At a recent conference for high net worth investors, TPG Co-Founder David Bonderman repeated a cliche which private equity guys bandy about when the markets get hot.
“We are selling everything that isn’t nailed down,” he said, remarking on high market multiples and strong private equity (PE) returns in recent years. Probably not the first time he said it, nor is he alone in making the comment (Apollo CEO Leon Black made the same comment in 2013). But ironically, TPG in February was finishing up fundraising on its 7th mega-fund with $10 billion in commitments, presumably to buy new companies. Is this logically consistent behavior, another example for Bernie supporters of Wall Street greed or a market paradox?
The answer is all of the above. Let’s call it the Bonderman paradox. It’s difficult to raise money when it’s a good time to invest, i.e. prices are low. It’s easier to raise money when it’s a bad time to Invest, i.e. prices are high. In private equity as in other markets, investors make lagging decisions based on historical results which often don’t reflect changing circumstances and crowd each other out.
That’s why the private equity market is highly cyclical. Between 2010 and 2014, the combination of cheap debt, low, expanding multiples and recovering GDP resulted in strong PE returns. Now those elements have reversed: leverage is harder, entry multiples are high and growth is sluggish. Recent data from Cambridge Associates shows that the PE market cycle peaked in 2014. Returns are coming down. So why are investors still piling in?
For institutional investors: “4 is the new 8,” but is PE the panacea?
At institutional investor conferences this year, consultants have been proclaiming somberly that “4 is the new 8” referring to anemic returns recently relative to typical 8% hurdle rates for pension funds. McKinsey published a report this month questioning whether returns are really coming down to a new normal or just returning to their historical norm; instead, McKinsey argues in “Why Investors May Need to Lower Their Expectations” that the last 30 years were the anomaly. (My brief counter: McKinsey underestimates opportunities for productivity gains in the U.S. economy – not only in technology, but in major sectors undergoing change like healthcare and infrastructure). You don’t need a consultant to tell you that it’s a tough market to generate sustainable returns. But increasingly private equity has become the panacea of choice to offset low public equity and fixed income returns, because of recent relative outperformance, illiquidity and long timeframes. It’s become another way for institutional investors to kick the can down the road. As a result, pension funds and endowments are relying more heavily on private equity allocations than ever before to make up for lost ground in other asset classes. Hedge funds are choking on volatility. Fixed income returns are anemic, distorted for 8 years by zero-rate central bank policy. Public equity markets have diverged from fundamentals, with slow growth and sluggish returns.
The conventional wisdom for institutional investors has become to increase their private equity allocation, especially to mega funds like Blackstone and KKR. These firms provide scalable vehicles to write big checks on long-term bets that are difficult to evaluate on a short-term time frame. Recent vintages have comfortably beat the public markets. But the outlook is uncertain.
For investors, illiquidity masks the volatility and cyclicality of the private equity asset class. There has always been high variability in PE vintage performance based on where entry and exit multiples are in the market cycle. The typically long J curves are getting longer. The statutory life of a PE fund is 10 years but the true average is almost 14 years and many extend to 15-17 years. Long term returns in PE are down due to overcrowding – the highs are lower and the lows are lower.
For U.S. companies: PE “Sponsors” Are Crowding Out Owner-Operators
Cyclical downturns get solved in time, but private equity (and limited partners) now face a more serious secular problem due to the sheer size of the industry which has ballooned relative to the opportunity from $500 billion in 2000 to $4 trillion in 2015, according to analyst firm Prequin. Historically, PE has played a positive role in improving the productivity of the U.S. economy, by fostering growth and increasing the scale of companies. Periodically, the industry binges and blows itself up – most famously, RJR Nabisco in 1988 and TXU in 2007 – but the buyout model is not just about bloated megadeals.
The middle market ($20MM to $1 BB in revenues) used to be a growth milestone between small and large, instead of an endpoint. For middle market companies, the predominant model for private equity financing is control buyout transactions. The pervasiveness of this “middle market buyout” model is bad for the U.S. economy. It has caused harm to one of the key engines of U.S. innovation and may have undermined the economy recovery since the Great Recession. Buyout firms create perverse incentives for founder and family-owned businesses to exit earlier than they might have otherwise. Middle market private equity- backed companies are developed to scale and exit to enrich their private equity owners versus owner-operated businesses that have created some of the world’s most durable, long-term companies (Ford, Microsoft, Comcast, Bechtel). The big exception to this rule is Silicon Valley’s venture capital industry where the founder-owned model still dominates amid generous equity valuations. But for less sexy industries like infrastructure, manufacturing and healthcare services, a growing and profitable business often has limited options for growth financing without losing control and being subject to high levels of debt.
Financial buyers with large funds want control so they can write $50-500MM equity checks and raise cheap debt to lever their returns. As a result, private market transaction multiples rival public multiples — a function of excess leverage capacity, not the potential for corporate efficiency, operating scale or rationalization. The result is a shift in emphasis among growing middle market companies to financial engineering versus innovation and long-term growth. Excessive debt and outside ownership run counter to the ethos of the owner-operated business which has historically built many of the long-term franchises and generational family-owned businesses. PE-owned companies carry 5-7x EBITDA in debt resulting in excess financing costs which detract from investment dollars in product and people. Outside managers might be well-trained and highly rational, but the agency cost of hired guns versus owner-operators is difficult to quantify.
Looking Beyond PE: Non-Sponsored Credit and Growth Capital for the Middle Market
In terms of size, the private credit market is almost as big as the private equity market was in 2000. In terms of development, it is still an immature industry. Private equity allocations are mostly just spilling over into private credit, but the next step is for private credit to stand on its own as an asset class. Most private credit firms today are adjuncts of the private equity industry, providing leverage services to PE firms and outsourcing origination, structuring and portfolio management to their PE partners.
At Lateral, we believe there is a $1 trillion opportunity to create a non-sponsored private debt and hybrid debt-minority growth equity market that generates 4-10 percentage points of premium (as historically, private equity has done relative to public equities) by developing proprietary origination, bespoke structuring and high-touch portfolio management capabilities in partnership with great owner-operated private companies. Opportunities abound for growth amid upheaval in the healthcare industry and pressing needs for infrastructure upgrades to name two of our investment themes. For investors, the opportunity is to take uncorrelated idiosyncratic risk in and receive outsized rewards from growing private companies and add some life into their moribund fixed income portfolios. For companies , the opportunity is to retain control, align long-term interests and scale successful companies beyond the middle market – or remain as a successful cashflow generator for owners with no exit in mind.
The private equity industry over the next decade is unlikely to be the panacea for the unfunded liability crisis that pension funds and endowments are facing. Eight years of easy monetary policy produced a strong financial recovery with stock market gains and private equity returns, but failed to restore growth. Now too many asset allocators are chasing returns in PE and too many funds are chasing too few deals, resulting in high entry prices and the prospect of low returns. The unprecedented number of businesses owned by financial owners instead of owner-operators is bad for the U.S. economy. This problem is going to get worse, before it gets better. The overhang of nearly $3 trillion in unlevered dry powder in PE funds (theoretically $6-9 trillion in potential buyout values) may take 15 to 20 years to work off.
Ultimately, only real GDP growth will provide the panacea investors are looking for. Long-term economic growth is rooted in widespread productivity gains and the development of long-term business franchises that enrich a multitude of business owners and their employees, not a concentrated group of financial buyers.