Private equity (PE) managers are going through a challenging year as record amounts of capital flow into private markets and valuations hit a new peak. On top of that, negative macroeconomic factors are currently making the global economic climate much more unpredictable, says a recent Bain & Co report.
According to the annual Global Private Equity Report from the consultancy firm, last year investors poured US$ 894 billion into the private capital sector, the highest in the last decade excluding 2017. PE accounted for 40 percent of overall private capital, the highest amount since 2006. The PE investment market overall saw the best six-year stretch in the history of the industry.
Figure 1: Buyout funds have outperformed public equities in Europe and Asia-Pacific, but the spread has started to converge in the US
Note: Data for US and Asia-Pacific calculated in US dollars; data for Europe calculated in euros; Europe includes developed economies only; PME is a public market equivalent based on the Long-Nickels methodology; mPME is a proprietary private-to-public comparison from Cambridge Associates that evaluates what performance would have been had the dollars invested in private equity been invested in public markets instead.
Source: State Street Private Equity Index; Cambridge Associates Private Investments Database
However, PE dry power (referring to committed but unspent capital) hit a record high of US$2.5 trillion in December last year. Valuations of companies have also been rising across all sectors. Over 55% of US buyout deals in 2019 had an EV/Ebitda (enterprise value over earnings before interest, taxes, depreciation and amortisation) purchase price multiple of more than 11 times, compared with about 20% a decade ago.
For the first time, the returns of public markets and PE have converged in the United States over a 10-year period. This raises questions about how PE can stand out and remain attractive to investors going forward,” says Hugh MacArthur, global head of Bain & Co’s PE practice.
In other regions, PE still outperformed the public markets.
The anomaly in the US is due to its accommodative monetary and tax policy and the flight to quality as bad news flooded the European markets.
US equities, however, are unlikely to achieve long-, double-returns, the study states. To stand out, PE companies need to be smarter in setting targets, gaining insights into the market, doing due diligence and finding new ways of generating value.
Even as PE’s outperformance is attracting record amounts of capital, the average returns have declined over time, according to the report. However, the top-quartile returns have held steady, which explains why most of the capital flowing into this asset class is targeting top-tier firms.
Why do they outperform the rest? The answer is in their focus, say the authors of the report. According to the report, “the best firms know what they are good at and wield that as a competitive weapon. In a world of high prices and intense competition, they understand that expertise matters. You have to be much more focused on the sectors you are investing in, the risks you are underwriting and your ability to actually get the value once you own the asset.”
The consistent outperformers were either sector specialists, had a focused hunting ground, had differentiated playbook funds or were scale managers with broad expertise.
Some of the sector specialists highlighted are Thoma Bravo, Silver Lake and Vista Equity Partners in the technology space and Charlesbank and L Catterton in consumer-related companies. These firms can assess risk and opportunities in ways their competitors cannot.
PE firms tend to avoid the most hyped tech segments and invest in the enterprise software sector instead, which offers strong growth and insulation against a downturn.
These companies are more resilient and have strong revenue growth and solid fundamentals as their customers are rapidly digitising to stay competitive. In addition, the sector has low levels of capital impairment because enterprise software solutions are crucial and hard to dislodge once installed. The opportunities to invest are also growing as innovations in cloud computing and mobile technology have expanded the pipeline of investees.
According to the report, hardware and consumer software stocks comprise 63% of the capital invested in public markets, whereas 72% of PE capital is concentrated in enterprise software and IT services.
In PE, returns from tech deals have outpaced those from non-tech deals, especially for software buyouts from 2010 to 2018.
“Valuations of enterprise software companies have risen over the past five years and their businesses are not immune to an economic slowdown. But these businesses tend to be more stable in a recession. While consumer-driven revenue can fall off sharply when the economy slows, B2B (business-to-business) customers are less flighty,” say the report.