As an advisor to PE, I am a big proponent of PE. I believe that the overall mechanism for creating and maximizing value creation through PE is undeniable and validated more often than not. Nevertheless, as with any market, there are ups and there are downs - and all leading indicators point to a harder road ahead to make better than market returns.
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3. Leverage: Debt has been very easy to get in the markets. The historic low interest rate markets, combined with the better capitalized or well-capitalized banks and financial institutions, lenders have gotten very aggressive on pricing and covenants, making future deals going south a higher probability. At a recent PE conference, all panelists were worried about the risks of "covenant" light deals. Once some of those new more aggressive financings run into some headwinds, there will be a negative domino effect in the markets, resulting in higher funding costs for everyone. Add to that the fact that the low rate environment cannot last forever, higher financing costs do not help PE returns.
2. GPs only make money - if they put the money to work With too much money chasing too few "good" risk-adjusted deals - the limited partners run a higher risk of tying up there money with a higher risk of losers than winners. GPs on the other hand, collect a (1.0-2.5%) fee on the invested capital, and ultimately profit with you, if the investment does increase in value. The below chart highlights this current market reality.
There are 3 commonly known levers that have a significant impact on PE returns: PE Multiple, Leverage, and EBITDA improvements. All three of these levers are currently experiencing higher levels of greater uncertainty. As a result, the historical higher returns that the PE class has generated will under-perform the markets over the next 2-3 years.
1. Current Market Valuations / Pricing: PE ratios and the commonly used TEV / EBITDA ratio for PE investments are much higher than historic norms. The current market PE ratio is at 26.0 vs. a historic average of 16.5. This 57% value above the historic norm suggests that over then next 2-3 year time horizon, PE ratios in aggregate will more likely move closer to the historic norm rather than continue to move to even higher valuations. As you evaluate funds or PE managers, keep in mind the historic and current multiples for new investements and evaluate vs. historic returns.
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