Editor’s note: Sustaining private equity’s virtuous cycle

Tech appears to be single-handedly dragging along private equity M&A activity this year, keeping it at least on par with last year’s volume levels.

In our quarterly issue, Steve Gelsi reports that of the 10 largest third-quarter PE deals, seven were in technology, media and telecom. Tech businesses are drawing lofty valuations, 5x to 10x revenue for businesses with narrow and growing margins, says Peter Davis, managing director and head of financial technology banking at Macquarie.

Those valuations are motivating owners to seek growth capital or pursue sales, he said. “The goal is either to take money off the table or to seek strategic partners to help companies achieve their objectives,” Davis tells Gelsi.

Check out our quarterly M&A story, along with our quarterly fundraising and exit coverage, in this issue. We’re finding that deal activity remains robust, in part because fundraising continues strong, even though it slowed down in the third quarter compared with earlier this year. This year’s fundraising total to date is off by about $20 billion from the year-earlier total.

This is the natural PE cycle in action — GPs invest money, exit in various ways, distribute back to LPs, who then recycle the proceeds back into private equity. A lot of money is flowing into the PE ecosystem these days, keeping dealmakers and fundraisers busy.

One interesting development is the rise of distressed funds, including so-called reserve funds that are being raised to keep capital locked up just in case the economy implodes.

Private markets are signaling their expectation of a downturn in the near future, though with interest rates remaining steadily low, it’s not clear what would trigger a slump, barring the Federal Reserve finally increasing interest rates. A low-return environment seems to be on the horizon in the near future.

The low interest rates that have compressed returns have made the asset class ever more popular with institutional investors desperately searching for yield. PE and private credit are the happy recipients of eager investors looking for any sort of returns in the double digits.

Investors are willing to take more risk to hit their return targets. And with large public pensions leaving hedge funds, investors will need to lean even more on private equity to achieve their goals. One could question the morality of the Fed forcing investors into taking on more risk, but we’ll leave that for another time.

Could a rate rise interrupt this PE virtuous cycle? Hard to know — certainly hints of increased rates immediately cause grave concern among public investors, and ripples from the public markets eventually make their way into the sea of private capital, buffeting valuations a quarter or two down the line.

The Fed is meeting again in November to consider a rate hike and must contend with accusations from presidential candidate Donald Trump that it is leaving rates low to help Democratic candidate Hillary Clinton. With politics pushing in, will the Fed make a political statement about its independence and lift rates? Futures markets are pricing in a 10 percent chance of a rate increase next month and an about 60 percent chance for a rise in December, according to USA Today.

So something wicked may this way be coming, and soon. But PE appears prepared in case the Fed’s decision sends the market into a spiral. For now, dealmakers and fundraising continue to reap the benefits of the Fed’s policy, quarter by quarter.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky