As I was wrapping up a panel at the recent PEI CFO and COO Forum in New York, I asked the 500 members of the audience for questions. Within a few seconds my iPad screen was full of them.
How will the industry deliver above-market returns when the easy gains have been realized and regulatory pressure is increasing? How will firms compete for deals in a market that’s getting more crowded by the day? Should we expect lower returns from private equity going forward? The volume of tough questions was telling: private equity is concerned about meeting increased expectations from regulators and investors alike.
Despite its challenges, the industry is still one of the best draws for investment capital:
• Industry assets under management swelled to a high of $3.6 trillion in 2015, excluding venture capital, according to Deloitte estimates based on Preqin data;
• Since the end of 2005, assets have risen by a robust 13.7 percent compounded annual growth rate;
• The amount of capital raised by private equity funds has grown at a 4.6 percent CAGR over the past decade;
• Institutional investors surveyed by Preqin report increasing their allocations across the board in recent years; they plan to commit the same amount of capital or increase their allocations in 2016.
Private equity’s outperformance over long periods explains its popularity among investors. Cambridge Associates’ US Private Equity Index, a proxy for industry returns, has beaten the Nasdaq Composite, Russell 2000, and Standard & Poor’s 500 indexes consistently, from 1990 through to the third quarter of 2015. Private equity funds have earned a reputation for increasing fund profitability through favorable deal terms, easy access to capital and financial engineering.
A new phase of growth
Now the industry’s talents are truly being tested. In the wake of the global financial crisis and market tumult, the holding periods for many funds have extended well beyond traditional norms. Gains from recapitalizations and other financial engineering strategies have mostly been had, thanks to historically low interest rates. Regulatory oversight is escalating, demanding more attention from fund leaders.
Meanwhile, increased competition from the likes of crowdfunding sites, VCs and public corporations has dramatically shrunk the pool of available investment targets. While the number of US companies has barely budged over the past 20 years, the number of private equity firms has grown by a factor of 14 (see chart on page 5), according to Census data.
As a result, investor capital is piling up on the sidelines. Uncalled capital, or dry powder, has risen at a 9.2 percent CAGR over the past decade. That’s twice as high as the rate at which money has been raised. The pressing questions now is: Will investors remain patient as the industry addresses these challenges or will they seek other alternatives for their capital?
The answer may hinge on whether private equity investors are willing to reset their expectations for returns. An analysis in a recent Deloitte report suggests that they will. The industry is embarking on a new phase of growth, one we believe will see AUM grow at a 5.2 percent CAGR from year-end 2015 through 2020 in the most-likely scenario. If realized, that would be a significant stepdown from the run rate over the past 10 years.
Our research also shows that it’s not just the pace of growth that’s likely to change in the coming years. The composition of that growth will change as well. Gains in unrealized value expanded at 16.7 percent CAGR over the past decade, contributing heavily to asset growth. We expect that rate to slow to just 4.7 percent over the next five years as competition intensifies and appreciation is harder to come by. At the same time, we’re likely to see the growth rate of uncommitted capital settle at 6.3 percent CAGR.
A stronger support system
This significant shift – with dry powder overtaking unrealized value as the industry’s biggest driver of growth – could present a big opportunity for private equity funds who figure out how to put money to work in this intensely competitive environment. How should private equity firms respond?
Based on our experience at Deloitte, we’ve identified a standout trait that successful private equity firms share in this environment: a best-in-class support system. Specifically, we see general partners strengthening their core capabilities when it comes to technology and operational due diligence.
Take technology investments, which are primed to rise. Technology spending was once seen as a drag on returns, so many PE firms limited their investments to offline solutions such as spreadsheets. In an article on page 18, my colleague Roland Waz chronicles how increased competition for deals, investor demand for information and transparency, and other factors are pushing PE firms to elevate technology’s importance.
While priorities vary by firm size, business focus, and existing technology infrastructure, he sees four areas attracting the most dollars: modernization of core applications, cloud HR and finance solutions, investor portals, and data analytics platforms.
Another way for private equity firms to boost returns in today’s environment is to make major operational changes in portfolio companies. While this approach can deliver bigger returns, it carries bigger risks. On page 12, Deloitte principal Kamal Mistry outlines the reasons why GPs shouldn’t be tempted to short-change operational diligence despite the pressure to move quickly on deals. In an environment of increased competition and diminished returns, more thorough diligence on the target company’s operations and market positioning can find potential pitfalls and spot alternative ways to deliver value.
The drive for data
We’re already seeing evidence that these efforts are bearing fruit. Empowered by new technology platforms and information, leading private equity firms are strengthening their ability to compete for deals and unearth new sources of returns. Importantly, their investors are being rewarded not just by the performance they have come to expect but also through increased transparency into the underlying investments and strategies that make it possible.
Just a few weeks ago, Deloitte hosted a meeting that included finance executives from a number of the largest PE firms. One of the most revealing observations to come out of the meeting was just how varied their processes and approaches are for obtaining investment information from their portfolio companies, summarizing it, and reporting it to investors. While no one firm had a silver bullet, it was clear to me that each finance department was very focused on developing as efficient a process as possible, one that doesn’t overly burden portfolio companies while yielding useful insights for front-office analysis or financial reporting purposes.
For an industry that relies on patience to succeed, private equity is counting more than ever on investors’ forbearance. There’s a new sense of urgency to the performance questions investors are asking. “Give it time” isn’t a sufficient answer. Private equity leaders need to branch out from the traditional way of doing things and find new opportunities for growth. Those that don’t revisit and revamp their tried-and-true formulas may find it much more difficult to raise capital in the future.
Investing in technology and due diligence capabilities are two ways private equity firms can find new opportunities and keep investors engaged. But other approaches will almost certainly be needed in the months and years ahead. This industry has a long track record of funding promising companies and capitalizing on disruptive ideas. Now it’s time for private equity to transform the business of private equity. Investors expect no less, and neither should we.
This article is sponsored by Deloitte. It was published in the September supplement with pfm magazine.