Caveat Emptor, Private Equity LPs!
PitchBook just released its 2016 annual report on U.S. private equity, and the picture does not look pretty for private equity LPs. Deal prices have soared to the highest levels ever recorded — surpassing the peak of the private equity bubble in 2006–2007.
Figure 1: Private Equity Deal Multiples
Source: PitchBook
Capital inflows into private equity have been significant. Investors committed over $180 billion to the asset class in 2016, with a strong bias toward larger managers, who are typically buying more expensive deals than the smaller niche players. This money is adding to an already substantial inventory of private equity-owned companies.
Figure 2: U.S. Private Equity-Backed Company Inventory
Source: PitchBook
LPs are pouring money into PE funds expecting high returns and low volatility — high returns because of the last 20 years of outperformance, low volatility because they compare the mark-to-model accounting of private equity to the excess volatility of public markets.
Surveys of private equity LPs reveal a level of optimism that is, in and of itself, a bearish signal. About 40% of private equity LPs expect the asset class to generate >4% outperformance of public markets. High expectations and high returns do not usually go together, and this type of exuberant optimism is likely not be rewarded.
The base rate of return on private equity deals done at >10x EBITDA is abysmal. Historically, over 50% of deals done at >10x EBITDA have lost money. The aggregate multiple of money has been barely 1x, and the internal rate of return (IRR) has been lower than 5%.
In the graph below, I show the results of a back-test of this expensive LBO strategy from 1999–2016. It shows the estimated return of an equal-weighted portfolio of all liquid, public companies trading at >10x EBITDA with >5x Net Debt/EV based on annual rebalancing.
Figure 3: Portfolio123 Back-test of Expensive Leveraged Equity Strategy
Source: Portfolio123
It is evident from the graph that this universe of stocks underperformed the market. Worse these stocks showed greater drawdowns, higher volatility, and negative alpha. Buying companies at >10x EBITDA with >5x Net Debt/EV might be a dangerous and risky decision. The reference class of both private equity deals and public equity investments made with these quantitative parameters is poor. And consider that the results of this back-test simulation do not include private equity’s massive fee load.
I started Verdad because I believe that the private equity strategy employed in the 1980s, 1990s, and early 2000s is one of the best money-making investment strategies ever created. But, I believe that the strategy currently being employed by many private equity firms will not work. The level of money flowing into the asset class, the leverage being employed in deals, and the prices being paid are warning signs of a private equity bubble.
Combining leverage and high prices is a bad idea. With the prices private equity is paying (5–10% EBITDA/EV) and the leverage levels at which it’s buying (>50%), the current crop of LBOs is likely generating ~6% free cash flow yield. We estimate that to make a 15–20% IRR, these companies would either have to grow considerably or see significant multiple expansion. Net of private equity fees, that 6% free cash flow yield is not likely to generate a 10%+ return.
In contrast, the universe targeted by Verdad (>15% EBITDA/EV and >50% net debt/EV) is likely generating dramatically higher free cash flow yields than the broader market — and can generate 15–20% returns with only a minimum of growth or multiple expansion. This is how private equity made money in the 1980s and 1990s, and the math hasn’t changed.
Compare our back-test of buying leveraged small value equities to the return of leveraged small expensive equities shown above. The below back-test presents the current version of Verdad’s quantitative model for choosing leveraged small value stocks and is constituted through quarterly rebalancing.
Figure 4: Portfolio123 Back-test of Verdad Universe
Source: Portfolio123
As you can see, the results of this back-test dramatically outperform the markets, generating >15% per year alpha. We follow what we consider the old world private equity strategy — the approach that has made so many private equity LPs and GPs so rich.