Over the last three or four months, we’ve received countless in-bound calls from consultants and third-party managers offering access to late-stage venture capital and traditional private equity (PE). We view these unsolicited pitches and others like them as anecdotal signs of sentiment and supply/demand imbalances.
We’re by no means opposed to the strategic use of private equity. In fact, under the right circumstances, it’s a terrific addition to a high-net-worth-investor or institution portfolio. The asset class has, at least historically, added a couple percentage points of performance above public stock market indices. So, assuming an investor has a reasonable distribution policy, a sufficiently long time horizon, and the financial discipline necessary for material portfolio illiquidity, an allocation to private equity can be appropriate.
A private equity fund raises capital from investors, locks it up for 7 to 10 years, and then, depending on the type of strategy, invests in the stock or debt of private and publicly-traded companies. At its core, private equity buys-to-sell. A PE fund purchases the securities of a company, steers the firm to improve its financials, and then, if all goes well, the fund sells in 2 to 6 years to realize a onetime, outsized profit.
With interest rates near historical lows and U.S. public equity market valuations stretched, investors are looking for ways to generate higher returns — thus the draw to private equity and its track record of excess returns. Pitchbook, a data analytics firm that tracks the M&A, private equity, and venture capital industries, reports that U.S. private equity fundraising is at record levels and is on track to rise 16% this year. There’s a lot of capital chasing private equity today.
But private equity isn’t a panacea. According to Cambridge Associates’ U.S. Private Equity Index, PE funds have underperformed broad stock markets since the 2008/2009 financial crisis. And now, private equity, like its public market counterpart, looks priced to generate subpar returns compared to its historical rate. In fact, it may be one of the worst times to add fresh capital to the industry.
Bain & Company, the global management consulting firm, notes in its 2017 Global Private Equity Report that business acquisition multiples are at all-time highs. The EV/EBITDA multiple, the private equity industry’s standard measure of the price at which businesses change hands, is currently 30% higher than the 20-year average. This should come as no surprise, because public market equity valuations are also stretched, and there is a clear connection between public market and private market business valuations.
If EV/EBITDA multiples return to historical levels over the next five years, private equity returns would be 4% to 5% lower, per year, than if valuations remained static. That’s not to say that valuations won’t remain steady or even rise further, but if your intention is to lock up capital for 7 to 10 years, it should be more than a passing thought that you might be locking in low single-digit returns for the next decade. And while lofty valuations are reason alone for tempered return expectations, we’re even more concerned because we think we are late in the economic and business cycle.
The fundraising, capital calling, and investing timeline of private equity can take years. For instance, the bulk of money committed to a private equity fund started this year, a 2017 “vintage year” fund, might not be fully called and invested until 2018 or even 2019. Why is that relevant? Because vintage year matters.
In general, the worst time to make an investment in the public stock market is immediately preceding an economic recession. Private equity investments, on the other hand, tend to perform worst with vintage years two or three years before a recession.
For example, the private equity funds with vintage years of 2005 and 2006 — funds created two to three years before the 2008/2009 recession — have had worse rates of return than the funds started at the top of the market. As the Cambridge Associates’ table above notes, 2005 vintage year funds were the worst performers. We think that’s due mostly to the fact that they were called and invested during the last two years of the bull market, locking in deals late in the cycle before the recession began, and leaving limited uncalled capital available to take advantage of bargains created in 2008 and 2009.
A private equity investment today, unlike simply adding a lump sum to the stock market, is really a commitment to invest over the next year or two, perhaps more, and then to hold those investments for another 5 to 8 years.
Based on our estimates of where we are in the business cycle (late), current business valuations (high), and the state of funding in private equity (excessive), the likelihood of subpar returns on capital invested in private equity today is uncomfortably high.
On the bright side, if you own a business today, it’s a wonderful time to sell. But by our estimates, it’s probably not the best time to allocate new capital to private equity.