Behold the giants, the vast new buyout funds of private equity
Blackstone, Apollo and Carlyle lead the race and hope for lucrative profit streams
Chris Flood
A giant from French arts company Royal de Luxe is pictured in Liverpool. New PE funds from the likes of Blackstone and Apollo will also tower over rivals © Oli Scarff/AFP/Getty
The maxim that “size is the enemy of performance” for investment funds has been abandoned by private equity managers in favour of the motto “big is beautiful”.
Blackstone, Apollo and Carlyle are leading the drive to create vast buyout funds that will deliver lucrative profit streams to their top executives. Cinven, Apax, Permira and Advent are also set to join the race to create a new breed of mega-funds that are redefining the boundaries of the private equity industry.
The managers’ claims that they have the skills and resources to run these huge vehicles will be put to the test because the outlook for returns from PE strategies is weakening.
Rising investor inflows into PE funds over the past decade have led to intense competition among managers to win deals. As a result, deal valuations have risen to record levels. To secure deals, private equity managers are paying between 11 and 12 times earnings before interest, tax, depreciation and amortisation, a higher multiple than at the previous peak of the market in 2007, along with leverage multiples about six times ebitda, says Willis Towers Watson, the world’s largest adviser to pension schemes.
The fear is that deals have been “priced for perfection” and so returns could suffer if there is an economic downturn.
The response of some of the industry’s most experienced players is to look for areas where competition from smaller rivals is less brutal.
Blackstone is raising $20bn for its latest PE fund, a target it expects to exceed because of the high demand from investors. No explicit guidance on returns for the new fund, known as BCP VIII, was provided at an investor day in New York in September. Blackstone executives, however, repeatedly stated their confidence that performance would not deteriorate.
Joe Baratta, Blackstone’s global head of private equity, said at the investor day that the group has the potential to earn about $1bn a year from “carry” [performance fees] partly because of the scale of its PE funds, which have delivered annual net returns of 15 per cent since their launch in 1987.
Performance has weakened in the years following the financial crisis with the latest vintages of funds delivering lower returns compared with earlier, smaller vintages that were established when the industry was less mature and less competitive.
Mr Baratta said that “only a handful” of rivals could compete with Blackstone in large-scale PE deals and that three-quarters of these transactions were negotiated bilaterally with a seller.
This reduces the risk of overpaying.
“Competition for the very large deals is thinner as perhaps only four or five managers can write the cheque: they can be more rational about pricing,” said the head of private equity at a European pension fund who did not wish to be identified.
He believes that downside risks are more muted for the mega PE funds as their managers tend to target larger, more stable, companies that are better equipped to weather any market downturn or economic storm.
This requires a price to be paid in performance.
“Returns tend to be in a tighter band for mega PE funds, unlike the mid-market where you might earn 3.5 times your initial investment but where there is also a greater risk that the principal will be lost,” the private equity head said.
Many institutional investors believe there is less risk in working with the larger private equity funds, according to Andrew Brown, senior consultant at Willis Towers Watson.
“They are run by very smart people who are very good at negotiating and structuring deals so there is downside protection,” he said.
In addition, more pension schemes are looking to save governance costs by thinning out their list of external managers.
“An investor can write just one cheque and they might get a fee discount if they also agree a commitment to one of the private equity manager’s newer strategies,” said Mr Brown.
He is concerned that deploying capital for large PE funds could be a problem as there are few attractive buyout deals at the upper end of the market.
“There are not many available good buyouts deals that can be done at the upper end of the market. Deal pricing and debt multiples also tend to be higher [there]. As a result, more managers running large funds are reducing the target return ‘hurdle’ above which they can claim performance fees,” cautioned Mr Brown.
Robert Crowter-Jones, head of private capital at Saranac Partners, a London wealth management group, believes that investors in large PE funds should be braced for lower returns.
This is partly because of the weaker growth prospects of the more mature companies targeted by large funds. He is also concerned that deploying the huge sums of money raised over the life of a large fund could present problems. This could further bite into returns to investors.
“Passing 15 per cent plus annualised returns back to the fund investor will be increasingly difficult,” said Mr Crowter-Jones. Carlyle raised $17bn last year in new capital for private equity strategies.
“We have the ability to transact larger and more complex deals,” said Kewsong Lee, co-chief executive, speaking this month at the 2018 results presentation by the $216bn New York-listed manager.
Mr Lee also acknowledged that deploying capital could be difficult.
“High levels of dry powder [unallocated capital] across our industry combined with slowing global growth in volatile markets could affect both investment pace and realisations [money raised from asset sales] in 2019,” he said.
Another issue troubling investors is how the largest PE funds will perform in the event of a downturn. Fears have risen that the US economy could move into a recession as a result of interest rate increases.
Michael Elio, a partner with StepStone Group, a $46bn New York group that builds portfolios of PE funds, points out that large buyout funds maintained “mid to high single-digit returns” in the difficult years after the financial crisis.
“Loss ratios remained low in the last downturn because banks were willing to ‘amend and extend’ the terms of loans to prevent losses at the operating companies owned by large private funds.
“But a lot of the leverage now sits with private debt funds and private credit funds. They may not be as willing to amend and extend lending terms in the next downturn,” said Mr Elio.
Intense rivalry will hinder strong returns
Private equity managers are unlikely to deliver the strong returns of the past thanks to increased competition.
Higher investor inflows into PE funds have led to intense rivalry and managers also face a challenge from sovereign wealth funds and cash-rich publicly traded companies when pursuing buy-out deals.
As a result, deal valuations have risen to record levels and this has reduced the returns PE managers are likely to earn.
Investors should expect PE to deliver annualised returns of 3.9 per cent after inflation and net of fees over the next decade, only a modest advance over the 3.1 per cent net real returns expected from low-cost US stock market tracker funds, according to AQR, the $196bn US alternative investment manager.
“Private equity does not seem to offer as attractive an edge over public market counterparts as it did 15 or 20 years ago,” said Antti Ilmanen, a principal with AQR.
Institutional investors, however, retain high expectation for returns from PE strategies. They have continued to increase their allocations which leaves them open to disappointment.
PE managers tend to buy smaller companies and add significant debt to their balance sheets after the acquisition. This implies that an appropriate performance benchmark for PE strategies would be a leveraged small-cap equity index, rather than the S&P 500 index.
AQR’s analysis suggests that PE outperformed the S&P 500 by 230 basis points a year, net of fees, between 1986 and 2017. That outperformance dropped to just 70bp a year compared with a 1.2x leveraged Russell 2000 (US small-cap stocks) tracker.
“The bottom line for many investors is that private equity firms have clearly delivered higher net returns than the S&P 500 over the past 30 years, even if those excess returns could largely be accounted for by using more representative publicly traded benchmarks,” said Mr Ilmanen.
Performance data for private equity managers are commonly presented as internal rates of return but these are relatively easy to manipulate.
A better metric is the “public market equivalent” which assumes the same amount is invested at the same time in the stock market as the commitments made by a private equity fund. This metric suggests PE funds have delivered virtually the same returns as the S&P 500 each year since 2006.
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