PE Panorama: Investor 101 as opposed to PE rocket science

21 August 2017   Category: News, Asia, China, USA, Europe, United Kingdom   By Paul Mackintosh

This blog has not been short of comment on the current feverish fundraising climate in private equity (PE) – or the likely consequences for returns further down the line.

As it happens, last week there were a couple of new data points relevant to both of those issues. First off, the Financial Times and a number of other news outlets picked up the report from data provider Pitchbook that cites over US$240 billion raised year-to-date in Europe and North America for PE and venture capital funds.

That, of course, skips over the fundraising under way across Asia, the Middle East, and elsewhere. But the figure still puts the industry within sight of the $419 billion, which Pitchbook says was raised in the immediate pre-global financial crisis period, in 2007.

Investors with longer memories than the institutions currently ploughing bucks into PE will remember that many of the deals struck in the immediate pre-crisis period also turned out to be white elephants, as the volume of capital seeking an outlet pushed entry valuations up past any realistic prospect of returns on the downside.

Investments made in a peaky market are naturally going to be geared to that peak, and investors may wait in vain for any commensurate returns later on. That isn’t PE rocket science: it’s investor 101. But, rather than waste time wondering why institutions are ignoring this basic principle, let’s move on to how the entry valuation environment actually looks right now.

Valuation services provider Murray Devine has conveniently provided a timely report on just that. Its Private Equity Valuations Report for the first half of 2017, just released and incidentally using Pitchbook data, notes that “valuations as a multiple of EBITDA [earnings before interest, tax, depreciation and amortisation] - at 13.7x in the first six months - represent a ten-year high so far, at 2017’s midpoint” for US PE deals.

Yes, US PE investments are now being made at far higher valuations that at any time during the immediate pre-crisis private equity gold rush of 2006-08, when average valuations hovered around 10-11x EBITDA.

This isn’t to say that PE firms are blindly rushing ahead – the report also notes that US deal flow and deal count has pulled back sharply during 2017. But the report does demonstrate that returns from the vintage being raised just now may be severely challenged.

“Scan recent history and over the past decade, it’s the 2009 vintage year funds, raised in the wake of the global financial crisis when valuations were at a trough, that have generated the best returns,” Murray Devine’s analysts observe.

And now entry valuations are at astronomical highs. Can we expect to see correspondingly low returns from this vintage? I’d hope not, but I wouldn’t be surprised.