LPs like US mid-market despite high valuations – study

Placement agent Probitas Partners released its Private Equity Institutional Investor Trends for 2016 Survey, which produced what managing director Kelly DePonte called a “schizophrenic finding.”

DePonte was referring to the survey result that 41 percent of the 104 respondents said purchase price multiples for middle market buyouts are “too high” and “threaten future returns,” making this among the most highly ranked fears along with too much capital entering PE and fear that PE is at the top of the market cycle.

“Yet, they’re still focused on middle market buyouts,” DePonte told Private Equity International. “They’re not necessarily taking on large defensive actions.”

The survey polled public and corporate pension plans, funds of funds, insurance companies, family offices, endowments and foundations, and consultants and advisers globally.

Of those, 76 percent expressed a strong interest in the US middle market buyouts of between $800 million and $2.5 billion. Among the North American respondents, this interest was even stronger, with 85 percent of them choosing the US middle market buyouts as their sector of interest.

One of the reasons for this is that over the past two or three years, LPs received a lot in distributions of their past investments, and are now trying to plough the commitments back into PE, DePonte said.

The survey, which was held online in late September and early October, found that 27 percent, the biggest portion of respondents, said they are “roughly at our target and are looking to maintain that level of exposure,” meaning they have neared the top of their allocation.

At the same time, over half of investors said they are “evaluating re-ups with current GP relationships with a limited look at new relationships,” reflecting the trend of large LPs like the California Public Employees' Retirement System cutting the number of managers.

“But the real danger is that prices are very, very high. For both US and European buyouts, purchase price multiples are near or above the 2007-2008 levels. The more you pay for something, the harder it is to get good returns,” DePonte said.

The trick for investors is to make sure they are not sitting on the peak of the cycle when making new commitments, he said. When the cycle comes down, purchase price multiples will fall, creating a favourable environment to buy with dry powder, which currently sits at $1.3 trillion. But that also means a more difficult time for GPs to fundraise, he noted.

Only 6 percent of large investors said in the survey they do not pursue co-investments or direct investments, while 46 percent said they have an active internal co-investment program and 14 percent said they invest directly in companies.

DePonte added that, while a lot of investors focus on the cheapness of co-investing compared with traditional fund commitment, at the end of the day, it doesn’t matter how much they save on fees if they make a bad co-investment and lose money.

Moving forward into 2016, DePonte said the record amount of dry powder could be beneficial if there is a market correction, and the longer it takes for the cycle to come down, the $1.3 trillion puts pressure on GPs to invest at the currently high prices.

“Private equity is cyclical; when you have a good thing, too many people pile into it. It’d be crazy not to anticipate a correction anytime between six months to two-and-a-half years from now,” DePonte said, adding that, when the market corrects itself, however, it won’t be like 2008.