Asset AllocationMarch 6, 2015

Bain: Private Equity's Success Could Be its Investors' Downfall

An impressive track record could mean higher hurdles for private equity managers—and their investors.

Reported by Featured Author

Private equity exits and dry powder skyrocketed in 2014, securing strong fundraising and returns but creating new challenges for limited and general partners (LPs, GPs), according to Bain & Co.

The consulting firm’s data found it was a great time to be a seller in 2014. Exits shattered all expectations at $456 billion from 1,250 sales last year, surpassing the peak of $354 billion in 2007. The figure was nearly 67% higher than it was in 2013.

Buyout exits also hit record highs, with the help of a heavy influx of capital and expensive assets, reporting a 22% increase in North America and 16% in Europe, the report said.

“The flow of so much capital came as a welcome relief to limited partners and general partners alike and has infused the industry with new confidence that returns from holdings acquired during the peak investment years will end up better than most industry pundits feared,” wrote Hugh MacArthur, head of Bain’s global private equity team.

Private equity firms also enjoyed a solid fundraising year, benefitting from ample cash distributions from exits and increasing number of LPs looking to top up their allocations.

According to the data, 1,001 funds secured nearly $500 billion in new commitments last year, just 6% less than in 2013. Funds raised over the past two years also surpassed amounts raised since 2003, except for the boom years between 2006 and 2008.

However, Bain foretold a danger of investors flooding the market with new commitment.

The report’s data revealed the median return of private equity holdings in a public pension fund portfolio was 10.8% over a 10-year period as of mid-2014, outperforming public equities, real estate, and fixed income.

Anticipating similar outperformance in the future, a large majority of LPs said they planned to maintain or increase their private equity allocation, according to Preqin data.

GPs, on the other hand, had difficulty catching up to the booming demand, Bain said, with the average time needed to raise a new fund lingering at 17 months.

“By identifying funds that have a demonstrated model for generating alpha, LPs can differentiate successful funds that will likely win again” —Bain & Co.

According to the report, the overflow of cash and demand has also trickled down to smaller GPs with shorter track records and even into LPs’ direct investments.

However, these conditions—massive exits, strong returns, and the excess of cash—are likely to create an even more challenging environment for the industry, particularly for GPs, Bain said.

“The challenge of how to make money investing in private equity has never been greater,” MacArthur said. “Supported by a continued abundance of low-cost debt and high valuations for comparable public companies in most markets, more private equity money chasing the same assets has led to stubbornly high pricing.”

The consulting firm forecasted pricing bubbles would continue to form in 2015 as firms sat on record amounts of dry powder last year: Nearly 6,000 firms had $1.2 trillion in undeployed capital.

It would become increasingly difficult to identify winners from losers as well as the lucky going forward, the report said. The gap between the top-performing and bottom-quartile GPs continue has narrowed to less than 50 cents, the data showed, largely due to to high acquisition prices and longer holding periods that could erode returns.

The key to identifying the truly successful GP must ensure that it is able to generate alpha repeatedly, the report concluded.

“By identifying funds that have a demonstrated model for generating alpha, LPs can differentiate successful funds that will likely win again from those that are not apt to repeat their past success—though this is easier said than done,” the report said.