The news that private equity investment in the U.S. fell by almost 50% to $41 billion in the second quarter, compared to investments totaling $80 billion in Q2 2017, may have startled some market observers, who had watched the segment hit record heights in 2017. But keen observers remain unfazed, confident that investors will soon be itching to jump back in as valuations improve.
The second quarter also saw U.S. private equity fundraising volume (as opposed to investment volume) fall nearly 70% to $19 billion in Q2 2018 from $55 billion in Q2, 2017, according to data from the American Investment Council’s (AIC) 2018 Q2 Private Equity Trends Report. Research firm Preqin also marked the downturn. Its recent Q2 Fundraising Update, titled Private Capital: Easing Off, stated that “following a slowdown in Q1, 2018, the private equity fundraising market saw a continued slump in Q2.
In fact, the first quarter of 2018 saw 246 funds close, raising a total of $88 billion–the first time in six quarters in which fundraising totals did not exceed $100 billion. Similarly, the second quarter recorded 234 fund closures worth a combined $86 billion.” Preqin expects these figures to rise by up to 10% as more information becomes available, “but nonetheless it looks as though 2018 is some way off 2017’s fundraising levels,” the report said.
Given all the data, the numbers don’t tell a particularly promising story for the sector. Yet researchers caution that these figures don’t necessarily signify a downward trend in the PE market. Instead, they chalk the declines up to high valuations, which may point to investors taking a breather, before barreling back into the sector.
“Valuations of prospective companies for acquisitions are high right now, so fund managers are being prudent,” reasoned Bronwyn Bailey, vice president of research and investor relations at the AIC. “They don’t want to purchase companies at exceptionally high prices. Instead, they are looking for companies with the potential to grow. They are being a little pickier, which is why you see the drop in investment,” she said.
Looking at the overall market she noted: “Generally speaking, investment levels have not been keeping pace with fundraising, and in my view, it’s because fund managers are being more prudent about where they put their capital,” Bailey added. She predicted that as valuations come down, investments could pick up later in the year.
Is there too much dry powder?
Another reason investment could pick up is because private equity funds continue to sit on high levels of dry powder. “The U.S. private equity industry has amassed $353 billion of dry powder, as of December 2017, according to the AIC report. It marks a 44 percent increase from the $245 billion of U.S.-based callable capital reserves available in December 2016, according to the report. That’s a whole lot of money sitting around, waiting to be put to work.
“Dry powder levels continue to hit historic levels and reflect the robust and fast-paced fundraising environment over the last few years,” Bailey stated. “With record levels of dry powder, fund managers are well-positioned to invest more capital in growing businesses and industries across the country,” she said.
With so many options to choose from, the balance of power is swinging ever more in investors’ favour, enabling them to negotiate more favourable terms and fees.
Researchers at Preqin wonder if the amount of available cash is the result of too much success with the asset class. “The industry is possibly a victim of its own fundraising success: huge inflows have seen total, private capital dry powder approach $1.80 trillion, as of the end of June, with over $1 trillion alone available to private equity fund managers,” the Preqin report said.
It continues: “Investors remain committed to most private capital asset classes, but it is possible that some may be waiting to see fund managers deploy some of that capital before making further investments. When investors do make commitments, though, there are a myriad of funds [sic] seeking their capital. With so many options to choose from, the balance of power is swinging ever more in investors’ favour, enabling them to negotiate more favourable terms and fees.”
Lower valuations good for the market
The pullback of investment in the sector in the first half of this year actually began before Q2, according to Bailey. “Our data shows a drop in 2017 in volume of investment,” she noted. Bailey blames high valuations, which peaked last year, but have since come down. The average purchase price multiple of a company for U.S. buyouts in Q2 2018 dropped to 8.3 times EBITDA compared to Q2 in 2017, when it was over 10 times EBITDA, she said.
“Valuations have dropped; if that sustains, then we will see more investments, Bailey said. “Firms have been prudent in investing, but investments are more attractive when you can buy them cheaper. If valuations continue to be close to 8 times EBITDA, I expect to see more investment,” she said.
Looking to end of 2018
Going forward, “I expect valuations to even out as interest rates rise and debt becomes more expensive,” Bailey predicted. She also believes that when this happens, fewer fund managers will be competing for investments. “As some fund managers stay on the sidelines, there will be less competition for deals, and valuations will go back to normal levels,” she predicted.
The flip side is that fund managers with lots of dry power will be poised to make a lot of investments. Similar circumstances “happened in the last recession,” Bailey observed. “A number of firms that had just raised large funds had the benefit of investing when valuations were at historical lows, and those funds performed very well,” she said. In fact, PE investment volume reached a record high last year of $379 billion, making it the second highest year since to 2007, when investment volume reached $631 billion.
A move from public to private
The introduction of new private deals to the market should continue to abound in the coming years. In fact, the rate of growth of new deal offerings is currently in stark contrast to the number of companies going public. “Studies show that the number of public companies has halved since the late 1990s, as many companies now wait for billion-dollar valuations before considering going public,” Bailey said. The number of listed companies shrank to 4,331 in 2016 from 8,090 in 1996, according to the World Bank, World Federation of Exchanges database.
By contrast, the amount of capital flowing into private markets has quintupled since then, indicating that more companies that are hesitant to go public may continue to look to the private markets for funding, Bailey said. According to data from the 2016 Preqin Alternative Assets Performance Monitor, assets under management grew from just over $500 billion in 2000 to just under $2.5 trillion in 2016.
There may also be a trend on the horizon of public companies returning to the private sector. Chief Executive Officer (CEO) Elon Musk of the approximately $60 billion Tesla–an American multinational corporation that specializes in electric vehicles, lithium-ion battery energy storage and solar panel manufacturing–recently announced that he may take the company private. In a letter to Tesla employees, Musk cited quarterly earnings reports that may distract from the company’s long-term goals and scrutiny from short sellers, as reasons for doing so.
The $5.270 billion data and analytics company Dun & Bradstreet also recently announced it was going private. It will be acquired by a group of investors led by CC Capital, Cannae Holdings and funds affiliated with Thomas H. Lee Partners, for $5.38 billion in cash. Dun & Bradstreet shareholders will receive $145 in cash for each common share, the company said. “Under a private ownership structure, the Board of Directors believes the company will be able to accelerate the execution of its long-term strategy and focus on delivering the unique and vital data, analytics and insights that customers have relied on for the past 177 years,” said Emile Lee, a spokesperson for the company.
Looking ahead, Bailey believes the future of private equity investment is as bright as ever. “There are many reasons to be optimistic about PE this year,” she asserted. “LPs continue to invest in PE funds after receiving historical distributions, or gains, over past years from earlier PE investment,” she said. “The opportunity set for investment is still rich, and if valuations start to drop, we will see more investment,” Bailey said.