Private Equity | |
Private Equity | |
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Friday, January 26,
2018 12.32PM / Palico
I’m not the first to say it, but it bears
repeating: This is the the golden age of private equity investment. To
paraphrase Michael Milken, private equity affords very unusual rates of return
thanks in large measure to PE’s flexibility. Indeed, private equity is more a
style of investment than anything else. What defines it is a long-term focus
and an active effort to shape and improve investments, whether we're talking
about a debt-backed corporate buyout, or a custom-designed loan from a private
debt fund. These 10 predictions depict a bright future for private equity in
2018 and beyond – though there are shoals that investors and fund managers must
avoid. - Antoine Drean, Founder and Chief Executive of Palico
Private Equity Fundraising Hits a
New Record
With some $621 billion raised for private equity
funds last year, 2017 finally surpassed the longstanding fundraising record of
2008, when $557 billion was raised across all PE strategies and regions,
according to industry estimates. This year should set a new annual fundraising
record of $750 billion, based on calculations of rising allocations to PE from
existing investors and estimates of fresh capital from new investors.1 A
particularly slow upward march of interest rates and private equity’s credible
promise of double-digit annual returns is fueling ever-greater investor
allocations to PE. Incidentally, this fundraising estimate does not include the
tens of billions that Norway’s $1.1 trillion Government Pension Fund Global,
the world’s largest sovereign wealth fund and potentially this year’s most
significant new PE investor may shortly decide to invest in the asset category.
Larger and Larger Funds are Raised
Private equity fund size records are being quickly
achieved only to be quickly broken. Last year saw Apollo close the largest
buyout fund ever at $24.7 billion and KKR gather $13.9 billion for the biggest
ever North American PE pool. Silver Lake raised $15 billion, briefly an
unprecedented sum for a technology-focused vehicle, only to be surpassed by
SoftBank’s $98 billion Vision Fund, the largest tech pool and the biggest PE
fund ever – four times the size of the Apollo fund. Investors are limiting
relationships to make portfolios manageable and doubling down on managers they
trust. Whenever they can, they’re also investing more in one go, keeping
liquid, low yielding investments to a minimum. In a recent Palico investor
survey, 50 percent of investors and managers said that managers would shortly
raise a significant number of $30 billion-plus PE funds. Moreover, 56 percent
believe that in the next three-to-five years the $98 billion Vision Fund will
be surpassed.
‘Alternative PE’ Funds Emerge as a
Source of Alpha
In the last six years, average private equity fund
size has nearly doubled to $1.3 billion. Yet larger mainstream funds competing
against each other are having a tougher time producing the kind of outsize
returns for which PE – historically characterized by smaller funds and
inefficient markets – is celebrated. There is mounting evidence that
sector-focused PE funds and emerging managers, those raising their first or
second fund, outperform the typical later-generation mainstream fund. The
result is a growing willingness on the part of investors to invest in
specialists and emerging managers – what Palico dubs alternative PE – even as
overall average fund size gets bigger. A barbell investing style will take firm
root in 2018, with limited partners putting large sums to work in big funds,
but seeking a bigger bang for their buck by investing smaller sums in
alternative PE.
Private Debt Funds Continue Their
Rise
In the five years through this past June, the
assets managed by private debt funds tripled in size to $475 billion. The funds
have offered limited partners low double-digit annual returns with minimal risk
during a period of historically subdued interest rates. Global liquidity is now
at an unprecedented level – even as benchmark interest rates slowly rise – and
the typical annual return of private debt funds is down to the high single-digits.
Yet that return is still well above what’s available in credit markets of
similar risk profile. This makes the continued growth of private debt funds a
virtual certainty in 2018. Looking to 2018 and beyond, when PE managers expand
product ranges, it’s more than likely that they’ll do so through a private debt
fund. Analysis of creditworthiness neatly complements equity analysis, and
extending debt to the same types of companies in which managers invest, keeps
PE firms within marketable specialties. Credit provision equally offers
insight. In an increasingly competitive market, that edge is often critical for
profitable equity investment.
GP Consolidation Picks Up Pace
As forecast in my last private equity outlook,
mergers and acquisitions bringing two or more PE managers together – previously
rare outside of the funds-of-funds space – took off in 2017. The floodgates
were opened by a landmark 2016 deal that saw two highly regarded general
partners, L Capital and Catterton merge from positions of strength. M&A
among fund managers had until then frequently been seen as a necessity brought
on by crisis. Deals done between strong partners last year ranged from the big,
Eurazeo’s purchase of Idinvest, to the small, Apax France’s acquisition of
small cap specialist EPF Partners. Activity is set to ratchet up significantly
again. Midsized and smaller managers now see M&A as a stigma-free means to
combat rising marketing and regulatory costs as investors commit more to fewer
managers.
More Leverage Means Rising Secondary
Value and Volume
Leverage, used to buy stakes in funds that are
done fundraising and that have begun investing, is reconciling buyers in
private equity’s secondary market – who have traditionally wanted discounts to
net asset value – with sellers who only sell funds at par or above. Rarely
employed four years ago, leverage, in the form of debt, deferred payments and
preferred equity, accounted for an all-time high of 23 percent of record
secondary volume of $45 billion in 2017. It also fueled record pricing, with
the typical fund purchased on the secondary market selling at 96 percent of its
net asset value, surpassing the previous annual high of 94 percent in 2015 and
2014.1 The recent emergence of scores of banks and private funds eager to
provide low-risk leverage to buyers of secondary funds should see the levered
portion of the market hit a new high in 2018 of 30 percent or more of total
value, driving new pricing and volume records.
Restructurings Rise to a Third of
Secondaries
Accounting for a record 24 percent of secondary
volume in 2017, up from 20 percent the previous year and some 5 percent a
decade earlier, fund restructuring – the collective transfer of PE fund
ownership from one group of investors to another – is set for further
innovation and growth this year. Such deals should rise to a third of volume in
2018, fueled by innovations like ‘strip’ transactions. In strips, exposure to a
certain type of asset that some fund investors like but others dislike is
reduced or eliminated through a spin-out of the investments into a new vehicle,
usually managed by the same general partner. Done right, strips offer all
investors a welcome pay out. Bulls double down on the strip assets by investing
in the new fund, often alongside new investors, while a new stand-alone fund
category is added to the GP’s product range. Meanwhile, the original fund’s
bears are reassured as exposure to the controversial assets is reduced. The UK
assets of global funds could be ripe for strip deals in 2018, given deeply
divided opinion concerning the opportunities and challenges posed by Brexit.
The Transparency of Private Equity
Funds Increases
Many speculate that 2018 will see a Trump-inspired
roll back of transparency in the core U.S. private equity market. Yet
regardless of the fate of Obama-era Dodd Frank regulations concerning PE, or of
U.S. Securities and Exchange Commission oversight of the industry, the clarity
of PE fund terms and performance will improve both in the U.S. and globally in
2018, driven by demanding institutional investors and, even more importantly,
by the strong desire of fund managers to win significant investment from
individuals. High net worth individuals and the family offices and registered
investment advisers that serve them are currently in the sights of PE managers,
while beyond 2018 managers have their focus trained on the mass retail market.
The only way to significantly increase the appeal of PE for individuals – apart
from sovereign wealth funds, the sole credible replacement for commitments from
disappearing discretionary pension vehicles - is through increased
transparency.
Private Equity Becomes (More)
Comfortable with Digital
Private equity managers and investors are keen to
own companies in the tech sector and eager to employ digital innovation to
improve performance at portfolio companies. But they have been notoriously slow
to adopt new technology for their own operations. This has begun to change and
the adoption of technology by both fund managers and investors shows every sign
of accelerating in 2018. Last year, a few cutting edge general partners, mainly
headquartered in Europe, began using blockchain – the technology behind virtual
currencies – to track and quickly share information on transactions, cash
flows, contracts and regulatory compliance. In California, some venture capital
fund managers are now using artificial intelligence systems to screen
investment opportunities. Meanwhile, a summer survey from Coller Capital shows
that three out of four of the world’s investors believe they could
significantly improve their PE programs through better use of “external data
sources,” a catchall category that includes everything from third party
software and cloud applications to digital marketplaces like Palico. Growing
investment in alternative PE funds, smaller and harder to find than mainstream
vehicles (discussed above), should in particular benefit digital marketplaces.
U.S. Tax Changes Improve Private
Equity Returns
While there have been some alarmist claims that
U.S. tax changes coming into operation this year are negative for private
equity returns and for the compensation of fund managers, the opposite is true.
Average yearly interest payments at PE portfolio companies in the U.S. are
between 32 percent and 42 percent of annual cash flow, not much above the new
deductibility cap on interest payments – set at 30 percent of corporate cash
flow. In isolation, the deductibility cap would modestly impact PE returns. But
any deleterious fallout will be more than offset in 2018 and beyond by the
general corporate tax cut from 35 percent to 21 percent – an enormous boon to
private equity returns, and by extension to the carried interest compensation
of fund managers. The tax reform measure that lengthens the time needed for
fund managers to qualify for favorable carried interest tax treatment to three
years from one year will also have an impact that pales in comparison to the
effect of the corporate tax cut – today only 11 percent of portfolio companies
are sold in less than three years.
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