Private Equity: Still Overrated and Overvalued?

By: Dan Rasmussen

Four years ago, I published a long-form essay critiquing private equity as overrated and overvalued. “Beware markets where investors are not only bullish but also borrowers,” I argued, highlighting what I perceived as excessive valuations and excessive leverage levels.

But over the last four years, investors would have done well to ignore my essay completely. As measured by private equity’s results over the past four years, my thesis appears to have been wrong. According to the latest Pitchbook benchmarks, private equity has significantly outperformed public market benchmarks over the trailing three- and five-year periods. So it’s time to process what’s happened in private equity since I wrote my article and to evaluate my thesis.

The core of my initial critique of private equity was that valuations were too high and that, historically, returns had been highly correlated with purchase multiples, both on an individual deal basis and also comparing vintage years to entry multiples. The below chart compares US buyout’s public market equivalent return (PME) to the difference between private equity purchase multiples in aggregate and the S&P 500. The below chart shows that PMEs were highest prior to about 2004, when valuations in private equity were significantly below public markets. In about 2006, private equity valuations began to exceed public market valuations and private equity returns went below public markets.

Figure 1: US Buyout Public Market Equivalent (PME) and Excess EBITDA Multiples, 1998–2021

Source: Cambridge Associates, Pitchbook, Capital IQ

And so as private equity valuations went ever higher relative to public markets in the 2010s, I argued that PME returns would fall further. But, as the chart above shows, in fact PMEs have been healthy throughout the 2010s.

So what happened? How did private equity generate such good returns despite paying very high valuations and using almost scary amounts of leverage?

The answer is that private equity managers also looked at this data and came to a different conclusion than I did. The conclusion they came to was that, if high multiples were the price of entry, then the industry needed to shift focus from traditional industrial and cyclical sectors into high-growth sectors like tech and healthcare. Buyouts shifted toward growth equity, with software and healthcare going from 15% of transaction value in 2007 to ~40% of transaction value in 2021 according to Pitchbook, numbers that probably understate the shift.

And so private equity returns went from looking like small value returns to looking like small growth returns. And this shift from value to growth coincided with a period of exceptionally strong returns for small growth and weak returns for small value.

Figure 2: Annualized Returns by Asset Class, June 1986 – June 2021

Source: Pitchbook, Cambridge Associates, Ken French data library, Verdad

A combination of real technological advances in cloud computing and a dramatic expansion of valuation multiples for tech companies led to a robust exit environment. And small changes in valuation multiples can lead to big changes in equity returns for highly leveraged companies, making private equity one of the biggest beneficiaries of the boom in technology stocks.

Over the past decade, we’ve seen high valuations lead to good returns, not bad returns. We’ve seen high leverage levels juice these returns rather than lead to high bankruptcy rates. So the exact type of behavior I warned about in my piece turned out to be a pro, not a con, to the private equity industry. As a result, valuations have soared to extraordinarily high levels. The below chart compares TEV/EBITDA multiples for the S&P 500 to Verdad’s estimate of GAAP EBITDA multiples for US buyouts (we take the pro-forma numbers from Pitchbook and adjust them based on a KPMG study of the difference between pro-forma and GAAP).

Figure 3: TEV/EBITDA Multiples of US Buyout vs. S&P 500

Source: Pitchbook, Bloomberg, KPMG

Valuations in 2021 for private equity deals were 10% higher than the S&P 500 and about double where valuations were in 2010! This has been a significant tailwind for the asset class.

Leverage levels have increased proportionately, with debt levels reaching an all-time high. This leverage is provided by new lenders—private credit firms—which are taking novel risks and raising massive amounts of capital. The chart below compares US buyout leverage levels to leverage levels of B-rated bonds. Most of the debt is issued at the boundary of distressed credit ratings (~20% of B-rated bonds go bankrupt over five years according to data from Moody’s, which doesn’t bode well for private credit instruments issued with similar characteristics).

Figure 4: Net Debt/EBITDA Multiples

Source: Pitchbook, Bloomberg, KPMG, Verdad

We can plug these valuations and leverage numbers into a simple LBO model to understand historic and estimated returns for private equity. The below table shows a simple underwriting model for deals done in 2000, 2010, and 2021.

Figure 5: US Buyout Underwriting Model

Source: Verdad, Pitchbook, Bloomberg

Historically, entry and exit multiples were one of the main drivers of US buyout returns. Private equity returns benefited significantly in 2000 and 2010 from exit multiples well in excess of entry multiples. The model above assumes that valuation multiples are flat from 2021, but valuation multiples at 19x EBITDA are 70% higher than the S&P 500 long-term EBITDA multiple of 11.2x. A 15% drop in exit valuation multiples to 16.4x (i.e., 40% above the S&P 500 long-term average multiple) would take the net IRR down to 6%. Clearly, mean reversion in long-term valuations poses significant risks to private equity returns.

And while the last decade has been wonderful for small growth investors, the long-term profile is far less comforting. In fact, small growth has been one of the worst performing sectors of the public equity market, with some of the highest volatility. Growth investors have been much better off in large-cap growth companies than in the riskier small growth sector.

Figure 6: Performance Indicators by Strategy, June 1986 – June 2021

Source: Ken French data library

So while the past four years have been very kind to private equity, we would argue that future returns look materially worse and future risks materially higher than when I wrote my original article in 2018. As we’ve written, smart investors are often too early in calling bubbles, though we don’t know yet whether my call on private equity was too early or wrong.

The average US buyout transaction looks quantitatively like a highly leveraged micro-cap public equity. In 2000, the average buyout was completed at a 50% discount to the S&P 500; in 2021, the average buyout was completed at a 10% premium to the S&P 500, during a period when S&P 500 valuations soared to near record levels. To justify these prices, PE firms have shifted to growth sectors like tech and healthcare. Leverage levels have increased. Credit stats look significantly worse than B-rated corporate bonds. In sum, PE LPs are paying higher-than-S&P 500 prices for near-distressed credit quality micro-caps with a heavy sector bias toward tech and healthcare. With cracks showing in public markets for these sectors, and for growth in general, I fear that the reckoning might be finally arriving for private equity.