By Wu Guowei Jack, CFA – Director of Content, APAC at CAIA Association
Late Cycle Risks
In the private markets world, the term “late cycle risks” has been much bandied about in recent years. A combination of high-entry multiples, high leverage, and a record amount of dry powder no doubt has driven concern among investors.
The concern is real and there are signs of late-cycle behavior. In recent years, deal timelines have become compressed, due diligence schedules have accelerated, and business plans are relying on the best-case scenario. The result is a rush to complete deals while pricing them for perfection.
Declining average returns, but steady top-quartile returns
The rise of private markets has been a structural trend for about two decades. Attracted to higher returns amidst a low interest rate environment, investors have allocated more and more of their capital to private markets, allowing them to capture multiple sources of return and create a well-diversified portfolio in the process.
With the backdrop of increasing demand for private investments, yet a limited opportunity set, competition for deals has driven up average entry multiples. From private equity to private real estate, private markets have become a victim of their own success and making money by “buying well” is getting tougher.
In fact, average private equity returns (as measured by IRR) have been trending downwards over the last two decades. According to a recent report by Bain1, average global buyout returns, which we can use as a proxy for private equity returns, have fallen quite substantially since 1999.
Figure 1: Average private equity returns have been trending downwards, while top-tier returns remain steady.
Source: Bain Global Private Equity Report 2020
This suggests a maturing market. In the past, a private equity General Partner (GP) with a long horizon could enter a down market, buy low, and exit in an up market. But such inefficiency has been reduced as the more GPs have entered in the industry and investors have chased returns to the point where dry powder has increased to record levels.
However, what remains unchanged is that private equity enjoys a natural advantage in having a long time horizon to create value. In contrast, most public companies are under pressure to deliver good quarterly earnings or to maintain a constant dividend payout.
GPs with a skilled team can still buy good companies and make them better, or buy bad companies and turn them around. The problem for LPs is that return dispersion is much greater in private equity than in public markets.
Bain’s report1 also points out that while the average private equity returns have trended downward, top-quartile returns have remained steady. Importantly, they were able to establish that it is still possible to consistently outperform. In their study of a pool of 113 successful private equity firms, 25% of them were able to consistently achieve top quartile performance with at least 80% of the firm’s fund across a period of 16 years. They further characterized the outperformers along various parameters. From my perspective, the key commonality among the outperformers is their emphasis on sector expertise and value creation.
There is a long list of value creation strategies: using strategic levers to change the business model and in turn achieve a higher multiple, using operational levers to improve the execution of the business, or “buying and building” in fragmented markets. All of these options point to a combination of improvement to the company’s top-line, bottom-line, margins, pricing, or product mix. These value creation strategies have been covered extensively by various management consultants and advisors.
I believe that value creation should be the front and center of every acquisition. Instead of shooting at every deal and trying to retrofit with a value creation plan, maybe one should establish a few high-conviction value creation plans and find the deals that fit into that plan. This means having a clear value creation plan should be a pre-deal consideration and should be used in deal screening.
Another good reason to focus on value creation plans first is the enduring competitive advantage it provides. In Bain’s report1, they point out that the group of managers that consistently outperform have a specific focus on sharpening their value creation proposition. As a result, this group sources deals where others are not actively looking. They also have better judgement on what works, or what does not work in the execution of the business plan. Finally, they are always developing and adding capabilities to better execute their value creation plan.
In today’s environment, where valuations sit at high levels and the competition for private deals continues, it’s becoming harder to simply finds deals where multiple expansion and financial engineering will promise consistent top quartile performance. GPs who rely on finding distressed deals or utilizing leverage to generate attractive returns may achieve above average performance in the short run, but their returns will eventually mean revert to, or below, the average.
Instead, GPs who take the effort to form a well-developed business plan, focus on their competitive advantages for value creation, or even create new paths to create value should be rewarded with above average performance with some level of sustainability. Perhaps the astute LPs will lean towards the GP’s value creation strategy moving forward.