April 20, 2014
Dear Friends of PPE:
Just our luck. We decided to start a value-oriented private equity firm just when the Fed began pumping a massive amount of liquidity into the economy, inflating asset values to record levels. We had bragged to our investors about our sober and disciplined investment style. We assured them that we have an investment approach for all seasons—that even in periods of excess we can find diamonds in the rough and deliver solid returns. As it turns out…not so much.
We are simple people—we want to buy decent businesses at fair valuations without using excessive leverage. We want to be good corporate stewards, help our businesses grow, and ultimately sell them at a profit so that we can deliver promised returns to our investors. If we do this properly everyone benefits—the seller, company management, employees, our investors and us. Very old school.
However, as we were moving into our new offices, unpacking boxes and booting up our computers in early 2013, some early warning signs started to emerge. Private equity valuation multiples were approaching all-time highs, and ultimately would eclipse even the outlandish multiples of 2007 and early 2008 (just before the last bubble burst). Lenders, awash in liquidity and desperate to put money to work, were lending at record multiples of record earnings. We started to bid on companies that met our investment criteria and were surprised to find that we were consistently getting outbid by wide margins. And the margins by which we were losing seemed to increase over time.
Long portage through a frothy market
Then and Now
I am a bit of a dinosaur. I was trained by a prominent value investor, Martin Whitman of Third Avenue Funds, who is a consummate contrarian. Marty has always had the insight and level-headedness to take advantage of irrational market fear and invest at compelling valuations when others are losing their heads. He trained me to use sound investment judgment, avoid the madness of crowds, and to be a good corporate steward when we acquired a business. With this simple approach we achieved outstanding investment results. Today, it seems, the world is not so simple.
I may be a dinosaur but I’m not dead yet!
What has changed since then?
First, the capital markets have matured. The fear that used to infect investors when a business fell out of favor has been mitigated by a much better understanding of value in all corners of the capital markets. As the saying goes, nature abhors a vacuum, and Wall Street abhors an unexploited arbitrage. Over time, there has been a proliferation of opportunistic investors focused on taking advantage of systemic imperfections in the capital markets generally and in the private equity market specifically. Buying a business with a “margin of safety” has become significantly more difficult.
Second, M&A investment bankers have perfected the art of the auction. Sale processes, even for small companies with as little as $3 million in EBITDA, are run professionally. Offering materials are distributed to a broad universe of acquirors, often numbering 50 or more (including both strategic and financial buyers) and successive bidding rounds tease out the highest possible valuations. Indeed, with a large, statistically valid pool of bidders in most sale processes, the market has become extremely efficient. Deals are priced to perfection.
Third, the good long term performance of private equity as an asset class has attracted a flood of capital. According to the Private Equity Growth Capital Council, there is currently over $1 trillion of private equity “dry powder” looking for a home, about half of which is focused on leveraged buyout transactions. Regardless of market conditions, this capital will be put to work. Institutional investors’ asset allocation strategies require that the private equity slice of their pie chart be filled and private equity sponsors know it is their job to meet this objective.
Beyond these fundamental changes in the structure of the market, there are some recent economic anomalies that have further influenced the inflation of private equity valuations. A prime mover of these anomalies has been the Federal Reserve, whose policy of quantitative easing and low interest rates has created distortions in the economy that have forced up asset values generally, including those in private equity.
Moral hazard? What moral hazard?
Overall, the Fed’s policies have had the unintended consequence of creating a high level of moral hazard throughout the capital markets. Professional investors are seemingly more focused on the Fed’s quarterly meetings than on efficiently allocating capital in a real market economy. The “creative destruction” that is central to a free economy seems to be a thing of the past. The real estate bubble has been reinflated, banks with troubled loans are permitted to “extend and pretend”, and every stock market hiccup brings another round of quantitative easing. Investors are conditioned to believe that risky, speculative behavior will always be insured against loss by a “Fed put”. This is almost certainly influencing investment decisions in private equity.
Asset managers allocate capital in large part based on a rear view mirror look at performance. Asset allocators use Monte Carlo simulation models to extrapolate historical returns and correlations into the future as an aid to decision making. However, these models are inherently based on the principal of “all else being equal” and do not have the sophistication to incorporate changes in the market itself or the future impact on the market of the decisions based on this very modeling. This can create perverse results at times, including asset “bubbles”. The internet and real estate bubbles are recent examples in which expectations based on historical data (yet arguably devoid of common sense) drove behavior that in retrospect seems irrational. Indeed, exuberantly irrational.
Is there a risk that the private equity market is entering a bubble phase? On the surface it seems improbable—private equity sponsors are investment professionals that have long term investment horizons and who perform extensive due diligence on their investments. However, even private equity firms are captive to assumptions based on the prevailing status quo. Today, the prevailing EBITDA multiple for all buyout transactions is a breathtaking 11.6x (Q1 2014) according to Pitchbook. Compare this to average EBITDA multiples of 5.9x in 2002 (according to Standard & Poors)—roughly half the current level. In the intervening period, multiples have risen inexorably (but for the sharp temporary decline in the wake of the 2009 recession). (Multiples at the smaller end of the market where we play are lower, but the trend is identical.)
How do private equity investors justify paying these nosebleed prices? There may be an element of hubris here—investors that have done well in the past based on a rising tide of asset values may be inclined to attribute success to their own brilliance rather than dumb luck. They have been trained to ignore the risks that come with excessive valuations, having been repeatedly rewarded for doing so.
However, consider the facts. At current multiples, if a sponsor funds a deal with 50% equity (compared to a historical norm of perhaps 33%) the acquired company will still be burdened with debt equal to almost 6x EBITDA. For most companies, it is a mathematical impossibility to service this level of debt, pay taxes, make necessary capital expenditures and still grow the business. It is only possible with continued access to cheap, patient capital such that the debt never actually gets repaid until the company is sold (securities with these characteristics were previously known as equity). At the time of the sale, the sponsor is counting on selling the company at the same or a higher EBITDA multiple to another buyer with access to the same cheap, patient capital. Optimistic assumptions layered upon optimistic assumptions.
So if we are worried about a bubble it is logical to ask the key question of whether it is likely that EBITDA valuation multiples are likely to stay the same or increase. Well, let’s see… Private equity EBITDA multiples are at historic highs. Since high private equity EBITDA multiples are in part dependent on cheap and abundant debt financing, it is also necessary and appropriate to ask whether the current debt market is sustainable. A reversion to the mean would involve significant (and painful) changes in both valuations and the debt markets.
Concerning the debt markets, interest rates are at historic lows and are being actively managed down by the Federal Reserve, a policy that most believe cannot be sustained indefinitely. If interest rates go back to historic norms, it seems self-evident that leverage multiples must go down. Higher interest expense will make it harder for companies to service their debt. At the margin, for loan quality to stay constant, leverage multiples would have to decline.
Concerning valuations, it seems equally self-evident that if interest rates rise, rational investors will demand higher returns from risky asset classes like private equity (a so-called “equity risk premium”). In order to achieve those higher returns, private equity buyers will have to acquire businesses in the future at lower EBITDA multiples. This, coupled with lower lending multiples, would depress valuations and cause current private equity investments (acquired at today’s nose-bleed multiples) to fall short of targeted returns. This in turn could reduce new investment in the asset class and create additional headwinds as the supply/demand equation changes. Higher interest rates, lower lending multiples and higher required equity returns could create a perfect storm for private equity.
For those of you who have not yet stepped off the ledge of your 36th floor office, keep in mind that this is not all bad. And in many ways, it’s nothing new. The timing of this bout of irrational exuberance is a little inconvenient for us as a new firm, but it is likely to create an equal and opposite reaction in the not too distant future, at which point we will once again be able to make sound investments.
After the fact we will all have the fun of second-guessing the Fed, criticizing the short-sightedness of private equity sponsors and berating our wealth managers. Maybe there will be an entertaining Congressional hearing or two. So we have that to look forward to.
For our part, we will continue to seek diamonds in the rough. They are out there, just harder to find. (However, if this market persists we may also do a little more fishing this summer.)