Private Equity’s Retreat
By, Robert J. Moss
For all intents and purposes, 2017 has been a banner year for the private equity industry. Investors continue to funnel money to private equity funds at record-breaking speed. Prequin reported that Q2 saw 256 funds raise $138 billion with 80% achieving or exceeding their fundraising targets. Likewise, earlier in the year, Apollo raised $24.7 billion, making it the largest buyout fund ever. Investors are flocking to private equity funds, and for good reason. Despite the bull market, funds on average are still outperforming the stock market. An article from Forbes last March relayed data from Cambridge Associates. The consulting company tracked the performance of funds relative to the S&P 500. It found that over a year, ending in June 2016, funds achieved a pooled IRR of 6%, compared to 4% from the index. The data was by no means startling though.
Private equity funds routinely outperform the market. In fact, another report by Bain & Company consistently tracked this pattern going back to 2007. They also tracked something else, a more worrisome trend for funds. The spread between funds and S&P 500 returns has been slowly narrowing over the last decade. One cause for the lagging IRR is due to the Financial Crisis. Private equity investment hit record levels shortly before the crisis. As a result, many funds bought high and were forced to hold on to investments for longer than desired. In addition, the current market has been relatively stable with valuations continuing to rise, diminishing the usual opportunities funds look to take advantage of. Right now, those funds wondering where to invest have a huge amount of dry powder on their hands.
Dry powder is industry jargon for cash and highly liquid securities. As of July, dry powder among private equity funds totaled $963 billion. It is staggering as an average person to imagine all that money just sitting on the sidelines. It is also worrisome for investors. Institutional investors, who usually fill the bulk of private equity firm’s coffers, are pressured to make returns and are increasingly opting to invest in ETFs, according to Fortune.
The state of dry powder in the industry seems quite precarious. Could private equity’s retreat from the market be foreshadowing the anticipation of a serious market correction? Or will we start seeing greater deployment of dry powder reserves as funds grow increasingly pressured by investors to do something with the cash? Maybe not. In a Bloomberg article, they point out despite the near record levels of dry powder, funds do not appear to be investing at a slower rate. In short, nothing to see hear. But that still negates the fact that despite private equity M&A transaction values being closer to the record 2007 levels, they are still significantly lower. Meanwhile, the build-up of dry powder has been breaking records throughout the past year and is estimated to hit $1 trillion by the year’s end. That suggest to me and imbalance. Only time will tell how and when it will be corrected.