Private Equity's Trillion Dollar Hole?

Andrew Blackman of the WSJ reports, Private Equity Has More Than It Can Spend:

How does it feel to have a trillion dollars burning a hole in your pocket?

Ask the private-equity industry. It has been so successful in raising money from investors recently that it can't spend it fast enough.

The amount of money raised by private-equity firms but not yet invested—known as dry powder—hit a record high of $1.073 trillion globally at the end of 2013, according to data provider Preqin, an increase of $130 billion from 2012. The total has continued to grow this year, reaching $1.141 trillion globally as of the start of June.

"Private equity has been the best-performing asset class for many institutional investors over the long term," says Hugh MacArthur, head of global private equity at consulting firm Bain & Co. "In a world where many other investments, like credit-based investments, offer a very low yield, they're saying they need to continue to pursue those returns, so they're putting more money into private equity."

The influx of capital is good news for the private-equity industry, but it may not be such good news for investors. Some analysts fear that private-equity firms will struggle to invest such a large amount, resulting either in money remaining uninvested for years or in fund managers overpaying for deals, both of which could affect investor returns.

Reinvesting Profits

For now, that's not deterring investors. They committed $431 billion to private-equity funds in 2013, the highest amount since the financial crisis that started in 2007, according to Preqin. And that is set to continue, as 90% of investors surveyed by Preqin in December said they intend to invest either the same amount or more in private equity this year compared with last year, and 92% said they would maintain or increase their private-equity allocation over the longer term.

One factor in those plans, says Bain's Mr. MacArthur, is that investors are reaping substantial profits from older private-equity funds.

Frustrated Shoppers

The problem for private-equity firms is that the same strong stock market that has allowed them to collect big profits in the past couple of years on their earlier investments is making it harder to find good investments now.

"A lot of the private-equity sponsors I speak with are really frustrated at finding opportunities at a price they're interested in," says Lee Duran, partner and private-equity practice leader at consulting firm BDO USA LLP.

Sectors like software as a service and health care are particularly popular among investors right now, says BDO's Mr. Duran, meaning valuations for companies with strong profits and good growth prospects can be very high.

In December, BDO asked more than 100 U.S. private-equity executives what their most significant challenge would be in the coming year, and the most common response was pricing, cited by 39% of respondents, up from 15% in a similar survey a year earlier. Second on the list was identification of quality targets, cited by 34% of respondents, up from 28% in the previous survey.

Despite these challenges, deal activity has remained strong, with $171 billion in private-equity-backed buyout deals in North America in 2013, up 10% from 2012, according to Preqin.

Money Is Still Welcome

The bottom line for investors: Private-equity firms may struggle to find compelling investment opportunities in such a strong market, and this could make it harder for them to achieve the level of returns that investors have come to expect.

It appears unlikely, though, that the private-equity industry will start turning away investors.

It would be very unusual for funds not to be able to find any suitable opportunities and to return money to investors, Mr. MacArthur says. It's more likely that they'll simply take longer than usual to invest.

"I don't think we're massively out of balance right now, but it's something that bears watching over time," says Mr. MacArthur.

In October, I wrote a lengthy comment on fresh signs of a private equity bubble, noting the following:

There is no doubt that private equity has been one of the best performing asset classes but I caution readers, there is a wide dispersion of returns among funds and top quartile funds typically outperform over long periods, so take past performance with a shaker of salt. If investors weren't in the right funds, they grossly underperformed the S&P 500.

I think it's important to understand why investors are piling into private equity. Faced with low yields in credit investments and volatile stock markets, pension funds are increasingly gambling on alternatives, making private equity and hedge fund managers obscenely wealthy.

But there are a lot of problems with all this money pouring into private equity. First, there are fewer deals available at attractive prices. As stock markets soar to record highs, it helps PE funds exit investments but it also raises valuations on current deals.

Second, the influx of pension and sovereign wealth fund money pouring into the asset class is diluting future returns. This isn't just a PE problem. The same can be said about private real estate and other asset classes. As money pours in, future returns diminish and for a good reason. There is more and more money chasing fewer and fewer deals.

Third, investors should be asking tough questions on the fees these private equity funds charge. In April, I discussed bogus private equity fees, but there is another concern. Large PE funds are fast becoming nothing more than glorified asset gatherers charging 2&20 on invested capital. The pressure to invest the capital to charge fees can lead to dumb decisions to invest in riskier deals.

Finally, there is something else that concerns me about the PE bubble. Over the weekend, William Alden of the New York Times wrote an article, A Mad Scramble for Young Bankers, basically going over the battle for talent between banks and private equity funds.

I will let you read that article but I like the way it ends:

Some analysts, however, are looking to leave Wall Street altogether.

Linda Lian, a former Morgan Stanley analyst, interviewed with private-equity firms last year. The process made her realize that she was not passionate about the business of buying companies and trying to revamp them. She recalled one interview in particular.

“I just remember speaking to one of the partners, and being interviewed by her, and realizing I didn’t want her life,” said Ms. Lian, 24, who graduated from Harvard in 2012. She now works in finance and business development for a mobile phone security company in San Francisco.

“Working at a private-equity fund was going to be like Banking 2.0,” she said. “Eventually, I just realized I simply didn’t want it.”

Of the recruiting process, she said, “it’s not really so much a process as a feeding frenzy, with banks, headhunters and private-equity funds all caring about their own interests.”

“When all this starts happening, you have no choice, really, not to engage with it,” she said. “If you don’t, there’s so much peer pressure around you, and you feel you’re missing out on opportunities.”

Smart lady. My advice to all these young ambitious graduates from top-notch universities is to follow her lead and stay the hell away from Wall Street.

Of course, these kids are graduating with piles of debt and the allure of big money will reel them in. They're too young to grasp the long-term consequences of their decision (remember the wise words of the late George Carlin: "it's all bullshit and it's bad for you.").

Below,  David Fann, TorreyCove Capital Partners, says investors need to be selective when investing in private equity. And Mark Okada, Highland Capital, shares his thoughts.