Private Equity managers aren’t paid to be patient, they are paid to put money to work and they’ve never had more of it. With over $1 trillion of committed capital coming into 2014, you would think that risk taking would accelerate, but several factors seem to be pushing the industry in a surprising direction; away from risk.
Surplus Capital is driving valuations higher and returns lower
Valuations are approaching record levels for the first time since 2007 and rumor has it that projected equity returns are in the “mid-teens” for large, leveraged buyouts. This means that the average equity investment is projected to return 2 times their principal in 5 years (before any losses or expenses). That’s better than public equity returns but leaves little room for error.
Debt markets are frothy again
Valuations are being levitated by the abundance of debt financing available. Leverage multiples are now exceeding 5X ebitda, on average. This is ok if interest rates stay at historic lows but it can lead to intoxicating overconfidence on a dealmaker’s perceived risk profile. One General Partner at a major fund told us that he was fine going over 5X leverage on a $1 billion buyout. He paid more than 10X ebitda and hence the deal was “under 50% debt to total capitalization”. That seems like cold comfort since a higher level of debt heightens the risk to both the debt and equity holders, regardless of valuation.
The cost of an investment mistake grows exponentially
Higher valuations and leverage magnify the impact of small changes in a deal, such as higher capital spending, loss of a customer, a rise in interest rates or multiple contraction upon exit. One or a combination of small changes in each of these can quickly crush the equity in a deal.
A single busted deal can put the “next fund” and its fees in jeopardy
If successful deals are projected to return about 15%, you can’t afford a hiccup. A loss on one or two deals in a portfolio can quickly bring the average return down close to or below the fund’s hurdle rate (generally 6-8%) and decimate the value of the GP’s carried interest. At current valuations, the likelihood of a large return from one deal (eg. 5X to 10X) to offset losses in the portfolio is greatly diminished. General Partners in large funds often make more in management fees than they do in carry. Hence, they are forced into “playing defense” in a low return environment; protecting that stream of management fees can become a dominant factor in deal selection, pricing and management.
All of these factors dampen a Company’s risk appetite
Historically, private companies were able to operate outside the spotlight of the public market and act more aggressively to pounce on opportunities. At today’s valuation and structures, the cost of increased R&D, acquisitions or expanding a sales force can become much more risky to fund. Large leveraged buyouts at high valuations can actually make management more risk averse. When banks have a say in funding these unexpected “opportunities”, covenant changes can be costly.
What does this mean for Entrepreneurs? Higher valuations and more choices sound like good news for Entrepreneurs but they need to do more careful homework on potential partners. Here’s what they need to know:
Funds will gravitate toward larger, more stable businesses with less risk but less upside where they can put more money to work. The private equity industry is now dominated by larger funds that prefer to “pay up for quality”. This implies investing at a higher valuation in a larger, more established business with steadier cash flows. This results in a lower, but more reliable investment return with less risk of loss. Higher risk deals for more volatile companies may need bigger discounts in valuation or have a harder time getting done.
Private Equity firms may become more bureaucratic
Success in Private Equity seems to result in bigger and bigger funds. The industry has grown over 1000% in the last 20 years and fund sizes have multiplied. Cultural change is inevitable when companies employ hundreds (instead of tens) of people. While Private Equity continues to attract the “best and brightest” people, they have added more layers and, hence, more uncertainty and complexity in their investment process. Larger organizations tend to be less entrepreneurial and slower moving. They tend to become more inward-focused; towards organizational survival, and less flexible for entrepreneurial CEO’s.
Private Equity could start to look more like the high yield debt market
The “debtification” of the private equity market represents a shift of emphasis towards return of capital rather than multiplication of capital. As Private Equity returns converge with high yield debt, they will favor terms that mitigate and shift risk to the Entrepreneur and founding shareholders who may get less value from a capital partner who is not as aligned with their interests.
Smaller funds will be more effective in the lower middle market
Large Cap funds will be replaced in the lower middle market by smaller funds, spinoffs and independent sponsors, who will be more eager to pursue investments under $10-20 million and allocate time and energy towards their success. Entrepreneurs will be better off avoiding large, “brand name” funds and focus on smaller funds that can give Entrepreneurs what they need most; attention from senior partners.
Cheap capital may not always be a good thing for Entrepreneurs
Lower returns can be indicative of a more efficient capital market which lowers costs and benefits everyone. However, it should also expand companies’ financing options, improve transparency and lower transaction costs which does not seem to be happening. Financing options for Entrepreneurs will become more perilous as funds chase returns lower but structure more onerous downside protection- something akin to offering “teaser rates” to borrowers. You may have to read the fine print to know what you’ve really got in a deal.
Potential Value of Management Options will Decrease
In deals of equal size, management options will be worth 63% less over five years at a 15% IRR versus a 30% IRR. Hence, management may need more equity or become more focused on current cash compensation and less on long term capital gains.
As Private Equity evolves into a large, institutionalized asset management industry, its success seems to be causing a shift away from its original constituency; smaller, privately-owned businesses that need support and guidance to achieve the next level of success. The economics of larger fund sizes and deals and, hence, fee income to GP’s are just too compelling to ignore. When funds chase bigger deals at reduced IRR’s, they become focused on return of principal, less able and willing to pursue riskier growth strategies and, structurally, more dependent on management fee income vs. carry as a percent of the overall professionals’ compensation. The additional layers of people needed to manage the larger infrastructure can also dilute the talent and attention to the portfolio companies.
Entrepreneurs have a bigger selection of potential partners than ever but a far more complex selection process. Smaller investment firms with a highly engaged senior team who get most of their compensation from capital gains may be harder to find but offer a significantly stronger value proposition as capital partners.