Life at the top

If in five years the U.S. economy emerges from another downturn and we all look back to 2014/2015 as the height of the exuberance, at least we can say – this time – we saw it coming.

A common refrain at private equity conferences after 2008 was, “We never saw this coming.” The implication being – yes, we screwed up some investments, but you can’t fully blame us because no one anticipated the global financial crisis.

This time is different. On panel after panel, and in keynote speeches at the Buyouts East conference in late March, delegates spent time talking about the top of the market and the dangers of investing in the current environment.

“Prices are very full, especially for businesses that are stable and clean. We’re picking our spots,” David Humphrey, managing director at Bain Capital, said in his keynote address.

On a similar note, Scott Sperling, co-president of Thomas H. Lee Partners, said: “We have to be cautious given where multiples have been.”

Navigating the peak environment was on the minds of both GPs and LPs at the conference, and for good reason. Prices are high, debt is cheap and private equity firms are stuffed full of unspent capital.

The perfect elements are in place for a challenged vintage year, said Brooks Zug, senior managing director and co-founder of HarbourVest Partners in his keynote address.

“It’s unlikely we should expect the kind of returns we saw a decade ago,” Zug said. “We’ll be lucky if the top-quartile funds have a 15 percent (net) IRR.”

This was a theme I heard from LPs on the sidelines, and one I keep trying to get my head around. How does an LP get used to the idea that private equity returns are going down – that the expectation is private equity will be a weaker performer going forward? The answer is that – even with weaker performance – private equity will still outperfom public markets over (pick your period of time).

Declining performance is not something confined to simply this vintage year, which will be affected by the high prices firms are paying.

The feeling is, private equity will be less spectacular than it has been in the past because it has become more competitive, more efficient. More firms, more money and, therefore, fewer proprietary deals are out there with the potential to produce the really spectacular returns.

On the other hand, a lot of people at the conference talked about the exit environment, which was described to me in a few different glowing terms, all pointing to the same conclusion: sell everything that isn’t nailed down.

Chris Mitchell, a managing director at Spectrum Equity, said during a panel on growth equity that he has never seen a better environment in which to sell investments.

In many ways, our Buyouts East conference was tinged with an overarching mood of pessimism, perhaps best exemplified by Mark Yusko, CEO and CIO of Morgan Creek Capital Management, who predicted we’d be in a recession by next year.

However, it’s not like anyone has taken themselves out of the market, and that’s important. So many people – both LPs and GPs – are aware that they are likely investing into a high point, but they won’t, or can’t, stop investing.

Why is that? GPs have raised so much money, they have to spend it. And that money comes with a deadline. Pitchbook found 2014 to be the strongest private equity fundraising year since before the global financial crisis, with LPs injecting more than $200 billion into funds. Pitchbook also found 89 percent of fund managers hit their targets last year, up from 80 percent in 2013.

And LPs have gotten so much money back through distributions, they also feel compelled to commit it to keep their allocations on track. It’s the way the private equity cycle is supposed to work: You commit to a manager, they gradually return your money as they exit investments, and you re-up with that manager’s next fund (as long as they’ve performed well).

Let’s just hope everyone is doing what they need to do to make sure when (if?) the market turns down, this industry is better prepared than it was last time.

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