By William Gilmore, Head of Primary Funds Europe
Private equity markets have become very crowded of late. More money is chasing fewer opportunities so valuations have become stretched.
Preqin, a research firm, found that the level of firms' dry powder - the funds available to invest - rose from $757 billion at the end of 2015 to a 10-year high of $839 billion at the end of September 2016. Approximately 63% of dry powder is in the buyout space, with 20% in venture capital.
Record inflows are also causing intense competition among managers for new deals. And with 56% of active private equity investors planning to increase their allocation in the longer term, the problem is unlikely to go away anytime soon.
As valuations remain high, private equity investors will have to think harder about what constitutes a good deal.
As valuations remain high, private equity investors will have to think harder about what constitutes a good deal. The challenge is that institutional investors want to deploy capital, but only at reasonable valuations. As competition for deals intensifies and dry powder accumulates, there is more of a temptation to be less selective when striking deals. However, selecting the best investors in each strategy, geography and sector is as critical as ever. Holding a diversified portfolio of investments, across sectors, geographies and vintage years is of equal importance.
It's hard to deny that the private equity industry faces structural challenges. Growth of the number of firms, competition and institutionalization of the industry has eroded many of the market inefficiencies that existed in previous years. In some parts of the market, there simply isn't much juice left to squeeze.
This new environment will therefore favor sector specialists - those private equity firms with strong expertise within specific sectors that are well resourced and that have wide networks with underlying companies in those sectors. Furthermore, those firms with a broad geographical footprint can uncover opportunities in regions that may be overlooked by other investors.
Often, it's the less exciting or trendy parts of the market that are worth investigating. They tend to get overlooked. For example, there are many firms focused on new products and devices in the healthcare market, but there are far fewer that are focused on the services provided by hospitals and nursing homes. The latter may not grab as much attention, but the potential for more solid and reliable returns is far greater. The former has limited exposure to technology risks, a less stringent regulatory environment and usually contains mature and stable businesses. Devices firms, in contrast, are largely young and very often expensive.
While attractive deals are harder to come by, they can be found if you look hard enough.
While attractive deals are harder to come by, they can be found if you look hard enough. Some of the most promising are in the technology space. Technology has long provided opportunities for private equity firms to invest in, and that trend has accelerated in recent years. Trends from Big Data to cloud computing, to digital retail and the "internet of things" continue to disrupt markets and drive activity levels.
Technology is also behind many developments in healthcare, from connected health (providing healthcare remotely through sensors and wearables) to new areas like robotic surgery and 3D-printed body parts.
Enterprise software (or business services) is a very promising area. Companies in this space range from tech start-ups to established blue chips, but all develop software for organizations. This software is behind everything from smartphone banking to cloud computing solutions. Many of the smaller companies in the business services space are ripe for consolidation, with inorganic growth seen as the optimal route for expansion. Private equity firms can identify hidden value in these fast-growing software, data and technology solutions companies. Collaboration with such tech firms can provide the necessary capital and long-term strategy required for their success.
A side effect of the current tough environment is that there will likely be more longer-dated funds. These funds may allow private equity investments in previously inadmissible areas and may interest investors with long time horizons like pension funds and insurance companies. Indeed, a U.S. alternative asset management firm recently announced its first long-dated (about 14-year) private equity fund.
So it's worth remembering that amid all the negative headlines, good companies and deals do exist if one looks hard enough. Patience and diligence are the order of the day.
Additional disclosure: The investments discussed herein may not be available or suitable for all investors unless the investor meets certain regulatory eligibility requirements.