When fundraising gets easier, investing is more challenging
The private equity (PE) market has seen solid fundraising for almost a decade from investors interested in maintaining, if not expanding, PE allocations (EXHIBIT 1). Increasingly, investors anticipating only modest long-term returns from traditional public markets have turned to PE to help generate the returns they need. Institutions, on average, require returns of 7.5% to 8.0%,1 while, according to our 2019 Long-Term Capital Market Assumptions, a traditional 60/40 global equity-debt portfolio can be expected to return something closer to 5.5% over the next 10 to 15 years.2 Fundraising has also been fueled by investors anxious to rebalance out of asset class holdings that have appreciated beyond their strategic targets and into PE portfolios where multiple years of healthy distributions (in excess of contributions) have served to reduce allocations below strategic levels.3
Global PE fundraising has been strong for almost a decade. How can all these funds be put to work effectively?
EXHIBIT 1: INVESTOR SENTIMENT
Source: FactSet, Thomson ONE; historical data and 2H 2018 total fundraising estimate as of June 30, 2018.
Yet when funds are more easily raised, it becomes more difficult to invest them productively. Demand outpacing supply generally means higher valuations, greater use of leverage and/or lower potential future internal rates of return. How, then, should investors be thinking about their PE portfolios in this late stage of a historically long recovery?
MAINTAIN A SENSE OF REALITY AND DISCIPLINEIn our view, investors have three choices: Lower return expectations, sacrifice underwriting standards or be disciplined in seeking out solid opportunities in this late cycle with the potential to deliver on private equity risk and return objectives over the long term. We believe that, even in the current market environment of rising valuations and intense competition, there are ample opportunities in PE markets to help investors achieve required, risk-appropriate returns. But it will take skilled, discerning investors with well-established sourcing networks, a disciplined due diligence process and the ability to implement effectively to achieve those goals. It may also require a willingness to underweight or overweight specific sectors depending on where high conviction opportunities can be found in this market.
AREAS OF OPPORTUNITY
Small to midsize private companies
Within corporate finance, which accounts for the bulk of PE assets, we see attractive opportunities in firms with revenues of USD 10 million to USD 100 million. While large and mega deals steal the headlines, smaller, below-the-radar opportunities are more numerous and typically less leveraged, with less inflated valuations.4 Private equity partners experienced in working closely with the management of these smaller firms can help realize business improvement and growth opportunities, enhancing the potential for greater investor returns.
Europe, China and, selectively, IndiaThe world economy is providing an expanding global opportunity set for PE investing. At the same time, we believe a broadly inclusive, top-down, globally diversified strategy may be less appropriate for private equity than for public equity investing. In our view, investors are best served by a more selective, market-by-market, deal-by-deal, bottom-up approach to PE investing, allowing identification of the best opportunities wherever they reside. Our focus outside the U.S. continues to be on the key private equity markets—Europe, China and, selectively, India—and the high growth areas within them.
Technological innovation and disruption
Finally, an unrelenting wave of technological innovation and adoption is giving rise to an array of new business ventures hardly imaginable a decade ago. These innovations are improving efficiencies, disrupting businesses and transforming traditional modes of communication—a fundamental shift we expect to continue. We see particular opportunities in rapidly changing e-commerce and in cybersecurity—a non-discretionary technology expenditure for many.
Such game-changing innovations are far more likely to be conceived and nurtured as start-ups than as homegrown businesses within mature public firms. And many of these ventures are choosing to remain private longer5—due in part to a greater availability of private equity financing and the costs and regulatory constraints involved in going public. Exposure to these technological innovation-driven growth opportunities is getting harder and harder to achieve through public equity markets.6 However, venture capital investing is risky and there are many failures; that makes expertise in specific technology sectors and access to early-stage companies with leading entrepreneurs critical to successful investing.
In short, private equity investors can’t ignore the macro environment—the length of the current recovery and the stores of dry powder seeking investment opportunities, now approaching $1 trillion.7 In our view, particularly within the small to midsize corporate finance market, valuations may not yet be as concerning as they were near their 2006–07 peak. But timing private equity markets is extremely difficult. Now, as always, skillful, disciplined investing at a measured pace over time remains the key to meeting return objectives.
2 2019 Long-Term Capital Market Assumptions, J.P. Morgan Asset Management; data as of September 30, 2018.
3 On a global basis, distributions to PE limited partners exceeded contributions in each year from 2011 through 1H 2017. Cambridge Associates Private Investment Database, 1H 2017. See http://docs.preqin.com/reports/Bain-and-Company-Global-Private-Equity-Report-2018.pdf Figure 1.16.
4 For example, purchase price multiples for deals below USD 200 million averaged 7.5x vs. 9.9x for the overall buyout market, for the 10 years ended June 30, 2018. Akerman Q3 2018 Perspectives RW Insurance; PitchBook, data as of June 30, 2018.
5 During the period 1996-2000, the average company completing an initial public offering (IPO) was 6 years old at the time of the offering. In the early 2000s, the average age rose to 8 years. Following the financial crisis, it increased to 10 years. https://corpgov.law.harvard.edu/2018/10/09/cashing-it-in-private-company-exchanges-and-employee-stock-sales-prior-to-ipo/.
6 For example, from 1997 to 2017 the number of U.S. listed companies declined from roughly 7,900 to 4,300 (Standard & Poors, September 9, 2018). In contrast, the number of venture capital (VC) deals involving start-up firms valued at over USD 1 billion (i.e., “unicorns”) rose from fewer than 10 in 2007 to 75 in 2017. Unicorn Report 2018, PitchBook; data as of August 1, 2018.
7 PitchBook, data as of September 2018.
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