For reasons unknown, many investors assume that private equity may have lost its edge as a key allocation for their portfolios. This perception, however, may not align with reality.
By taking a closer look, investors will see that the fundamentals are still intact and there are many attractive opportunities for skilled private equity managers. In this article, we’ll take a closer examination at private equity, and the reality that may be hiding behind some widely held perceptions.
Perception: Public equity market returns have been good in recent years. Why tie up money in private equity?
Reality: Many investors don’t believe that public equity will deliver high returns, especially not on a consistent basis. Over the years, private equity long term performance has been the subject of serious academic research. And these findings all point in the same direction: there is a consistent return premium associated with a thoughtfully constructed private equity portfolio.
Perception: Valuations are high, likely depressing future returns.
Reality: Investing in private equity is not a simple all-in or all-out decision. Investors may increase or decrease the size of new commitments depending on many factors. They should not, however, opt-out and stay entirely on the sidelines. It’s hard to be tactical in private equity, and attempts to time this strategy — even more so than the public equity market — almost never meet with success.
Perception: Use of leverage is rising, increasing risk and elevating valuations.
Reality: According to this chart, over the past four years, the use of leverage, as a multiple of purchase price, has been relatively steady in a range of 4.25x to 4.88x. This is below the peak in 2007. Moreover, as a multiple of EBITDA, purchase prices remain reasonable, averaging 8.82x over 2013 versus an average of 8.12x over the decade.
Perception: Too much money has been raised in recent years, making it difficult to invest in a disciplined manner.
Reality: We’ve noticed that top-tier managers usually have a keener sense of appropriate valuation levels, especially as they pertain to future growth prospects and opportunities. Having this skill allows these managers to be discerning, even in more robust pricing environments.
While valuations do cycle up and down, through various market cycles, we have consistently found better growth-adjusted valuations by focusing on growth equity and small/middle market buyouts. We also note that some private equity managers are specializing in technology, telecom, healthcare and consumer/retail, calling on their deep knowledge of specific industries to add value.