Having read this article from #Bloomberg this morning – “Private Equity is Starting 2020 With More Cash Than Ever Before” - on the amount of “dry powder” (meaning available investible funds) in the hands of private equity firms as we start the new decade, I am fully on the side that thinks this might not end well. Let me start with a caveat – the Bloomberg article is somewhat general, discussing investible funds across a variety of private equity investment strategies. This means that the volume figures presented in this article are not just available funds for P2P / leveraged buyouts, but also for other alternative private equity strategies like real estate, venture capital, etc. In this context, I realise some of my comments below are similarly general, and a more detailed analysis would need to be undertaken to drill down to the next layer. (If you want to go deep into this, Bain & Company does a very comprehensive report regarding private equity that is available here.) Nonetheless, having read the Bloomberg article and done some research, I stand by my conclusion – there’s too much money chasing too few transactions, and I am not sure this is going to end well. The facts are:
1. There is $1.5 trillion of dry powder available to invest, at a past recent annual deployment rate (if I read the article correctly) of $450 billion / annum; this is a 3+ year backlog of cash on hand, meaning P/E firms will be very keen and anxious to deploy this capital. This raises questions of investment discipline, although the larger, more established private equity firms have seen economic cycles before and most certainly understand the risk ahead.
2. Super-cheap credit (thanks Fed) is available, alongside a growing number of overly willing lenders. This includes not only traditional banks, but also shadow lenders - like private debt funds - that can't deploy loans quickly enough. Debt-to-EBITDA ratios are at six times, the highest since 2007 – see S&P Global Market Intelligence article. Below is the graphical depiction of leverage ratios for the last 20 years from LCD:
The increase in leverage multiples, both the total debt ratio and the “safer” senior debt ratio, is inevitably leading to an overall deterioration in credit, potentially setting the stage for the next downturn.
3. There is intense competition for large P2P transactions amongst private equity firms, as these firms get larger and bolder. They of course also face competition also from corporate buyers via traditional M&A transactions. This competitive dynamic will drive valuations higher and – along with overly aggressive capital structures (see 2 above) - reduce headroom on operating margins and coverages for companies post-buyout.
4. Public equity valuations are getting higher, as US indices reach record highs (and global markets rally, too). Now this isn’t an issue as long as earnings are driving the appreciation in equity prices, but this relationship seems to be breaking down as corporate earnings slow but stock prices escalate. I have used the Shiller (CAPE) P/E ratio for the S&P 500 in the graph below (from MULTPL) to look at this relationship, and here’s the reality:
Private equity LBO returns are trending down but have averaged 13%/annum the last 25 years, according to the Bloomberg article. This is superior to the average return on the S&P 500 of around 9%/annum, also according to this article, but had an investor simply bought a low-cost index fund at the beginning of 2019, the investor’s return would have been over double that of the private equity average return. So although a very short-term view and likely an aberration, investors might ask “why bother”, especially given the backdrop and context. (This is – also for the record – ignoring the positive effects on volatility in a portfolio of low correlation alternative assets.)
In summary, more money – both equity and debt – chasing what is likely to be fewer good opportunities, doesn’t sound that good to me!