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John Engle
John Engle
Articles (432) 

Private Equity Rebounds in 3rd Quarter After Slow Start

Investors continue to hunger for the long-term market-beating returns promised by fund managers

December 01, 2019

Private equity funds have experienced an explosion in popularity in recent years, as well-heeled individuals and institutional investors have sought greater exposure to alternative asset classes in their hunt for market-beating returns. Investors’ continued desire for exposure to PE was reflected in Private Equity International’s (Preqin) third-quarter industry update report, published in November:

“Appetite for private equity remains strong, despite escalating US-China trade tensions and an impending Brexit. The third quarter of 2019 saw private equity funds securing $163bn in aggregate capital, far surpassing the $138bn raised in Q2 2019.”

While all might appear well in the world of private equity on the surface, a deeper dive into the latest Preqin report reveals signs of difficulty ahead for the industry, especially for less well-established funds and organizations operating in the space.

Deal-making and exits face headwinds

2018 was a great year for private equity. Unfortunately, the industry failed to carry that momentum into 2019. Preqin found that while deals rebounded somewhat in the third quarter, the weakness of the first half of the year has yet to be dispelled completely:

“After a strong showing in 2018, global buyout deal momentum slowed in the opening quarters of 2019 amid challenging economic and geopolitical conditions. Q2 2019 recorded the second-lowest aggregate deal value since 2014. However, buyout deals have rebounded in Q3 2019 in terms of value: 1,157 transactions worth a combined $86bn were made globally. This was primarily driven by an uptick in activity in North America, Europe...In contrast, Asia-based deals experienced a 48% fall in value from $11bn to $5.8bn. Deal-making is not the only challenge facing managers, as buyout exits have also seen an appreciable drop in value and volume this year.”

After a tepid start to the year, private equity funds bounced back in the third quarter. While the uptick in deal momentum has helped to reverse much of the negative trend, there remains signs of weakness. Deal values stand out as the clearest example of this in the latest Preqin report. While the third quarter showed signs of improvement from earlier in the year, deal values remained below levels from a year prior:

“Private equity-backed buyout deal value in Q3 2019 increased from a three-year low in Q2 2019. However, at $86bn, the total value of deals in Q3 2019 was down 15% in comparison with Q3 2018 – every quarter of 2018 recorded over $100bn in deals.”

Allocations drying up amid liquidity concerns

As deal numbers and values have struggled in 2019, some investors have shifted some of their attention away from private equity. Preqin found that investors’ appetite for further allocations to PE funds and deals has diminished considerably over the past year:

“Investors generally intend to commit less fresh capital to private equity funds over the next 12 months. Nearly two-thirds (59%) of investors are looking to commit less than $50mn, an increase of eight percentage points on Q3 2018. Twenty-one percent of investors plan to commit a minimum of $100mn to the asset class over the next 12 months, a proportion notably smaller than this time last year (35%), which itself was down from the year before (50% in Q3 2017).”

Some investors have begun to question the value of their private equity allocations, especially with regard to the management and performance fees that remain very high across much of the industry. Allocators have also begun to fret about the long-term returns of their assets, though these remain largely muted. Of greater concern is the illiquidity of PE allocations, an issue that could become more severe in the event of a broad market or economic downturn.

Blue-chip brands stand out

Unsurprisingly, a reduction in allocations has also made raising capital from investors somewhat more difficult for private equity funds. This can be seen from a marked dropoff in fund closings:

“The number of funds closed has declined significantly though: 260 funds closed compared to 319 in Q2 2019, marking a five-year low in the quarterly number of funds closed. The concentration of capital among a small number of large funds continues its trend.”

However, while newer funds with more limited track records have struggled, older, larger and better established private equity funds have continued to enjoy robust interest:

“In this uncertain environment, investors are also flocking to established brands; in fact, the 10 largest funds closed in Q3 secured 77% of total capital raised in the quarter. With competition high and the market environment challenging, fewer funds are entering private equity: the number of funds in market has dropped since the beginning of 2019.”

A healthier approach to risk

For years, PE funds have found themselves inundated with allocator cash as individuals, institutions, pension fund and sovereign wealth funds have all sought to gain ever greater exposure to the asset class. When cash is flowing freely, funds often find it difficult to identify enough deals to go around. Competition among funds has certainly intensified over the past several years. With all these negative factors becoming increasingly visible, it is hardly surprising that investors and allocators would show greater caution.

In an October interview with Bloomberg, legendary investor Howard Marks (Trades, Portfolio) commented on investors’ broadly increasing propensity to hunt for higher returns in ever riskier places and why he sees such behavior as a danger sign for markets:

“I get nervous when there is too much optimism; too much risk tolerance...You can see signs of that...When investors fall over themselves to supply money for risky ventures, that’s the kind of thing one should look for."

Taken in this light, investors’ recent reticence to jump deeper into private equity can be seen as a somewhat heartening sign.

Verdict

Investors and allocators may still be chasing yield in dangerous places, but clearly they have not succumbed to irrational mania.

The heightened skepticism facing the private equity industry is perfectly warranted. Investors should expect further questioning from allocators in the year ahead.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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