What a difference a year makes. Flashback to the ACG Intergrowth convention in May 2009, when the mood of the Private Equity (PE) community seemed as somber as a mortician’s convention. Fast forward one-year later to this year’s event and the PE world is abuzz again with bullish sentiment and overall feelings of optimism and hope.
Conversations are no longer centered on which major financial institution is about to become insolvent or what bastion of U.S. corporate elite is about to declare bankruptcy. Talk now revolves around the growing strength of the U.S. economy, the stabilization of most middle market businesses and the return of PE activity, especially for companies with EBITDA of $10 million and above.
The return of PE activity is being buttressed by senior lenders who have begun to open up their checkbooks again while watching Sr. Debt/EBITDA levels approach 4.25 times and Total Debt/EBITDA levels climb north of 5.0 times. With more companies seeing improved financial performance, the return of senior lending and nearly two years’ worth of pent-up demand from sellers, things are beginning to look much brighter for the PE community. The near-term prospect of rising deal activity appears likely but there are still troubling signs.
All of the aforementioned positive attributes of the current deal market, coupled with the available equity on the sidelines ($400 billion in committed private equity funds and $1 trillion of cash on public balance sheets), could help prices for high quality assets rise. Word on the street would have you believe that solid companies with $10 million plus in EBITDA are selling for 8 to 10 times EBITDA.
One class of PE investors in particular are aggressively seeking out investment opportunities and helping drive valuations higher. “End of fund life” PE firms are best characterized as those that invested the majority of funds in deals from 2005 to 2007 and have a third, or less, of their initial capital left to invest. These funds are in very precarious situations. Many paid extremely high multiples from peak earning years using a highly leveraged capital structure. That means these portfolio companies are either significantly underwater or have very little hope of obtaining a substantial equity return upon a realization event. These funds are nearing the end of their fund lives and that means PE firms must either invest their remaining funds or return them to the Limited Partners (LP). You don’t need to be Stephen Hawking to figure out what the PE firms are going to do – they will invest the funds.
This confluence of events is causing many PE firms to use their remaining funds to make investments in the hope of hitting a home run. The near term result is that these PE firms will drive up prices, especially for the highest quality assets.
As I have written in the past, I believe the net effect will be that many of the vintage funds established from 2005 to 2007 will not survive the Great Recession. But, have no fears, there will still be plenty of PE firms to fill the void.