Aurum Wealth Management Blog

Equity

What’s the ‘Deal’ With Private Equity?

After decades of fundraising by private equity managers in the institutional investment world, pensions and endowments are tapped out. Allocations range from 10% to 30% in private equity to help these organizations hit funding and return targets.  This is likely the upper limit of where most investment committees would be. As a result, we are getting more inbound calls and emails than usual from private equity and debt managers looking to raise money. These titans of finance are even looking to 401(k) plans as a way to raise money in the future.

When new people ask us to join a club that pays themselves such high fees, we should probably step back a bit and wonder why.

Let’s see where we are in the lifecycle of private equity. Part of the reason for the industry’s early success is that there were so few competitors. As demonstrated in the chart below, the number of firms globally grew from a handful to nearly 8,000 today. In the 1990s, these firms put up gaudy return numbers. The industry and concepts were just starting out as teams left the big brokers to strike out on their own.  Early movers and investors had a big advantage, with their ability to buyout companies with leverage and improve operations.

 

 

 

 

 

 

 

 

 

 

Source: Bain Capital

In addition, the prices paid for assets was much lower. Buying at cheap prices outperforms buying expensive.  Back in the early days, investors paid multiples in the 4 to 6 times EBITDA (Earnings Before Interest, Taxes, Deprecation, and Amortization, a proxy for operating earnings).  At 5 times EBITDA, this gives a company a 20% operating yield. With some improvements and growth in the business, it easy to see how 30% returns were possible. Today is a different story.  The average leveraged buyout purchase price multiple hit a record of 11.2 times EBITDA in 2017. At the end of the first quarter, the U.S. public equity market traded at 10.7 times EBITDA, a discount to the average private market deal.

With so many firms chasing fewer deals, the cash continues to build. As seen below, there is now $1.7 trillion across the spectrum of private equity waiting on the sidelines, looking for an investment home.

 

 

 

 

 

 

 

 

 

 

Source: Bain Capital

The biggest growth in ‘dry powder’ (or cash waiting to be deployed) over the past year came from direct lending, up 36%.  This comes at a time when banks are lending to worthy borrowers, despite the ‘story’ private debt managers tell that the lending market is shut down.  Corporate bond spreads in public markets are near the lowest of the last ten years.  This means investors are getting paid the least amount of interest in years for the risk of lending to companies that banks and other investors will not finance.

There are a record number of firms, most with excess cash to spend.  This combination bids up the prices paid for companies, so it is natural to see returns lower than the past.  Returns dropped so sharply that the median fund barely outperformed the S&P 500 Index, as shown below on the left chart.  While managers claim an illiquidity premium should be earned for locking up money, it was hardly earned recently.

 

 

 

 

 

 

 

 

 

 

 

Source: Bain Capital

Not only is performance dropping, but so is the persistence of the best managers staying near the top.  While managers might claim they have proprietary deal flow and historical returns in the top quartile, it may not matter.  New research from the Massachusetts Institute of Technology shows that a top quartile fund only has a 33% chance of staying in the top quartile. Thus, manager selection becomes increasingly harder, and this new information may point out that there are not many fund managers who can consistently deliver outsized returns.

Finally, it is 2018. Investors should not pay commission for investment products. An advisor’s “access” at a broker dealer is not so great that it is worth paying an added commission.  In our experience, these types of funds are where we see the biggest problems – not the biggest source of returns. Problems range from high fees, to illiquidity, to selection bias.

All private investments are not bad.  In fact, we think they do play a role in thoughtfully constructed portfolios. Diversifying across strategies, managers, regions, and fund vintages is important.   Instituting a program for methodically investing in private structures over time is how we approach the space. Investment sales pitches can sound rosy. However, after reviewing a wide variety of investments over the years, the details and fine print cannot be overlooked.

New Call-to-action

 

Important Disclosure Information
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Aurum Wealth Management Group, LLC (“Aurum”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Aurum.  Please remember to contact Aurum, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  Aurum is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice.  A copy of the Aurum’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.
This entry was posted in Aurum Wealth Management, Mailchimp RSS and tagged , , , , , , , , . Bookmark the permalink. Follow any comments here with the RSS feed for this post. Comments are closed, but you can leave a trackback: Trackback URL.
© Copyright 2018 Skoda Minotti | Privacy Policy | Disclaimer | Remote Support
Cleveland 440-449-6800 | Akron 330-668-1100 | Tampa 813-288-8826
Website designed and developed by Skoda Minotti Strategic Marketing