Certain PE stocks have had a bumper 2019. In August, Barclays analyst Jeremy Campbell told Barron’s that PE firms are experiencing a “structural growth story”. Since, stocks such as Apollo Global Management [APO], Ares Management Corporation [ARES] and Blackstone Group [BX] have been receiving positive ratings from analysts.
In 2017, private equity firms raised record-breaking amounts of capital. Throughout the year firms globally raised as much as $714bn from investors, according to figures from management consultancy firm Bain & Company.
Amount raised by private equity firms in 2017
However, the success story may not be so clear cut. According to Private Equity News and figures from data provider eFront, global leveraged buyout funds delivered an average multiple of 1.44x on invested capital in the first two quarters of 2019, compared to 1.46x recorded in the last quarter of 2018 and the “10-year high” of 1.49x in the third quarter of 2017.
Recession fears have been cited as potential concerns for private equity, while leveraged loans faltered in the second half of 2019 as multiple large deals fell through. The slowdown has also been affected by a slew of highly-funded tech companies – such as Uber, Lyft, Dropbox and Slack – all plunged in value since listings in 2018 and 2019.
Private equity and public markets
The global private equity market has generated an average return of 17% in recent years, according to the Financial Times. This figure is impressive when held against 2018 figures of -4.4% for the S&P 500 or -8.7% for the FTSE 100.
However, some claim that such figures are overstated and are more reliant on how these figures are calculated.
“Private equity firms are notoriously parsimonious about sharing their data,” Jonathan Ford notes in the FT. “What they want us to see as members of the public (or pension schemes) are bulk anonymised numbers from which industry associations and tame consultants compile illustrative performance data.”
“What they want us to see as members of the public (or pension schemes) are bulk anonymised numbers from which industry associations and tame consultants compile illustrative performance data” - FT City editor Jonathan Ford
Compared to the industry favourite measurement of internal rate of return, when using the public market equivalent (PME) measure, returns have been about the same as on stock markets since 2006, Ford suggests.
However the picture, typically, may not be so clear. Using a modified PME metric, which according to Bain & Company allows for an “apples-to-apples comparison of PE returns with public equity returns”, private equity has outperformed public markets in the last three years.
However, the firm does note that buyout returns in the current cycle re still below pre-financial crash levels. It pointed to consistently high prices, capital market volatility, trade and geopolitical tensions, and the “ever-present threat of recession” as worries for dealmakers.
The leveraged loan market has had a tough time in 2019, with five deals – Vewd Software, Golden Hippo, Glass Mountain Pipeline Holdings, Chief Power Finance and Life Time Inc – falling through so far. Meanwhile, recently banks have been approaching private equity firms to back a monster $80bn sale of Walgreens Boots Alliance, which would be the largest buyout ever according to Reuters.
Valuation of Walgreens Boots Alliance sale
Leveraged loans – a high risk form of financing use to buy out debt-ridden companies – have long been a favourite for private equity firms over the past decade, according to Bloomberg. However, business has been more moderate in 2019 as investors worried about recession shy away from such deals.
The recent string of high-profile collapses has resulted in cash-rich private equity firms embarking on smaller transactions, according to Financial Times. This year has seen a record number of deals in which the total value of investments is $1bn or less. Deals valued below $500m have also hit a new record and now account for 30% of the industry’s total deal value.
The bigger they are…
Taking a company public has been a long-standing method of gaining big returns on private equity investments, and it appeared until recently to still be a fail-safe exit strategy, even with companies that had never made a profit.
A slew of tech behemoths – which had received billions of dollars in private equity funding – successfully went public in 2018 and the first half of 2019. But, 84% of the US tech companies behind these IPOs had not made profits, Vox reports. Furthermore, to date not one of Dropbox [DBX], Slack [WORK], Lyft [LYFT], Uber [UBER], Fiverr [FVRR], Peloton [PTON] or Pinterest [PINS] is trading above its listing price.
of the US tech companies which have failed to make a profit since IPO
Then came the WeWork debacle. A company that not only had never made a profit, but seemingly had no plan of how to become profitable, and that Goldman Sachs had previously suggested would be worth $65bn, cancelled its IPO. Today it is reportedly worth $8bn. The SoftBank Vision Fund that had funded WeWork, alongside other loss-makers such as Uber, has begun to look less powerful.
But, as of September 2019, a record $42bn worth of secondary deals – where assets are sold before a fund’s agreed terms expire – were completed, according to the FT. Based on figures from investment bank Setter Capital, this was up by a third year-on-year.
These types of deals have historically outperformed most other types of private equity funds, the FT suggests, while there is little evidence that return assumptions have moderated as this money flows into the market.
Where’s the upside?
So far this year, certain PE stocks have been flourishing. Blackstone has been rated as buy by 10 out of 16 analysts polled by CNN, while six rate it a hold. At $52.52 the stock is up 84% YTD (through 15 November), while it has been given a modest median 12-moth price forecast of $54.
Apollo has seen similarly explosive performance, rising 87% to $43.93 YTD. Analysts have given in a 12-month price forecast of $46.50 representing a modest 5.7% increase. The stock is a buy among 13 of 16 analysts polled by CNN, as is Ares, which received a buy rating from 10 of 13 analysts.
“While we are starting to see some delays and failures in deal execution as a result of market uncertainty, the pressure on PE firms to continue to put their capital to work means that deals will continue to happen and that any slowdown in deal activity is likely to be short-lived,” Big Four firm PwC said in its 2019 outlook for London PE.
Furthermore, Campbell estimates that PE firms are sitting on $2.1trn of committed capital, and as such have plenty of “dry powder” to play with. However, some are more sceptical about the state of the sector.
“There are growing signs that private equity is becoming a victim of its own success,” Patrick Jenkins writes in the FT. “So many pension funds, mutual funds, sovereign wealth funds and other yield-hungry investors want a piece of the action that private equity firms now have far more money than they know what to do with.”
“So many pension funds, mutual funds, sovereign wealth funds and other yield-hungry investors want a piece of the action that private equity firms now have far more money than they know what to do with” - Financial Times financial editor Patrick Jenkins