Private Equity has turned into one of the most sought-after asset classes for long-term investors. Long-term investors, such as insurance companies, pension funds, and endowments, account for 75% of the capital sources in Private Equity. Overheated equity capital markets, overall low interest rates and their superior return profiles, approximately 15% net IRR (Internal Rate of Return) p.a. over 15 years, made PE funds so attractive for investors. Last year was record-setting in terms of fundraising. Nearly USD 1,300 billion were committed to this asset class in 2021 alone.
A total of USD 5 trillion was raised over the past 5 years. In consequence, this also led to an all-time high in terms of undeployed capital (dry powder) of USD 3.4 trillion chasing for assets.
What returns investors are looking for in Private Equity? A fund’s performance is measured with two key parameters: the absolute multiple of the investment returned to investors and the net IRR over the investment period. Hence, to achieve the expected returns of 20% p.a. over 5 years, a fund needs to return 2.5 times the invested capital to their investors, also referred to as LPs (Limited Partners).
How can these returns be achieved? Originally, PE was all about financial engineering. At times, when a fund could acquire a company for six times EBITDA and re-finance the acquisition with 50% debt capital (i.e. three times EBITDA), hold the investment for five years, repay the loan and sell the company for the same multiple, the fund generated a multiple of two or an IRR of 16% p.a. on the investment.
Nowadays, these low multiples can no longer be realized. Too much capital chasing assets, low interest rates and the high public equity valuations led to an unprecedent rise in valuations. Buyout funds on average pay 12 times EBITDA for their investments. Still, lenders have not increased their appetite in providing more than three times EBITDA for the acquisition finance. Applying this equation to the LBO model, one can immediately see the impact on the return profiles. Ceteris paribus they would go down to multiples of 1.35 or IRRs of 6% p.a.
What does that mean for PE practitioners? The only answer to this situation is more focus on value creation within their assets. Simple financial engineering is not enough to meet the return expectations of LPs. Using the same example again, a fund would need to improve the EBITDA of the portfolio company by 5% p.a. to achieve the same return profile.
This completely alters the talent profile of an investment professional. Prior to the investment, a substantiated investment hypothesis needs to be developed with a clear path forward on how to create value in the portfolio company. What top-line measures can be realized; what bottom-line improvement can be achieved. What can be done? Who is needed? What are contingencies? How can it be monitored? Analytical thinking or Excel-skills become less relevant and/or more a hygiene factor. It is all about judgment, experience and execution.
What does that mean for young professionals? The straight career path of working for a bulge-bracket investment bank and then moving into Private Equity might not be the best way forward to succeed. Following a more horizontal career path, in different countries, sectors; combing start-up and corporate experience and being digitally fluent is a promising path forward to become a smart capital investor.
