Deal purchase prices vs. LP return expectations
Entry valuations in private equity deals have been increasing for every year since the Global Financial Crisis. Back in 2010, fewer than 20% of US buyout deals were completed at an enterprise value to EBITDA purchase price multiple of greater than 11x; in 2020, that figure had risen to over two-thirds, according to Refinitiv LPC data. That is a significant increase even on 2019 figures, when around 55% of US buyout deals were struck at EV/EBITDA multiples of over 11x.
Some of last year’s increase is likely to be down to a flight to quality as private equity houses targeted strong businesses that benefited from the changes wrought by COVID-19.
However, the longer term trend towards higher entry valuations has been driven by a confluence of factors, including low interest rates and high liquidity pushing asset prices, more generally, upwards, plus rising private equity dry powder as the industry has attracted significantly more LP capital. North American private equity firms alone currently have $976bn ready to deploy – a record amount – according to recent Preqin figures.
Given the high valuations we’ve seen in the market over recent times, it is perhaps unsurprising that some LPs are starting to wonder what will happen with returns for 2020 and 2021 vintages.
“It’s very difficult to be optimistic,” says Steve Moseley, Deputy CIO and Head of Private Markets and Alternative Investments at Alaska Permanent Fund Corporation. “We are certainly getting indications of some amazing realizations to come as valuations continue to climb, but we know that dollars invested in expensive markets return less than those invested when assets are cheaper. We’re closer to the peak than we were a year ago and so I have to assume that recent vintages will perform worse than the industry average – and that is barely into double digits.”
Scott Ramsower, Co-Head of Private Equity Fund Investments at the Teacher Retirement System of Texas, also has some concerns. “To the degree that our GPs get good returns from 2020 vintages, it won’t be because they acquired at attractive valuations during the COVID-19 blip,” he says. “All we really saw was a brief pause. It will be because of a continued movement up and to the right for purchase price multiples. We are seeing our 2018 and 2019 vintages already well into the 20s in IRR terms – and they are obviously young portfolios. We have to ask whether 2020 will beat that. We’re seeing incredible numbers currently because of the strength of the markets – it’s hard to see how that continues.”
Not all LPs are as bearish, however. A recent Coller Capital survey of LPs for its latest Barometer found that 70% of LPs were forecasting net returns of between 11% and 15% over the next three to five years, with a further 13% anticipating 16% to 20%. They are even more optimistic about private equity in North America. For venture in the region, 55% of LPs expect returns of at least 16%, and for buyouts, 31% are forecasting 16% or above.
J. David Enriquez, Head of Private Equity at New York City Retirement Systems*, believes that performance may well vary according to sector and those with the right specialist expertise could fare better than others. “If you separate out the 2020 vintage according to specialist areas, GPs focused on areas that are likely to benefit from COVID-19, such as healthcare and technology, really ran hard at assets and paid above-market multiples,” he says. “These GPs had a conviction that they could underwrite to generate private equity-level returns. It may be that we see aggressive and assertive investors with specialist knowledge do well compared with more generalist funds.”
Yet while the pandemic may separate the specialists from the rest, there is a view that it may have had a more widespread effect. “The biggest change from the pandemic,” says Lauren Goodwin, Economist and Director of Portfolio Strategy at New York Life Investments, “is a change in mindset around valuations. Pre-pandemic, pricing was already high, but there was no reset as a result of COVID-19. Some investors are now asking what it would take to bring the market downwards.”
Indeed, the fact that the market kept going and that valuations continued to increase even in the face of a massive shock may fundamentally alter investors’ thinking about pricing, suggests Goodwin. “There is so much available capital in the market, we may continue to see valuations remain persistently higher than historical average over the long term,” she says.
This trend, she concludes, makes it more important than ever that LPs back GPs with strong expertise. “It will be possible to generate strong returns,” she says. “But it will require GPs to pull multiple value creation levers. The emphasis will increasingly be on building organic growth. Our alternative investments teams look to GPs that have executed on their strategy multiple times before, that have a sector specialism and domain expertise so they can really understand what the levers are when looking to make management and operational improvements. We see potential for sustaining returns even in a high multiple market, but GPs really have to stick to the fundamentals.”
*The Wall Street Journal reported that J. David Enriquez’ last day at the NYC Bureau of Asset Management was May 7, 2021 and PEI subsequently reported that in June he will be joining Rothschild Five Arrows, the merchant banking group of Rothschild & Co.
