Ancient gladiators

Private equity knife fight

I started in private equity in 2006, catching the tail end of the last PE boom. Good companies in the middle market traded for double digits from time to time. But double digits were not the norm. PE hibernated in 2008 and 2009. In 2013, Leon Black said it was time to sell “everything not nailed down.”

By 2014-15, the credit markets were wide open, double digit multiples were becoming more common, and auctions were often pre-empted. If not pre-empted, 3-4 bidders would show up on the LOI date with their work largely complete – third party diligence done, financing arranged, IC signed off, etc.

Oh, those were the good old days. Today the U.S. LBO industry is in an all-out knife fight:

1) Over half of deals are trading at more than 11x EBITDA*, with some companies trading for 15-20x+.

2) Accounting diligence providers are backlogged and, horrors, M&A attorneys are turning away work.

3) Many processes – even for some sub-$5 million EBITDA businesses – are being pre-empted before LOI.

4) Earnings quality continues to decline. More and more of EBITDA is adjusted or pro forma.**

I should note – I know it is a little late in this post – that I believe in the private equity model. As a source of capital for smaller businesses, as a way to provide liquidity to families and founders, etc. The industry and ecosystem around private equity WAY oversell PE’s benefits, returns, etc. but that’s a story for another day.

Despite the INTENSE competition, money continues to flood into the asset class. 2019’s record fundraising will likely be eclipsed by 2021’s. Because there is no alternative. Because the illiquidity premium MUST exist. Because low interest rates. Because returns have been good. Because…

Private equity has become much more efficient over the last 15-20 years:

1) The big money moved into private equity. Sovereign wealth funds and public pensions looked at the success of the Yale model and said, “I’ll have what they’re having.” They upped their allocations to PE and many built out direct investing teams. But Yale, at $30 billion, is a small fish compared to the really big players.

2) Increased competition has shifted the balance of power to intermediaries and sellers. Despite many PE firms’ claims to source proprietary deals, in reality, that’s rare (especially for companies with $3 million or more of EBITDA). I’d bet the ratio of firms that claim to source proprietary deals to those that do is 30 or 20 to 1.

3) Buyouts traded at a significant discount to the public market in the golden age of alternatives (1994-2008). Buyout valuations converged in 2007-08 and have tracked public markets since.

I don’t know how things will play out over the coming years. Positive feedback loops have a way of continuing for longer than you’d think. Good returns –> more capital –> higher valuations –> and so on. At some point, valuations will flatten out or decline – they cannot go up forever. And the asset class will reach its capacity constraints – many on the front lines will tell you that we are already there.

This doesn’t mean that the best firms won’t continue to outperform (someone has to be top decile or top quartile – whether that’s by chance or by skill is a separate question). I do think certain models or firms that have limited fund size are more likely to outperform. But, unless valuations continue to rise (and the change is what matters), many will be disappointed by PE’s returns over the next decade.

*per Refinitiv data in Bain’s Global PE Report 2021; includes deals with disclosed purchase price and leverage levels.

**hey, the lenders will give us credit for it.

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