Bain's Global Private Equity 2020 report highlighted that the last decade in private equity is the first that comes anywhere close to the equivalent public market index returns. This can, in part, be attributed to the strong recovery the domestic U.S. economy saw following the Great Recession, however, this also points to the increase in prices and valuation multiples across the board for private equity. Over the past 10 years through 2019, the S&P 500 index has produced an IRR of ~15%, with private equity average returns through the same time period marginally topping that figure.
Half of the returns in private equity were derived through multiple expansion, which highlights the need for new sources of alpha in the future. This need becomes even more obvious with a close look at recent multiple trends, with record highs and deteriorating macroeconomic conditions following COVID-19, perhaps into the next decade. The spread between entry and exit multiples has likely plateaued and could start to diminish. Further, most GPs can no longer include multiple expansion as a given in their LBO models.
In order to continue growth and the expansion of the private equity industry, GPs must find new sources of value creation if multiples can no longer provide the same degree of return contribution. These new avenues of value can include rollup strategies, M&A, reducing costs, gaining market share, or expansion into new products or locations. However, this change in operations is new is easier said than done.
In Bain's report, researchers highlight that 65 fully realized buyout deals invested in 2009 through 2015, the average margin fell significantly short of the LBO model forecast, and the bulk of deals failed to meet projected margin expansion targets. To put a finer point on the issue, for the deals where margin improvement was critical as part of creating value, more than ¾ of the studied deals did not meet the margin target. In other words, the operating skills of private equity are currently inadequate to continue relative outperformance of public benchmarks.
Whatever strategy or strategies GPs decide to use; fund managers will continue to face a broad challenge: how to put record amounts of dry powder to work amid stiff competition and difficult macro conditions. The most effective responses will include more thoughtful approaches to talent, technology-driven insights and creating a scalable operating model that can contribute investment multiples without a need to rely on expansion.
If expense allocation software (or spend management software) could help your hedge fund or private equity firm, get in touch with us to learn more about what we offer. We can set up demonstrations, trials and complimentary consultations to see if Resolvr fits your fund's requirements, with no strings attached.
Matt is an ex-Morgan Stanley investment banker, bringing an innovative, go-getter mentality and facilitating new opportunities for the business.