Friday Letter: Pushed to pay

Funds are under pressure to deploy record amounts of cash in an expensive market. Adding value will be their next challenge.

The Carlyle Group’s announcement on 29 July that it had closed its Carlyle Europe Partners IV fund at €3.75 billion, overshooting its $3 billion target, was swiftly followed by its second quarter earnings announcement.

The numbers revealed that of the firm’s hefty $63 billion of dry powder, $26 billion is ready to invest in private equity.

Carlyle was the latest of the PE giants to report both earnings and the closing of a sizeable fund. They all have cash stacked up to invest. 

KKR’s latent PE firepower matches Carlyle’s at $26 billion, but both trail Blackstone, whose earnings show the firm has a whopping $82 billion ready to invest with $36.8 billion headed for PE. This is thanks to a record year of fundraising that saw the firm attract $94 billion of commitments.

Firms are succeeding with massive fundraisings as limited partners flush with cash following record exits rush to commit. The Private Equity Growth Capital Council reported record exit volume of $125 billion for Q2 2015. Carlyle co-chief executive David Rubenstein said on its earnings call that CEP IV’s problem was too much LP money and managing to shoehorn in enough investors.

The real problem for both general and limited partners is how to spend that money. Competition for assets is driving ever higher asset prices and good deals are hard to find. One GP told PEI of an auction for a mid-market asset where funds were offering 12 times the company’s estimated 2016 EBITDA just to get through the door to meet management. Perhaps unsurprisingly, that GP kept his cheque book firmly in his pocket.

For LPs, it’s Catch 22. If the money isn’t spent, they face the danger of paying fees on idle commitments. If it is, there is the danger of lower returns from investments made at the top of the market.

For now, LPs are eager to offload cash returned to them into new vehicles. Those vehicles will have to perform for PE to retain its allure and its allocations. And for that to happen, GPs need to be disciplined and play the long game. In the five-year window in which a GP must put that capital to work, they need to pick their targets wisely.

A tactic we’ve noticed among a couple of UK-based firms is beefing up the origination team. Inflexion is a good example. The firm, which has seen a run of realisations – nine in the last 18 months – has recently hired into its already fairly large origination team to give it some extra reach. Lloyd’s Banking Group’s buyout arm LDC has added three to its origination team, while Sovereign Capital has added four in the last eight months.

More bodies on the ground to sniff out good quality – and reasonably priced – assets can be no bad thing. But we’ve been hearing in the industry that prices are painfully high and unlikely to taper off any time soon. With a limited period in which to deploy their funds, managers will inevitably be pushed to pay full prices for portfolio companies.

The ability to really add value to portfolio companies, therefore, is imperative. No matter the entry multiple paid, if a GP has a clear strategy to make concrete improvements which will leave them with a very different business at the end of the investment period, then there is money to be made.

Improving operations is the one value creation lever that pays real dividends in any market. It’s also the one that requires the most time, effort and financial support from GPs.

For the fourth consecutive year PEI’s Operational Excellence Awards are celebrating those firms that have gone that extra mile to bring true value – and not just a stellar exit multiple – to their portfolio companies.

All the details and criteria can be found here and submissions will be accepted until 14 August. We can’t wait to hear your stories.