Don’t Count On Multiple Expansion And Leverage Anymore

Late Cycle Risks

In the private markets world, the term “late cycle risks” has been much bandied about in recent years. A combination of high-entry multiples, high leverage, and a record amount of dry powder no doubt has driven concern among investors.

The concern is real and there are signs of late-cycle behavior. In recent years, deal timelines have become compressed, due diligence schedules have accelerated, and business plans are relying on the best-case scenario. The result is a rush to complete deals while pricing them for perfection.

Don’t count on multiple expansion and leverage anymore

Declining average returns, but steady top-quartile returns

The rise of private markets has been a structural trend for about two decades. Attracted to higher returns amidst a low interest rate environment, investors have allocated more and more of their capital to private markets, allowing them to capture multiple sources of return and create a well-diversified portfolio in the process.

With the backdrop of increasing demand for private investments, yet a limited opportunity set, competition for deals has driven up average entry multiples. From private equity to private real estate, private markets have become a victim of their own success and making money by “buying well” is getting tougher.

In fact, average private equity returns (as measured by IRR) have been trending downwards over the last two decades. According to a recent report by Bain1, average global buyout returns, which we can use as a proxy for private equity returns, have fallen quite substantially since 1999.

Figure 1: Average private equity returns have been trending downwards, while top-tier returns remain steady.

Source: Bain Global Private Equity Report 2020

This suggests a maturing market. In the past, a private equity General Partner (GP) with a long horizon could enter a down market, buy low, and exit in an up market. But such inefficiency has been reduced as the more GPs have entered in the industry and investors have chased returns to the point where dry powder has increased to record levels.

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Connect with Wu Guowei Jack, CFA, Director at CAIA Association on LinkedIn more

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