2014 will test PE alpha skills

Private equity is facing a new reality, with “ferocious” fundraising competition, mountains of dry powder, rising asset valuations, an exit overhang and volatility in the capital markets that “could paralyze deal making”, according to a recent report on global private equity from Bain & Co.

“With asset prices high and showing no signs of coming down, GPs will need to stretch every link of the value chain—from deal sourcing to exit—to steer clear of bad deals and spot deals that have peak-performance potential and to find ways to reap their full value,” the report said.

Asia’s numbers are bleak, the report showed. Private equity deal value in China last year dropped 38 percent year on year to $11.4 billion. China’s GPs had ample dry powder – $36 billion at the beginning of 2013 – but unfavourable valuations limited investments.

Exit activity in China “has fallen steeply and steadily over the past four years, where economic headwinds and inaccessible public equity markets proved stronger than the pressure GPs have felt to sell assets”, the report said.

Last year, exits fell to 109 and exit proceeds to $21 billion. That compares with 2010, when GPs in China had 256 exits, realising a total of $63 billion. 

In India, deal value rose 19 percent, though the increase was largely the result of one deal: Qatar Foundation’s $1.26 billion investment in Bharti Airtel, a wireless telecom company.

Confidence in these markets won’t be restored until GPs start generating profitable exits. 

“The emerging market behemoths, China and India, have disappointed most of all,” the report said.

In Southeast Asia, deal value fell about 20 percent to $4.3 billion. However, the report pointed out that sovereign wealth funds doing $1 billion-plus deals have pulled back from the market, putting the total value of core deal making by GPs slightly higher than in 2012.

The report said GPs are in “brave new world where alpha rules”, and the firms with the edge in this environment are the ones that can generate alpha. 

GPs that managed one top-quartile fund had about a 65 percent probability that their next fund would perform above average, according to data cited in the report. 

Alpha-deficient GPs that managed an initial fund that placed in the bottom quartile faced a 61 percent probability that their successor fund would also be a subpar performer.

The consultancy said it found key differences between top alpha-generating funds and the laggards, and advised firms to evaluate risk/return carefully to avoid deals that could be losers and find winning deals that are bigger deals.

Alpha-rich funds not only have more winning deals than losing ones, but “they win bigger with their winning deals, and they convert more large deals into big winners”.