There are jittery signs in the world of private equity, as we enter a new era of rising rates, writes Christopher Jackson
For years it’s been almost a mantra of the wealth management industry: private equity is where it’s at. But at the start of 2018, a strange confluence of events makes one wonder whether we might be about to enter a new phase in private equity – in fact, there’s a slight queasiness in the air.
Of course no one is writing off this asset class. Private equity deals totalled $1.27 trillion in 2017 – that’s a record. The industry is also so flush with money that, according to MoneyWeek, it is reportedly sitting on $633 billion in ‘dry powder’ – which is to say, money waiting to be deployed. That represents a big increase in interest from pension funds in particular.
Bill Nixon, managing partner at Maven Capital Partners, told Spear’s last year: ‘With interest rates testing all-time lows, equity markets looking overvalued, and alternative investments such as hedge funds delivering mixed performance, wealthy individuals are turning to PE in search of higher returns.’ It’s no surprise then that according to a survey of 106 limited partners by Palico, 70 per cent increased their 2016 PE allocation relative to other investments.
But impressive as these numbers are, private equity moves fast, and there are signs that things are shifting. In the first place, as both the US Federal Reserve and the Bank of England begin to tighten monetary policy, there are no guarantees that private equity’s success rate will carry over into an era of rising rates. Furthermore reports suggest that the hedge fund industry rebounded in 2017 with the likes of Larry Robbins, Philippe Laffont and Chase Coleman in the US all posting impressive numbers. If hedge funds are doing well, perhaps PE will lose some of its relative attractiveness.
Hans van Swaay, the founder of Lyrique, who also set up Pictet’s private equity division, tells Spear’s: ‘Private equity is hot and probably somewhat overheated: there’s a lot of money in there especially at the larger end – a lot of competition for few deals with a lot of money.’ That’s the case both for that small pool of private equity advisers competing for deals, but also for investors who are being turned away at the door.
A case in point was CVC Capital Partners’ fundraising round in 2017: in raising a €16 billion fund, the firm – most noted for its 2005 takeover of Formula One – identified some €25-€30 billion in possible investment. Another large PE house, Bridgepoint also recently turned away €5 billion. So even if you want to be in on the action, you might struggle.
Of course, in one sense that testifies to the health of the sector. But there’s another side to this: as impressive as these numbers seem, for many they spark uncomfortable memories of a similar period of frenzied activity in the lead-up to the financial crisis. Van Swaay explains: ‘I’ve never been invited to so many cocktail parties: there’s so much money around. But we don’t know what will happen next: prices may collapse.’ Although Van Swaay points to PE’s ‘remarkable track record’, he is also mindful that its post-Lehman success occurred within a now-departing environment of low interest rates.
PE is of course meant to be inoculated from the wider economy – to be more about margins and squeezing out value from a particular company. Nevertheless, it is not too hard to imagine that if hedge funds continue on an upwards curve, the picture could change rapidly.
An additional worry is that some of the above developments feed into fundamental concerns about PE, whose effectiveness has in the opinion of some academics, been overstated in these last heady years. One such is Ludovic Phalippou, a finance professor at the University of Oxford’s Saïd Business School, who tells Spear’s: ‘Small and mid-companies that are listed have had the same returns as those privately listed. Private equity is being completely overstated by the industry.’
Phalippou has compiled a dataset of 1,328 mature private equity funds: assuming a typical fee structure, he finds that once fees are taken into account, these funds outperform by 3 per cent per year – that’s much less than the sorts of dizzying returns you will hear touted by the industry itself.
Another voice of disapproval of the PE industry is none other than the Sage of Omaha, Warren Buffet: in his annual letters to Berkshire Hathaway shareholders – his 2018 letter has just been released – he has often had negative things to say about private equity entities which, as he tends to remind his readers, used to be known as ‘leveraged buyout firms’.
Buffett’s critique is as follows: private equity firms swoop in on the back of borrowed money, then institute cuts to investment spending which are damaging to long-term growth, only to exit, leaving behind a company saddled with debts. The resulting company will often have lost intrinsic value and have become, according to Buffett, essentially a piece of merchandise. Beware any company that returns to the stock market from the hands of private equity, says Buffett. You’re likely buying debt.
Von Swaay, however, is quick to point out that 'even Buffet, who is a very savvy investor, could not resist teaming up with 3G in one of the world's largest leveraged buyouts, Heinz for $23 billion.'
And if you want an example of the pitfalls of private equity, look no further than the recent debacle at electronic goods retailer Maplin. Maplin was bought by Rutland Partners for £85 million in 2014. It loaned a huge amount to Maplin – but did so at a rather unfriendly interest rate of 15 per cent. The company was unable to make those repayments.
All this isn’t to say that PE is dead – it’s only that it isn’t a magic wand. Van Swaay is among those who argue for a cannier, more considered approach: ‘Good PE will outperform most other asset classes by doing lots of things a little better rather than revolutionise things.’
That might not be glamorous, but it’s a welcome voice of reason and moderation within a heated marketplace.
In a 2011 article, Guy Hands, the founder of Terra Firma wrote: ‘The days of the quick buck, financial re-engineering and asset-stripping as the way to achieve good returns have disappeared. Patience, insight, but above all, hard work are going to be the key. It is back to basics for private equity.’
That still holds true today.
Christopher Jackson is deputy editor of Spear’s