These are heady times for the private equity industry. With interest rates low and doubts swirling about the bull market’s longevity – not to mention dreary returns in the competing hedge fund industry – investors are pouring cash into private equity funds.
Indeed, there is more private equity capital to deploy than ever before. According to Preqin, a financial research firm, the amount of available cash in the private equity industry hit a record $1.5 trillion in 2019.
Dry powder in private equity is at record levels …
But a closer look at the numbers reveals a more nuanced picture of the industry, and shows a growing divide among firms. The largest private equity firms – those with individual funds of $1 billion or greater – are driving a disproportionate amount of capital flows. According to Bloomberg, over the past 12 months, 22 funds raised at least $1 billion, eclipsing their previous highs in any other reported period.
The largest private equity firms are driving a disproportionate amount of capital flows.
But smaller private equity funds are not seeing a similar number of launches . As of January, there are only 88 middle market funds with the necessary 60% funding that expected to launch over the next 12 months, compared to 141 over the same time last year. At this rate, RSM projects that middle market funds will raise approximately $18.6 billion in 2020 compared to $30.6 billion from the previous year.
Of course, this could change later in the year, but it’s apparent that the middle market, for now, is scrambling for its share of private equity capital.
What’s behind the change? Many factors could be at play, but we have identified three:
The presidential election. First, the political race has certain Democratic contenders proposing a sweeping reform of the private equity industry that would tax profits and create certain restrictions on conducting business.
Middle market managers who have raised and deployed capital, then achieved targeted returns, would be less compelled to raise more assets knowing these tax proposals would take large chunks of cash out of their pockets. This especially affects lean middle market general partner groups that have the flexibility to dictate strategy with less governance oversight than their large firm peers.
Elevated valuations. Next, elevated prices of companies have turned off many middle market buyers from deploying capital since it’s more difficult to generate the high returns previously attained during the rise of private equity.
According to Preqin, dealmakers continue paying up despite ongoing recession fears, and through 2019 these multiples were 10.9x. Private equity firms are agreeing to pay elevated prices because they feel pressures to invest freshly raised capital.
Rather than raise assets for the chance that targeted returns aren’t met, maybe middle market managers instead wait until the market settles a bit and better deals become available.
Consolidation. And last, the inflow of capital over the last several years has led to consolidation within the industry and more mega-funds. Over the last 12 months there was a record number of funds launched with at least $1 billion, including a Blackstone real estate fund that raised $11 billion. These launches accounted for $42 billion and through January another 73 are planned.
All of these pressures have prompted some middle market managers to look abroad for returns.
Of the 88 middle market fund launches planned for 2020, only 33 are focused in North America. Instead, middle market managers are increasingly taking capital to Europe and Asia to capitalize on market dislocations following Brexit negotiations and the recent China trade disagreement.
In the end, middle market managers must focus all the more on what makes them different. They must leverage their expertise in distinct areas of investment and operations to drive returns, including when and where they deploy capital.