Friday Letter: Trouble for some

Is it a bubble? Record amounts of institutional capital have been flowing into large-cap buyout funds, and there are few signs of a slowdown any time soon.

GPs hoping to organise heavyweight funds will probably do well to move swiftly, just in case some sudden shock to the system prompts investors to pull back. But the underlying trend is clear: investors are hungry for yield, and the buyout groups look like they can deliver. 

OK, fine – but is it a bubble? By its nature, this question cannot be answered with certainty. Bubbles have to burst first before a consensus will emerge that they really had been there in the first place. Shortly before a big bang, feverish talk about blatantly unsustainable growth will be widespread. But that talk always fails to provide the safety valve, the vent for all that steam. People still get caught in the resulting explosion. 

In private equity, few practitioners appear particularly nervous at this point – which leads us to conclude that an imminent explosion is unlikely. Experienced investors in the asset class tend to agree that all in all, the buyout market is probably up to the job that the big investors (especially the public pension plans) expect of it, namely help them fund their rising long-term liabilities.

Seasoned LPs often point out that relative to the public market, private equity remains a small asset class, even if roughly a trillion dollars has been put into funds in the last five years. Of course, with more capital coming in, absolute performance is bound to deteriorate. As assets under management increase, performance will go down, and erstwhile lithe financial entrepreneurs turn into slow-moving asset gatherers in the process.

But if you evaluate investment opportunities on a relative basis, you shouldn’t get too depressed about what is happening to buyouts. Here is how a leading fund investor describes his position: “Long-term buyout performance will likely be lower than the recent strong returns. However the asset class will outperform public markets by a small but relevant margin, of the order of two to three percent without any selection for better funds.”

This is a thesis based on the assumption that the asset class as a whole will continue to see “substantial and profitable growth”. Factor the intelligent use of manager selection skills into this most basic of equations, and it is easy to see why clued-up limited partners remain calm at the site of novice investors rushing to get into the class.   

So no bubble, then. Good. But as the fundraising boom continues, things will get messy at least for some – especially those that haven’t been around for long. Right now the veteran LPs do not have many encouraging things to say to investors that have just come in. Some of this scepticism is of course intended to patronise. But it is also telling that secondary specialists are already rubbing their hands at the prospect of getting to bail out some of the late arrivals. 

Says one such specialist: “A number of new investors are definitely biting off more than they can chew right now. The fundraising boom has many of the hallmarks of what happened in 1999 and 2000, and it will probably take no more than two or three years for some of these investments to re-appear in the secondary market.”  

1999 and 2000? Now there was a bubble. Perhaps private equity should let off some steam after all.