Private Equity Market Outlook: Could the Good Times Be Ending?
It’s time for managers and investors to know their options
Finbarr O’Connor and Gavin Farrell
What’s not to love about private equity?
In the low-interest era, the sector has become a juggernaut, doubling assets under management in the last 10 years and piling up $1 trillion in capital ready to be deployed, according to industry tracker Preqin. And it’s easy to see why the capital is piling in: PE funds have distributed over $400 billion back to investors every year since 2014.
But it might be time to start worrying.
We saw a similar increase in fundraising before: in 2007, a year before the financial crisis. Over the next years, investors watched helplessly as returns dwindled and funds staggered under the weight of assets they couldn’t sell, leaving some holding the bag.
And while there is no reason to believe we are headed toward an economic calamity of the same scope or severity as the Great Recession, a mild recession or even a simple correction could create significant problems for the private equity industry.
Does the private equity market outlook contain signs of a bubble?
There is already some fragility in the sector, stemming from an estimated $300 to $400 billion in private equity assets that are near or have reached their maturity dates. Managers of many of those funds are also juggling newer, larger funds. At the same time, asset prices and deal sizes are climbing to precipitous heights: Fueled by historically high amounts of covenant-lite leverage, buyout multiples last year reached a record high of 11.2 times average EBITDA, up from 10 times EBITDA in 2016, and average buyout sizes hit a new record of $675 million in the third quarter of 2017, according to a report by Bain & Company.
Yet the rising fundraising tide isn’t lifting all boats. Twenty-five percent fewer new PE funds launched in 2017 than in 2016. Investors are steering capital more toward well-known mega-buyout funds, making it much more challenging for smaller funds to raise capital, which not only limits their upside opportunities but also leads to retention issues with key investment professionals.
Stir it all together and you get a worrisome stew: maturing funds in a rising-rate, potentially overpriced environment where managers of smaller funds will struggle to raise additional capital. On top of that, many of those managers, or general partners, still hold strong convictions about the upside potential of the assets in their portfolios. But as storm clouds gather, investors, or limited partners, are increasingly likely to prefer liquidity, which may force GPs to seek solutions in the secondary market and will almost certainly lead to tension, if not outright conflict, between GPs and LPs.
The tension can be diffused, and the conflict avoided—if both managers and investors understand their options. For those who don’t, the time to get educated is now. Here are a handful of solutions that every GP and every LP should consider:
Extensions buy time for the private equity industry
Facing a maturing fund and a tight market, the GP’s most common first step is to request an extension to the fund’s term (assuming the terms of the fund’s LP agreement permits it). Most LPs will be familiar with these sorts of requests, so the key for fund managers is transparent communication and a short, clear timeline for monetizing tail-end assets. Needless to say, once an initial extension is granted, investors will grow impatient quickly if GPs come back to ask for more time. And conversations about management fee requests will become awkward.
3 liquidity alternatives private equity firms can use
Maturing funds should consider three liquidity alternative strategies:
Fund restructuring or recapitalization
In this scenario, the GP creates a new fund vehicle and raises capital from new and, sometimes, existing investors. The new vehicle then acquires the assets from the mature fund and provides liquidity to its investors. Existing investors may be provided the opportunity to roll their old fund interests into the new fund vehicle. GP economics will typically be crystallized at the old fund based on the value of the assets being transferred, while performance fees in the new fund will be based upon future performance. Because a majority (or more) of existing LPs must usually approve these transactions, open and timely communication is once again essential—as is an independent fairness opinion on the value of portfolio assets being transferred.
Here the GP offers investors a choice between a multiyear extension and a liquidity option with no consequence. Essentially, the GP is brokering a secondary sale process on behalf of the LPs. This may be a better alternative than a simple one-year extension when the GP believes that won’t be enough time to realize optimal returns. In some cases, new LPs may be asked to make a subsequent, or “stapled,” commitment to a new fund vehicle.
LPs can, and often do, go it alone and seek liquidity directly from the secondary market, although GP consent, typically not to be unreasonably withheld, will be required.
Secondary direct transactions
When the GP, in consultation with LPs, determines that an orderly sale of the fund’s assets is the best option, the remaining assets in the portfolio can be packaged for sale to a third-party buyer or buyers. The secondary market has been extremely active in recent years, and with an estimated $200 billion of available capital, there is no lack of interested buyers willing to acquire assets at levels approaching net asset value. However, portfolios containing distressed assets may be less appealing and subject to steeper discounts, making a sale less attractive and not in the best interest of LPs. In these cases, such distressed assets may be pooled and carved out into a special purpose vehicle, allowing the remaining fund assets to be sold and delivering some immediate liquidity for LPs.
Wind-down/General partner replacement creates options for a private equity fund
Most situations involving the above liquidity options depend on significant amounts of new investor capital; in the absence of attractive assets that simply require more time to deliver value, these types of liquidity options may not be appropriate or acceptable to LPs. Funds holding low-quality assets (often known as zombie funds) may become lower priorities to many GPs as their economic incentives decline and they focus on managing newer funds and raising new capital. Indeed, in some cases GPs were happy to collect management fees while doing little to actually extract value and distribute capital back to their LPs. In either scenario, it may be time to change horses and for LPs to consider replacing the GP.
But LPs should proceed with caution. Finding a replacement GP often requires finding motivated management with operating capacity and who will likely seek a performance incentive to manage out the fund’s remaining assets, a circumstance that may change the economic terms for LPs. It is also possible to engage a mature fund specialist as a replacement GP to extract maximum value from tail-end assets while lowering operating costs. LPs can take comfort that a new GP will take full fiduciary responsibility and apply a fresh mindset, unencumbered by decisions of previous management. In most cases, the new GP’s compensation should be based on the value realized and distributed to LPs.
For most funds, it won’t come to that. Still, as rates rise and the window for profitable exits narrows, managers and investors alike are well advised to know their options, plan accordingly and communicate openly and often. Nobody wants to be left with a single option—holding the bag.
Finbarr O’Connor is a managing director and member of BRG’s Corporate Finance practice.
Gavin Farrell is a director of business development and member of BRG’s Corporate Finance practice.