Back to School: GPs must close riskier deals to justify high fees

Expensive deal markets are here to stay.

As the private equity industry’s stockpile of committed capital continues to rise and limited partners chip in larger amounts to new deals as co-investments, Bain & Co sees no relief for the high prices general partners are paying for assets.

For the “foreseeable future, that’s going to be the future of the industry,” said Hugh MacArthur, who leads the consultant’s PE practice. “The world is just awash in financial capital, and financial capital has been growing at a very rapid rate the last couple decades.”

Paying top dollar for assets near the top of a market cycle makes it more difficult for firms to generate top-quartile returns later. As PE investors increasingly rely on co-investments to generate returns at lower costs, GPs who collect high fees and carried interest will face greater pressure to look for deals outside the “middle of the fairway.”

“PE funds are getting pushed into the rough and the sand traps, where the higher-risk deals live,” a report says. “At the end of the day, you have to take more risk” to generate the returns that will justify the asset class’ high costs, MacArthur said.

Acquisition multiples have hit or are approaching records in the U.S. and Europe, the firm reported in its annual industry review. Citing Preqin data, Bain & Co noted that PE dealmakers consider pricing the biggest challenge for the industry.

While large-buyout prices have consistently hovered around double-digit EBITDA multiples for some time, another recent report, from LP consultant TorreyCove, suggests the pricing surge has moved down market. From 2015 to 2016, multiples for mid-market deals grew to 10.7x from 9.6x.

“It’s across markets. The lower middle market has traditionally been the most inefficient part of the market. We’ve seen a huge amount of LP money say, ‘no, the lower market and middle market is where we want to be,’” MacArthur said.

Further, PE’s dry powder is buttressed by shadow capital, a term Bain & Co uses to describe co-investment and co-sponsorship capital. LPs’ increasing willingness to co-invest and take direct stakes in portfolio companies could add as much as 20 percent to the $1.46 billion GPs amassed across private-market strategies last year.

Notably, LPs have more incentive to seek additional exposure to the asset class through co-investments because they’re typically offered on a no-fee, no-carried interest basis. This effectively reduces the cost of the investment and increases the investor’s share of the return.

Cambridge Associates data cited by Bain & Co suggests fees, expenses and carried interest the GP eat up around 6 percentage points of investors’ returns.

“Institutional investors want it; it improves their investments,” MacArthur said. “If it’s not offered, those folks are going to have a tougher time raising capital in the future.”

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