Do not adjust your expectations

Many of the world’s most influential investors have been articulating what has been known for some time: it’s getting harder to generate returns across the board.

Chinese sovereign fund CIC, for example, said recently it had taken a number of steps to bolster returns amid “ever-growing downside risks” in global markets. Singapore’s GIC followed suit, reporting slowing returns over the last year, caused by “all-time” low interest rates, high asset valuations and an uncertain outlook for economic growth. ADIA, too, has reported diminished returns against a “backdrop of slowing global growth”. The California Public Employees’ Retirement System has been forced to defend its performance amid “challenging” conditions.

This is an issue that cuts across all asset classes, and private equity will not be spared. As one New York-based industry veteran put it: “You tell me what the public markets will return, and I will tell you what private equity will return.”

In other words, while private equity will continue to outperform the public markets (as Blackstone’s Steve Schwarzman pointed out in a July earning’s call), there is no evidence to suggest these returns will be of the same magnitude achieved in years past. Data released this week by State Street show total returns for the asset class – while positive – have been slowing for several years.

“We have borrowed from the future,” said the same veteran. “Public equity returns will be subdued as companies grow into their stock prices; this will have a knock-on effect on private equity.”

So how does this “helicopter view” of diminishing returns fit with what is happening on the ground? Presumably general partners are sitting down with prospective investors, presenting them with a set of marketing materials that includes a realistic, slightly-smaller-than-last-time target return? If you’re laughing, so did most of the placement agents and investors we asked.

One investment consultant noted a recent conversation with a GP in fundraising mode. After discussing the increasing pile of dry powder chasing deals, the consultant asked whether they had adjusted their returns expectations accordingly. “Certainly not” was the response; they would just have to be smarter and more selective in their deal-sourcing. While this seems sensible on one hand, on the other, were they not doing that already?

A placement agent put it like this: if you are a mid-market firm competing for LP capital, then a promise of anything less than a 2.5x money multiple and 20 percent IRR does not go down well. After all if you – a private equity GP – suggest that you are moving down the risk-return spectrum, then your profile becomes more like a private debt fund. If an LP wants low-risk, low-return, they can get that elsewhere. Maybe the handful of mega-firms raising capital from giant institutions for long-term “strategic” investments that blur strategy lines can get away with it, but most cannot.

When a GP says it is “being more selective”, it most likely means taking more time to invest: taking the whole five-year investment period to draw down the fund, rather than investing it and returning to fundraising mode within three years. To illustrate: German firm Deutsche Beteiligungs’ latest €1 billion fund has an investment period of six years rather than its predecessor’s five.

So having promised 2.5x and 20 percent IRR, what is a GP to do? The first thing is to bring genuine operational improvement to bear on its portfolio; the lion’s share of that 2.5x money multiple will come from EBITDA growth, which is why firms of all sizes are focused on disruptive growth companies and operational excellence. As one LP said: “It is about keeping an eye out for companies with that break-out potential that will deliver a safe 2x, but could be a possible homerun.”

The second element is the use of leverage, which is available on “better terms than I have ever seen”, noted one GP. Operational improvement is hard won and takes time, and time takes its toll on IRRs. By taking advantage of finance at the fund level, GPs are able to mitigate the effect that longer holding periods are having on IRR. Firms are increasingly financing acquisitions in the first instance using bank bridging facilities, buying extra time to generate returns without drawing down LP capital.

None of this is to suggest that every firm will be able to successfully navigate today’s environment as needed. The next 10 years will be revealing.