Friday Letter: Joined-up thinking

It has been yet another breathtaking week for the private equity industry. The globe’s buyout behemoths played their part in “Merger Monday”, when in a frantic 24-hour period firms announced $75 billion worth of deals.  

The Blackstone Group was at the heart of the activity with its record-breaking deal to acquire property mogul Sam Zell’s real estate investment trust for $36 billion. The investment, which combined two of financial services’ hottest sectors, ended the brief, four-month reign of hospital operator HCA at the top of the buyout pile as the world’s largest deal.

Buyout activity has helped push the value of mergers and acquisitions announced this year above the $3.33 trillion record set in 2000 at the peak of the dotcom boom. Dealogic, the data provider, estimates private equity accounts for a fifth of all the takeovers and unions this year.

Meanwhile, investor appetite for private equity secondaries has hit a new high as well. Coller Capital has raised the cap on its latest fund by 22 percent to $4.5 billion.

Are these two phenomena linked? Absolutely. Demand for private equity’s outsize returns is seemingly limitless and investors are now pushing on into the next layer of the asset class.

And even if the secondaries market is just a fraction of the primary market – estimates vary as to how big this more opaque part of private equity really is – the dramatic increase of capital being set asid for the strategy is having an impact.

Anecdotal evidence suggests prices in some secondary deals are increasingly at a premium to net asset value rather than at the traditional discount. Some participants benignly suggest this is a sign of the asset class’s maturity. Undoubtedly true. But, fundamentally, it is about demand outstripping supply. Or as one investor told PEO, in a coy reference to the top of the market: “ Perhaps it is a sign we are at that stage in the cycle”.

But if some investors are piling into secondaries, because it is simply another route into the hottest asset class of the day, then it is also true that some of the more persistent investors see their secondaries investments as a hedge against some of the excesses of the current market. They are anticipating a fall-out similar to what they witnessed in the melt-down after the TMT debacle at the beginning of the century. There will be some fire-sale bargains to be had from less committed investors when the cycle turns.

The same investors are also hedging their mainstream buyout bets with more niche pursuits in special situation funds. Orlando, a German turnaround specialist, hit a home run this week with a flawless fundraising which never made it beyond a small group of hand-picked investors.

Another investor making strides in special situations is Jon Moulton of Alchemy, who has held a first close on his distressed debt fund. Moulton’s move into credit securities is prescient. But as far as one one large UK limited partner is concerned, even  Moulton may not be going far enough in terms of providing the safety net that some investors are looking for.

As the UK LP told PEO, the real hedge against the booming buyout market is in credit-focused hedge funds, which are flexible and nimble where buyout funds might labour. A hedge fund’s monthly reporting also offers investors real insight into the performance of their investment during potentially uncertain times.

Much has been made of the competition that hedge funds might offer their buyout rivals. But the real battle has yet to commence. The UK regulator Financial Services Authority has highlighted the uncertainty of financial ownership in today’s increasingly complicated credit markets as a high risk threat to financial stability. Astute investors are aware that where there is uncertainty there is opportunity. And if they join the dots they are well placed to profit.