Using leverage is like using power tools: if you know what you’re doing, you get more work done faster. If you don’t know what you’re doing, you can drill a hole in your head.
Anonymous investment banker
Private equity (PE) investing has changed dramatically in the twenty-first century, evolving from niche strategies that appealed to a narrow set of investors into mainstream vehicles that many investors see as essential to obtaining diversified global growth exposure. Private equity has grown more than sevenfold since 2002, twice as fast as global public equities. In the United States, the number of PE-backed companies more than doubled between 2006 and 2017, while publicly traded firms declined by almost one-fifth.1
As the industry has expanded it has developed structures that offer investors greater flexibility to optimize their exposures: capital-call lines of credit, long-duration funds and secondary fund investing, i.e., buying interest in existing PE funds on the secondary market. Secondary investing has broadened and deepened, affording greater liquidity to the asset class and making it easier for general partners and limited partners to manage their portfolios tactically as well as strategically.
Global economic developments also have contributed to the PE industry’s evolution. Central banks around the globe met the financial crisis of 2007–2010 with unconventional monetary policies, such as quantitative easing, that altered historical risk-return relationships across many asset classes. Public equity market valuations burgeoned in the low-risk, low-yield conditions QE engendered. This prompted a search for greater return potential, which pulled many investors to private equity and led to a surge of capital raised in PE funds.
As of September 30, 2018, private equity firms had amassed $1.14 trillion in near-term capital (“dry powder”), more than any year except 2017.2 Secondary PE funds raised unprecedented amounts of capital last year and observers expect 2019 to be another record-setting year.3 Burgeoning raise-ups intensify the need to deploy capital, increasing competition for investments and driving up prices. As a percentage of net asset value (NAV), prices of secondary interests in PE funds have risen from 87% of NAV in 2013 to 92% in 2018.4
This highly competitive environment intensifies the challenges in achieving profitable fund results. For larger PE funds these conditions are especially challenging, as deploying capital in this environment has the potential to compromise their selectivity. (Smaller funds generally are more nimble and potentially can be more selective.) Against this backdrop, many PE funds have sought to boost performance through greater use of leverage, a practice that has become common in the industry.
Should investors worry about this? Here we look at the benefits and trade-offs of PE fund leverage and suggest ways to keep leverage in perspective.
Pros and Cons of Leverage in Private Equity Funds
Just as consumer credit plays an important role in everyday personal transactions, leverage is an important tool for conducting day-to-day fund operations. PE funds often use the capital committed by limited partners as collateral for short-term credit facilities, typically referred to as capital-call lines of credit or subscription facilities.
Having access to such credit facilities enables PE fund managers to operate more efficiently and reduce expenses. General partners (GPs) use the credit facilities to fund short-term working capital needs — and to quickly take advantage of investment opportunities — without waiting for limited partners to respond to capital calls. Fund managers can smooth out the capital-call process, thus lowering costs for the fund; also, they can reduce the need for unexpected capital calls, increasing the predictability of call timing for LPs.
Secondary PE funds seek to purchase interests in existing primary PE funds, often after the early phases of a multi-year fund, when investment cash flows are turning positive and beginning to accelerate. At that juncture, payouts from existing investments may partially cover the costs of the fund’s credit facility, further reducing the need for capital calls to LPs. Capital-call lines of credit thus play a role in compressing the “J-curve,” i.e., the portion of a fund’s life when it experiences negative cash flows and returns; over time, this potentially increases internal rates of return for limited partners.5
During 2018, 52% of PE buyers reported they used leverage. Of those respondents, about four in ten used a special purpose acquisition vehicle and six in ten used a fund facility. Funds also enhanced performance through the use of deferred payment structures, a sort of vendor funding in which the buyer pays the seller a portion of the purchase price up-front, then pays the rest through regular installments; similar to buying a home with a mortgage. About one-fourth of PE transactions were subject to deferrals in 2018; for more than half those transactions, the deferred portion of the purchase price ranged between 40% and 60%, and the deferral time range was six to 12 months.6
Leverage and deferred payment structures thus have played important roles in enhancing returns in a highly competitive PE market. On the other hand, leverage is a two-edged sword: it can increase both upside and downside potential, in similar fashion to buying stocks on margin (Figures 1A and 1B).
Leverage allows buyers to bid more competitively on assets in a tight market, but it also reinforces upward pricing pressures. This raises the question of sustainability: How long can prices keep rising? This is a main source of the concerns voiced about the use of leverage among private equity funds.
Too Much of a Good Thing?
Investment costs seem poised to increase, further intensifying the pressures on managers to boost results. Leverage remains historically cheap, and thus attractive as a performance enhancer — however, it may also pose longer-term risks, since it leaves funds more vulnerable to changes in the rate environment and magnifies downside risk in an environment where attractively priced deals are harder to find.
We saw a record year for secondary private equity fund investments in 2018, mirroring the ongoing strength in the primary PE markets. Thus far in 2019, secondary volumes have not decreased. According to Greenhill, secondary market buyers hold a record $192 billion of near-term capital sourced from limited partners and borrowed funds, representing 2.6 times the transaction value of the last 12 months.7
With record amounts of dry powder, fund managers face ever greater pressures to put money to work, which increases the likelihood of higher prices down the road. High demand for PE investments continues to spur greater use of leverage, facilitated by low interest rates. Lenders are competing to extend credit on easy, “covenant-lite” terms.
Highly-leveraged purchases are becoming commonplace as a result, and debt multiples have risen to levels not seen since the end of the last credit cycle.8 After the global financial crisis, regulators discouraged private equity buyouts above six times earnings before interest, taxes, depreciation and amortization (EBITDA). In the more relaxed regulatory climate of the Trump administration, however, buyout multiples have risen; in 2018 almost 40% of buyouts were priced at multiples greater than seven times EBITDA.9
Notwithstanding the benefits of leverage, paying higher prices for investments generally makes it harder to achieve higher returns. According to UBS, buyers recognize this and have been lowering their return targets as more transactions get priced at par or a premium.10 What’s more, the true level of risk may be understated: as has happened in past times of high risk tolerance, banks are allowing borrowers to calculate multiples based on projected earnings, rather than actual results. This can lead to overoptimistic estimates of potential cost-cutting, synergies and revenue increases.11
Navigating today’s PE Marketplace
For prospective investors, gaining a comprehensive view of private equity funds is critical to identifying potential risk in the current environment. How can investors protect their interests? First, don’t buy a slice of the generic secondary market — it’s expensive. Despite a record year of market deal flow — $74 billion in 2018 compared to $28 billion five years ago — the industry average discount to NAV in 2018 was about 3%.12
Every fund manager’s goal is to purchase better-than-market assets at better-than-market prices, but not everyone is able to do so. Bigger funds, in particular, must put dauntingly large amounts of dry powder to work as quickly as possible, and may have to buy pretty much the entire market. It is unrealistic to buy “C-level” assets and expect “A-level” returns. By contrast, modest-sized funds do not face the same pressures to invest hurriedly, and can be more strategic about the assets they acquire.
Look for secondary fund managers who have the ability to focus on quality: PE funds that have strong management expertise, historical track records of growth and reputations for LP exits at gains. Effective secondary fund managers know their risks, and seek margins of safety in the way they select and manage their investments. Risk mitigation tools might include controlling fund size, building diversified portfolios, hedging currency exposure, focusing on quality and price, seeking transactions with identifiable near-term liquidity and taking a conservative approach to leverage.
Leverage is appropriate when used as a liquidity tool or for hedging purposes. Funds that rely on leverage to enhance performance may be exposing LPs to greater potential risk than they realize. Common measures such as internal rate of return may not be enough to evaluate private equity fund performance. Investors should consider using supplementary metrics such as multiples of invested capital, e.g., the total-value-to-paid-in ratio or public market equivalent benchmarks. In some cases, to get a truer picture of fund performance it may be necessary to disaggregate the effects of investment selection from the effects of leverage. As more investors pay attention, some firms have begun doing this.
The private equity market has broadened and deepened in recent years, and today offers many choices for investors to build diversified exposures to meet their specific needs. Given the attractive return and diversification potential of secondary funds, we expect the market to keep growing, offering general partners and limited partners more options to manage the trade-offs of risk and return.
Private equity valuations have advanced due to investors’ willingness to pay higher multiples, backed by access to cheap credit. Credit is somewhat more expensive now than several years ago, but not so much that it is likely to cause a pullback of leveraged asset purchases. So far in 2019, public equity markets are posting gains despite concerns about the global economic outlook and the expected slide of corporate earnings growth. Should public price/ earnings multiples contract, we could see a spillover into the private equity markets; on the other hand, we might instead see greater interest in private equities for their still greater-than-public-market return potential.
Given the expected path of Federal Reserve policy for 2019 – likely no further interest rate hikes, and maybe even a rate cut – the forces that have sustained leveraged private equity investing seem likely to persist over the near to intermediate term. In our view, the highly active secondary market provides greater liquidity, and at least partially offsets the risks of more expensive fund investments.
1 Source: Private Markets Come of Age, McKinsey & Company, 2019, p. 2.
2 Source: Prequin, as cited in “5 Signs We’re in a Private Equity Bubble,” Barron’s, November 29, 2018.
3 Source: “Global Secondary Market Trends & Outlook,” Greenhill, January 2019, p. 3.
5 Source: Private Markets Come of Age, McKinsey & Company, 2019, p. 33.
6 Source: Secondary Market Survey and Outlook, UBS, March 2019, p. 10.
7 Source: Greenhill, op. cit., p.4.
9 Source: Loan Pricing Corp., quoted in Global Private Equity Report 2019, Bain & Company, pp. 8-9.
10 Source: UBS, op. cit.
11 Source: Bain & Company, op. cit.
12 Source: Greenhill, op. cit., p.3.
There are no guarantees a diversified portfolio will outperform a non-diversified portfolio.
All equity investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. Foreign investing does pose special risks including currency fluctuation, economic and political risks not found in investments that are solely domestic. Emerging market stocks may be especially volatile. Stock of an issuer in the Fund’s portfolio may decline in price if the issuer fails to make anticipated dividend payments because, among other reasons, the issuer of the security experiences a decline in its financial condition. Securities of small- and mid-sized companies may entail greater price volatility and less liquidity than investing in stocks of larger companies.
Private equity investments are subject to various risks. These risks are generally related to: (i) the ability of the manager to select and manage successful investment opportunities; (ii) the quality of the management of each company in which a private equity fund invests; (iii) the ability of a private equity fund to liquidate its investments; and (iv) general economic conditions. Private equity funds that focus on buyouts have generally been dependent on the availability of debt or equity financing to fund the acquisitions of their investments. Depending on market conditions, however, the availability of such financing may be reduced dramatically, limiting the ability of such private equity funds to obtain the required financing or reducing their expected rate of return. Private equity funds as well as securities that invest in such funds and companies in which such funds or securities may invest tend to lack the liquidity associated with the securities of publicly traded companies and as a result are inherently more speculative.
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