It's All Relative, Until It's Not

May 15, 2021 by Ted Seides

Private equity has been the rage for a while. Managers delivered, and capital is abundant. As a result, purchase prices for new deals keep rising. Add to that the capital deployed in late-stage privates through mega-funds, crossover vehicles and SPACs, and it all feels like a feeding frenzy.

I’ve long thought that these conditions would cause private equity managers to disappoint investors. I wrote about that a year ago in The Day of Reckoning for Private Equity.

But I was wrong.

My focus on entry prices and fees left out the important consideration of the alternatives for allocators. A lightbulb went off when I talked to Fran Kinniry from Vanguard about their entry into private equity afterthis long and successful run. Fully cognizant of the environment, Fran noted that investor allocations to private equity are coming from public equities where multiples are equally high.

Allocators have nowhere else to turn. We live in a relative world, and private equity is the best-looking asset class amidst a sea of unattractive options.

I no longer believe the day of reckoning for private equity is close at hand. The combination of dry powder in the hands of managers and strong incentives for them to put money to work cause a well-supported pricing environment.  It is hard to envision how prices will fall any time soon.

That said, this won’t forever. Relative outperformance works until returns fall below absolute return requirements. When private equity generates high-teens net returns, investors have an ample margin of safety above their spending needs. The same will hold true in the mid-teens, low teens, and high single digits. If returns fall below the magical 8% absolute hurdle needed to fund liabilities, the high cost, relative return argument will fall on deaf ears.

Until then, it’s still game on for private equity.