April 20, 2018
– The Silver Lining in Norway’s Rejection of PE
– Yale’s Pointed Rebuttal of Buffet on PE
– Buy and Build Becomes the Norm in LBOs
– A Record 80 Percent of Leveraged Loans are Cov-Lite
– LBO Funds are Registering Record Returns
– PE KeyTrends Quick Question Results
THERE’S A SILVER LINING BURIED IN NORWAY’S REJECTION OF PE. With Bloomberg and other news outlets reporting that Norway’s $1.1 trillion Government Pension Fund Global – the world’s largest sovereign wealth fund – will not be investing in private equity, there’s disappointment in general partner ranks. Yet GPs should take heart: this was a political decision, not one based on investment sense. The government feared controversy tied to the cost of active management. It wasn’t focusing on the outsize net returns that private equity credibly promises. Indeed, as Bloomberg reports, “the government went against both the wishes of the fund and the recommendation of a government-appointed expert group” in rejecting private equity. Asset managers today – including those at the world’s largest sovereign wealth fund – want to invest more in private equity. The Norwegian government pension fund’s campaign – which may not be over – is an example of that.
THE YALE ENDOWMENT’S POINTED REBUTTAL OF WARREN BUFFETT ON PE is a highlight of its much anticipated annual report. Yale has been the top-performing U.S. university endowment over the last 20 year and it attributes its 12.1 percent annual net return, as well as the superior returns of many peers, to reliance on alternative investments, particularly private equity. In addition to revealing that the $27.2 billion endowment has more invested – roughly a third – in the PE subsectors of buyout and venture capital than in any other category, the report takes aim at Buffet’s derision, delivered in one of his investment letters, of the PE-reliant, ‘endowment model’ of investing pioneered by David Swensen, Yale’s chief investment officer since 1985. “Buffet notes that alternative assets often carry high fees, but net returns matter, not gross fees,” writes Yale. “Not only has the [endowment] model worked for two decades, it will work for decades to come.”
BUY AND BUILD STRATEGIES ARE NOW THE NORM IN PE, at least in the U.S., private equity’s biggest market. Reuters writes that in the first three months of 2018, a U.S. record of “70 percent of LBOs were bolted onto private equity portfolio companies,” rather than purchased by funds as standalone investments. Though “it was rare 10 years ago for a [private equity] investment case to be predicated on making additional acquisitions…now it is common.” Heated competition among funds for assets and the record prices managers must pay to acquire those assets explains the dominance of buy and build. Synergies and expansion into new products and geographies through bolt-ons are frequently key for creating value in PE today – particularly in the crowded mainstream buyout sector.
A RECORD 80 PERCENT OF LEVERAGED LOANS ARE COV-LITE TODAY, notes Fitch Ratings, versus just 25 percent “at the credit cycle peak before the last recession.” Although covenant-lite terms give lenders less recourse in the event of deteriorating financials at private equity portfolio companies, they actually make the PE-backed firms and the funds that own them more resilient. Less stringent covenants means PE funds and their portfolio companies have greater freedom to borrow and to dispose of their assets in the event of difficulty, making recovery more likely.
LEVERAGED BUYOUT FUNDS ARE REGISTERING RECORD RETURNS, according to eFront’s latest Private Equity Performance Overview. The value of the typical leveraged buyout fund reached an all-time high of 1.49 times the value of its original investments in the third quarter of last year, according to the 20-page report, which covers the returns, risks and liquidity of PE funds. Fund values are likely to climb higher as long as the bull market for publicly quoted companies continues, notes eFront. As the saying goes, a rising tide lifts all boats. But in the event of a downturn, smaller private equity funds operating in the less efficient, frequently cheaper, small cap sector and in less correlated specialities – precisely the types of funds commonly found in Palico’s marketplace – may do best.