is then leveraged to buy distressed companies that they then restructure and sell on for a profit. This method of investment generally entitles the debt financiers to tax breaks that make the prospect attractive to investors. PE companies can also bypass costs with which standard companies are often burdened. While PE is still considered a security asset, it is not publicly traded and is therefore out of reach of standard investors.
As we move into H2 2018, the return on private equity assets is still relatively attractive. With somewhere in the region of 3 trillion USD looking for a home, you might wonder where the problem lies. PE returns have consistently exceeded the performance of public equities (which haven’t done too badly themselves in the last 24 months), even though the volume of listed companies has actually fallen to half what they were in the mid-1990s. With gains around 15% in the past 20 years, which is almost double that of world stock indices, it would seem a no-brainer why money wouldn’t positively flow into PE coffers. However, in reality the picture is a little more complex.
The fact is, the current cycle of private equity is over-extended, and central bank governors have been pulling their support from this type of financing. And with third-party analysts sounding alarm bells that the sector is ready for a fall, it’s no wonder that PE investors are shuffling their feet. One of the key concerns is that with so much money lined up, PE managers may actually overspend on assets, creating an asset bubble, thus further reducing investor returns. Experts, such as LudovicPhalippou, professor of finance at the Oxford Saïd Business School, has suggested that valuations are simply too high, and consequently returns have become “super low”. He adds that a drop in PE returns would mean, “…embarrassment for pension funds who will not only have learned little but will have made Wall Street yet a lot richer”.
With what is commonly termed “dry powder”, or unallocated assets approaching one trillion USD, many investment managers are questioning whether the PE market will be able to generate investment returns of yesteryear. There is simply too much money running after the same assets. The market is overcrowded, and there is nothing like excess competition to kill a market. With internal rates of return of PE assets hovering around 15%, this asset class may still look attractive, but this rate has fallen from 25% five years ago. If this trend continues, general partners are likely to start pulling their money out of the PE market, seeking more attractive returns with similar risks, such as distressed debt or real estate.
While the PE market still has some wind in its sails, now might be the better time for investors to jump ship before the breeze turns into a wheezy rasp.
First published in FXStreet.