Private Equity Report 2014 — Paying for the Recovery

By 2014 private equity had not merely recovered from the crisis; it was in its strongest fundraising environment on record. The reason was performance, and the performance was real: funds that deployed in 2009 and 2010 produced exceptional returns.

The US Venture Capital Report 2008 explains why crisis vintages perform, and the mechanism applies equally to buyouts. Entry prices were low, competing bidders were scarce, and the holding period coincided with an extraordinary expansion in valuations and a collapse in the cost of debt. Those funds bought cheaply into a decade of multiple expansion.

The difficulty is that success attracted capital, and the capital arrived into inverted conditions. By 2014, purchase multiples had recovered to pre-crisis levels or beyond, debt was abundant and cheap, and competition for assets was intense. The capital raised on the strength of buying cheaply was committed to buying expensively, and this is the central tension the report examines.

The analytical tool that resolves it is return decomposition, and it is the discipline the industry is least enthusiastic about. A buyout return comes from three sources: the multiple at exit versus entry, the leverage applied, and the improvement in the business itself. Only the third is attributable to skill. The first is a market outcome; the second is a financing decision available to everyone.

Decompositions of the pre-2008 and post-2009 vintages consistently find that multiple expansion contributed a very large share of returns — a component that requires nothing of the manager beyond having bought before prices rose. That is not a criticism of the returns, which were genuinely earned by whoever took the risk. It is a statement about what should be extrapolated, and the answer is: less than the headline suggests.

Cheap debt compounds the problem in a way that is counterintuitive. Abundant, low-cost leverage is usually described as helping returns. In a competitive auction it mostly raises the price. If every bidder can borrow more cheaply, every bidder can pay more, and the winning bid absorbs the advantage. The benefit of cheap debt accrues to the seller, and the buyer is left with a higher entry multiple and more leverage on it.

What 2014 actually looked like

Establishing the conditions matters, because the argument is about the relationship between them.

Fundraising. Very strong, with capital concentrating toward established managers. Investors reallocating from fixed income — where yields had been suppressed — found private equity's return targets attractive relative to the alternatives.

Purchase multiples. Recovered to pre-crisis levels in many segments. The distressed entry prices of 2009 were long gone, and competition for quality assets was intense.

Credit conditions. Abundant. Leverage multiples had risen back toward pre-crisis norms, covenant protections had weakened — the erosion the Distressed Debt Report 2010 traces from its origin — and the cost of debt was very low.

Dry powder. At record levels. Substantial committed but undeployed capital, carrying a deployment obligation.

Exits. Strong, which is the other half of the picture and the reason conditions felt good rather than concerning. Selling into a high-multiple market was excellent for the crisis vintages, and every exit at a high price validated the environment for the buyer paying it.

The uncomfortable observation is that these conditions are not independent. Abundant capital raises purchase multiples. High multiples produce strong exits for earlier vintages. Strong exits produce distributions that fund new commitments. The cycle is self-reinforcing while it runs, and every participant's experience confirms it.

A market where everything looks good simultaneously is usually one variable expressed several ways. In 2014 the variable was the price of capital, and it was setting fundraising, entry multiples, leverage and exit values at once.

Decomposing a buyout return

The exercise is simple arithmetic, and its results are consistently uncomfortable.

The three sources:

• Multiple expansion. Exit at a higher multiple of earnings than entry. Requires nothing of the manager — it is a market movement.
• Leverage. Debt amplifies equity returns when the asset return exceeds the cost of debt. Available to every participant; a financing choice, not a skill.
• Operational improvement. Growth in the earnings themselves — revenue growth, margin expansion, better capital allocation. This is the only component attributable to what the manager does.

What decomposition studies consistently find for pre-crisis and post-crisis vintages: multiple expansion contributed a very large share, frequently approaching or exceeding operational improvement.

Why that matters for extrapolation, in three steps:

• Multiple expansion is not repeatable at will. It depends on where multiples start and where they end. Buying at a low multiple in a rising market delivers it; buying at a high multiple requires them to rise further from an elevated base.
• It is mean-reverting over long horizons. Multiples cannot expand indefinitely, and a decade of expansion raises the likelihood of the opposite.
• It is the component the track record cannot distinguish from skill. A manager who bought in 2009 and sold in 2015 shows an excellent return. Nothing in that number separates their operational contribution from the market's movement, and the industry's reporting conventions do not require it to.

The honest position is not that private equity adds no value. Many managers genuinely improve businesses, and the evidence for operational improvement is real. It is that the historical return numbers overstate the repeatable component, and the overstatement is largest for vintages that bought cheaply — which is exactly the record being marketed in 2014.

Why cheap debt raised prices rather than returns

This is the most counterintuitive mechanism in the report and the most practically useful.

The intuitive view. Cheap debt improves buyout returns: borrow more at a lower cost, amplify the equity return.

Why it fails in a competitive market:

• An asset is sold by auction, formal or otherwise. The winner is the bidder willing to pay most.
• The maximum a bidder can pay is set by their required return, the financing available, and their view of the business.
• If financing improves for everyone, every bidder's maximum rises together.
• The clearing price rises to absorb the improvement, and the winner pays it.

So cheap debt is capitalised into the purchase price. The seller receives it. The buyer holds an asset bought at a higher multiple with more debt on it — which is more levered, not more profitable.

Three consequences follow:

• The margin for error narrows. A higher entry multiple and more leverage means a smaller decline in performance exhausts the equity.
• The position becomes rate-sensitive. An asset bought on cheap debt at a high multiple depends on debt remaining cheap through the hold and on the exit multiple holding.
• The advantage only accrues to a bidder who has it uniquely. A structural financing edge others lack is genuinely valuable; one available to all is competed away.

The exception proves the mechanism. Where a buyer had a genuine financing advantage — a relationship lender, an unusual structure, the willingness to underwrite complexity — that advantage did produce returns, because it was not available to competing bidders. Common advantages go to sellers; unique ones go to buyers.

The obligation to deploy

Committed capital creates a structural pressure that has no equivalent in most asset classes, and 2014 is when it became acute.

How it works. Investors commit capital for a defined investment period, typically five years. If the manager does not deploy it, the commitment expires unused.

What that means for behaviour:

• Fees are charged on committed capital during the investment period, so undeployed capital earns fees while producing nothing — an uncomfortable position to defend.
• Returning capital undeployed is a negative signal for the next fundraise, implying the manager could not find opportunities.
• The clock is fixed and does not respond to conditions. The investment period does not extend because prices are high.

So the manager faces pressure to deploy that is insensitive to whether deploying is attractive — and the pressure is highest exactly when it should be lowest, because record dry powder coincides with the high prices that record fundraising helped create.

This is a structural conflict rather than a failure of character. The interests of a manager holding undeployed capital and an investor wanting capital deployed only when attractive are genuinely different, and the fee structure sharpens the difference.

Two things partially offset it, and both are imperfect:

• Reputation. Managers who preserved discipline through expensive periods built durable franchises. The offset works only for managers with a franchise to protect.
• Carried interest aligns the manager to the return, not to deployment. But carry is an option — worth something if the fund performs and nothing if it does not — and an option's value rises with volatility, which does not discourage paying up.

What a high entry multiple demands

The practical consequence of expensive entry is best expressed as a requirement rather than a warning, because that is how it should be underwritten.

The arithmetic. A fund targeting a given multiple of invested capital over a five-year hold needs total value creation to reach that target. If multiple expansion contributes nothing — a reasonable base case when entering at elevated multiples — the entire return must come from leverage and operational improvement.

With entry multiples high:

• Leverage is already substantial, so there is limited room to add more.
• Debt paydown contributes, but at low rates the cash flow diverted to interest is smaller while the required earnings growth is larger.
• The residual falls on operational improvement, which must therefore be very large.

The required earnings growth in that scenario frequently exceeds what the business has historically achieved, and often what its sector has achieved. At that point the underwriting rests on an assumption that has become the entire thesis rather than one input among several.

Worse, the assumption is usually correlated across the portfolio. Multiple contraction affects every holding at once, and the earnings growth needed to offset it is required from all of them simultaneously — the common-factor problem the US Housing & Mortgage Report 2008 describes in mortgage pools, appearing in a fund's holdings.

Entering at a high multiple does not reduce your expected return by a modest amount. It transfers the return from a component you observe at purchase to one you have to deliver, and it requires you to deliver it everywhere at once.

This is why 2014 sits where it does in the archive. The Global Investment Outlook 2015 opens on the breaking of the synchronised-easing consensus. Every private equity asset bought in 2014 was underwritten on debt costs and exit multiples that assumed conditions the following years would begin to question.

What an allocator could act on

Demand return decomposition before extrapolating a track record. Multiple expansion, leverage and operational improvement are different things, and only the third is repeatable by the manager. A record dominated by the first is a statement about entry timing.

Ask what the entry multiple was, not just what the exit was. Crisis-vintage performance is substantially explained by purchase price. That is a genuine achievement and it is not evidence of repeatable skill.

Treat cheap financing as a price effect. Widely available leverage is capitalised into purchase prices and accrues to sellers. Only a financing advantage others lack improves the buyer's return.

Watch dry powder as a forward indicator of entry prices. Committed capital must deploy on a fixed clock. Record undeployed capital is a reliable signal that competition for assets — and therefore entry multiples — will be elevated.

Underwrite the required operational improvement explicitly. Calculate what earnings growth is needed for the target return assuming zero multiple expansion. If it exceeds what the business or sector has historically delivered, the thesis is the assumption.

Check whether required improvement is correlated across holdings. If every position needs above-trend growth to offset the same multiple risk, the portfolio is one bet held many times.

What 2014 established

• Crisis-vintage performance attracted capital into inverted conditions — a record raised on buying cheaply, committed to buying expensively.
• Return decomposition separates skill from market, and multiple expansion had been contributing a share that headline returns do not disclose.
• Cheap debt raises entry prices rather than buyer returns when it is available to all bidders; the benefit accrues to sellers.
• Committed capital carries a deployment obligation insensitive to opportunity, and it peaks exactly when prices do.
• High entry multiples convert operational improvement from one return component into the whole thesis, and require it from every holding simultaneously.