There are three theories doing the rounds of the private equity community at the moment. The first is that the current abundance of capital – for both equity and debt – is pushing up prices and that this will inevitably erode future returns. The second is that performance over the long term is good and certainly good enough to justify investors allocating ever-increasing amounts to the asset class. The third is that investors, i.e. LPs, are not expecting to maintain their current net returns.
Given that there is some truth in all three theories, the question for investors must be how to pick, from the rather large crop of funds now being launched and raised, those that will deliver the best returns.
Valuation methodology has changed over time as fund managers took steps to justify investments at higher prices. In the 1980s, businesses were valued on multiples – usually six to seven times – of historic, actual, proven and audited profits after tax. In the early 1990s, the same multiples were being applied to larger profit figures, stated before interest, tax, depreciation and amortisation. By the late 1990s, valuations were made on the basis of undelivered and unproven future earnings and, in some market segments, on the basis of revenue multiples. The bubble burst and we all went back to profits though, this time around, on run-rate EBITDAs at similar multiples to those that we applied in the 1980s to historic P/Es.
The price is high
It is salutary to note that if we were to apply 1980s valuation methodology and multiples to today’s transactions, we would effectively be paying two thirds of current prices.
In the UK, the money raised for private equity investment has increased exponentially over the past 15 years and the number of fund managers has grown five-fold. Although much of the money raised by BVCA members has been raised for pan-European funds, there remains a substantial amount of overhang money still waiting to be invested in UK businesses. And the gap will grow as each year the total money raised exceeds the amount invested.
This on its own may drive up prices, as excess money chases every deal. Moreover, the situation is currently exacerbated by lending banks being relatively aggressive with their cash. Readily available debt is also driving up prices and thereby, through greater leverage, maintaining returns to private equity houses.
A mid-market buyout making PBIT of £1 million would have cost £7 million of debt and equity in 1996. Today, these deals are costing up to £14 million. Similar price increases are evident across the buyout board, although only the largest deals attract the attention of the press.
So, undoubtedly, we are in an era of increasing prices. As a result, discipline in negotiating transactions is key. Some firms are already walking away from deals or not even entering into auctions because they cannot see their way to making good returns. A manager’s proven ability to hold back firepower until the market adjusts or the determination only to invest on sound multiples must be hallmarks that LPs will be looking for in backing new funds.
Long-term decline or cyclical dip?
Given high prices, are we still confident of producing returns over and above other indices? The table shows unrealised IRR by vintage year since inception for funds invested by BVCA members. Historic returns have been good – typically, over 20 percent. But returns have been falling since 1994’s funds. We do not yet know whether this is a trend in our industry or just the effect of a cycle. Returns thus far still exceed other markets, but are we culpable of resting on our laurels?
True performance is of course only apparent when a fund is wound up, so investors are taking a punt on all but the longest established firms. Even then, LPs are investing in a very different market and, invariably, backing different teams with most of the original private equity firms having experienced generational change. We have no clear benchmarks in our industry and, in spite of recent improvements, we still lack strictly comparable transparency – even to our LPs.
A variety of strategies has emerged over the past 15 years as the private equity market has grown and become competitive. A few firms started with clearly defined strategies, modifying them to the strengths of their teams, but for many, differentiation has been a reaction to competition. So, we have seen the market segment into size and type of deal, structure of deals, portfolio management styles, deal sourcing mechanisms, sector focus and geographical focus. Our market has become sophisticated. And, with the advent of hedge funds competing for deals, we shall see further differentiating strategies evolve this decade.
The next five years will reveal whether falling returns are a trend or part of a cycle and how successful the many differentiation strategies have been. If the decline is a trend, we will see money falling away from all but the best private equity funds. The differential between top quartile returns and the rest is some 10 percent. I believe we will see that gap widen at all parts of the market, from venture through lower mid-market to very large buyouts.
That being the case, how should fund managers pick the funds that will produce good returns?
Directions for savvy money
Money, in theory, follows historic performance, but historic performance is no guarantee of future success, especially when the more dynamic members of an established firm have left to set up their own partnerships. The trend of long-established fund management teams raising larger and larger funds based on historic performance, may not deliver future returns. Much of the ‘savvy’ money is following experienced managers in new firms, new niches and with new products.
Secondly, the focus should not be on today’s hot sectors or geographies but on those that will be hot in seven to 10 years. It is too late to back a sector, a niche or a geographically defined strategy when upward trends are already established. LPs need to look for the GPs who are looking for the beginnings of upward trends and finding the opportunities of tomorrow. Ten years is a long time in any market.
Finally, as the market continues to become more sophisticated, the only way to protect future performance is to invest in funds managed by the best people who have a defined focus, the discipline to adhere to that focus and adequate control of both the team and the portfolio. Even in a mature market, there will always be winners. LPs need to focus on specialised, local, proven and yet motivated GPs with clear strategies that really add value and with whose interests their own are closely aligned.
Peter Brooks is managing partner of Sovereign Capital in London.