Is Private Equity Losing Its Shine?

Private equity has started 2013 with a home run. Technology czar Michael Dell has joined with Silver Lake to take Dell Inc. (DELL - Analyst Report) private for $24.4 billion. This is the largest leveraged buyout since the financial meltdown of 2008.

But the deal has already run into trouble -- most recently, shareholder opposition. T. Rowe Price Group, Inc. (TROW - Analyst Report) and Southeastern Asset Management are of the view that the deal to take the 25-year old public company private is undervalued. T. Rowe Price and Southeastern are Dell’s two largest independent shareholders and own around 13% of the tech major. Michael Dell holds 14%; he is the only shareholder with a larger stake than these two.

This development is symptomatic of the trends that have come to define private equity activity in recent times. One of the major factors pushing up the cost of deals is that private equity companies are flush with funds. According to research firm Preqin, private equity buyout funds focusing on North America collectively held idle capital to the tune of $189.4 billion as of Jan 2013. This is just 12% lower than the amount in Dec 2011. So, a large volume of capital has piled up, which private equity either has to utilize optimally or return to investors.

The other factor pushing up deal values has been persistently low interest rates. Speaking at the SuperReturn conference in Berlin, Leon Black, Chief Executive of Apollo Global Management, LLC (APO - Snapshot Report) said the average price for private equity deals in the U.S. is 9 times EBITDA. One of the major assumptions resulting from such high valuations is that interest rates will continue to be soft over the next five years, he said.

However, Apollo has managed to strike deals at lower valuations, around 6 times EBITDA. This has primarily happened by acquiring corporate "hive-offs" or businesses being offered for sale by a parent company. Together with these two factors, the lack of growth opportunities across the globe has meant private equity may never generate the kind of returns it has in the past.

It would still be wrong to say that private equity has completely lost its shine. Over time, private equity has consistently outperformed other asset classes. The Cambridge Associates LLC U.S. Private Equity Index has an internal rate of return (IRR) of 13.7% for the ten years up to Sep 30, 2012. This is significantly higher than the S&P 500’s return of 8% for the same period

However, returns are now comparatively lower. Data from Cambridge Associates shows that the top performing 25% of U.S. funds managers who launched funds in 2001 have to-date returned an IRR of 36.5%. This is significantly higher than the IRR of 13.9% of the top performing 25% of funds launched in 2004. By this time, the number of funds had grown from 24 to 66, which shows that returns have fallen since the number of funds increased.

The focus now seems to be on prudent financial transactions, a far cry from the complicated financial engineering of the past. Fund managers are now seeking out companies with a high intrinsic value, before even attempting to turn them around. Such a strategy is aimed at launching a second IPO, the most lucrative outcome of a private equity deal.

Therefore, deals are evaluated with an increasing focus on operational feasibility. This is why propositions such as Best Buy Co., Inc. (BBY - Analyst Report) are viewed with skepticism by fund managers. The major concern in this case is that the company operates in a dying industry and a turnaround would be highly risky.

It’s not that the entire industry has reoriented itself towards a low risk, conservative approach. Speaking at the SuperReturn conference, Howard Marks, Chairman of Oaktree Capital, said the slow recovery in both Europe and the U.S. has meant investors are moving towards riskier propositions in the quest for higher returns. Marks said the ratio of debt on leveraged buyouts is moving towards “pre-crisis highs.”

However, even in such a scenario, the U.S. is being preferred over Europe. This is primarily due to robust earnings growth from companies, a shale gas-fueled boom and a higher number of deals. But overall, it is the emphasis on bargain hunting and improving a company’s operational efficiency which has made the U.S. a standout destination for private equity. And the trend looks set to continue.