The private equity industry has seen rapidly growing capital inflows and strong investment performance in recent years… How then should investors re-assess private equity exposure following recent falls in public equity markets?
As we move towards the end of 2022, with listed markets’ technology valuations having fallen sharply, interest rates rising quickly, global inflation set to hit 8.8% in 2022, continuing geo-political tensions and supply chain disruption, we felt it would be timely to examine these key issues for private equity.
Consideration 1: Is there too much capital or ‘dry powder’ chasing the available deal flow?
‘Dry powder’ is the aggregated amount of ‘committed, but not yet invested’ capital that private equity firms across the industry have at their ultimate disposal. The industry has always operated with large amounts of dry powder, reflecting the model of General Partners (GPs) raising their funds before investing the capital over a five-year investment period. With the largest GPs raising ever larger funds, and where >$20bn fund sizes have become increasingly commonplace, coupled with buoyant fundraising conditions over the last five years, it is no surprise that levels of dry powder have reached record levels.
It is estimated that at the end of 2021, after ten years of steady growth, there was approximately $1 trillion of dry powder sitting in global buyout funds alone (accounting for around a third of total private markets dry powder). This has undoubtedly put pressure on GPs to put money to work over the last two to three years and has helped fuel the high levels of investment into technology and tech enabled industries where deal valuations became elevated.
Whilst this $1 trillion of current dry powder is of course extremely large, it should be viewed in light of four distinct contextual factors, which we believe makes it much less of a cause for alarm than it might immediately appear.
- There has been a huge volume of annual buyout investment, with $1.7 trillion worth of buyouts concluded globally in the 18 months to June 2022
- All of this money is not contractually available for immediate deployment, but can be ‘called’ in the first and subsequent years of a fund’s investment period
- The stale unfunded commitments phenomena, or ‘stale UFCs’, means that there is money that has yet to be drawn from the investor. Our experience suggests that most growth and buyout funds ultimately deploy only around 90% of potentially deployable capital.
- Significant capital commitments made by GPs to their own funds acts as a safeguard against underwriting standards being lowered
Consideration 2: Given it is no longer possible to rely on financial engineering, can private equity continue to generate excess returns?
Over the last ten years, the level of debt used in buyouts has been fairly steady at around 50% debt and 50% equity. The rapid expansion in growth capital and late stage venture capital investing, particularly in the technology and tech enabled sectors, has typically employed less leverage than buyouts as high growth companies are less able to sustain the levels of debt that larger more mature businesses can.
The large amounts of capital flowing to private equity over the last ten years, and the resulting increase in competition and asset prices, has meant that the earnings multiples being paid by GPs for new US buyout transactions now averages 12.3x EBITDA, steadily rising from below 10x in 2012. This has led managers to focus on specific industry sectors and build deep domain knowledge and develop specialist teams of experts in order to move quickly and decisively, and add real operational and strategic value to their portfolio companies.
Whilst the use of leverage continues to be an important contributor to overall returns, both the degree of leverage employed and its relative importance as a value driver have both declined significantly. With debt financing costs materially rising this year, this trend is not about to suddenly reverse.
Consideration 3: Does the growing inventory of unrealised investments raise questions about the performance of the asset class?
The British Venture Capital Association 2021 performance measurement survey, produced in conjunction with PWC, tracks the amount of capital paid in by investors and the amount of capital distributed to investors on an annual basis going back to the 1980s.
This latest survey shows that in aggregate across all funds raised each year, for all vintages up to 2014, investors have received more capital back in distributions than they have paid in. The levels of distributions versus paid in capital for the more mature vintages (pre-2010) are predominately in a range of 160% to 200%. For the 2014 vintage, investors have received back 105% of their paid in capital and this reduces steadily over more recent vintages to 39% for vintage year 2017.
It must also be noted that whilst the absolute number of privately held companies now exceeds publicly listed companies, the combined enterprise value of private companies remains a fraction of the capitalisation of public markets. In addition, the so-called secondary market, where specialist firms raise capital to purchase seasoned interests in existing private equity funds, has expanded even more quickly than the overall private equity market.
In conclusion, the private equity industry continues to evolve. Faced with a tough economic environment, our specialists at Sarasin Bread Street continue to monitor opportunities closely and consider new trends that will play out over the coming decade.
Alex Barr is a Partner in Sarasin & Partners LLP and co-heads Sarasin Bread Street, a specialist private markets business formed in 2022. Prior to this he co-founded Bread Street Capital Partners, held senior investment roles at Janus Henderson, Aberdeen Standard Investments (now abrdn) and Deutsche Asset Management, and started his career with Franklin Templeton in 1993.
James Witter is a Partner in Sarasin & Partners LLP and co-heads Sarasin Bread Street, a specialist private markets business formed in 2022. Prior to this he co-founded Bread Street Capital Partners, held senior investment, product and capital markets roles at Aberdeen Standard Investments (now abrdn), SVG Advisors, Nomura and Merrill Lynch, and started his career at Dresdner Kleinwort in 1985.
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