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Why Private Equity May Be on a Highway to the Danger Zone

Private equity has produced pretty astronomical returns in recent years, and these admittedly stellar returns have sent investors flocking to the asset class. But as return expectations fall and dry powder piles up, that may finally be changing, writes columnist Meredith Jones.

I went on my first date in the spring of 1986. We met when I tried out to be part of the flag corps in the high school marching band. It was like at first sight. I was a flag twirling Molly Ringwald to his saxophone-playing Jon Cryer. We quickly agreed to go to the movies that weekend.

The first sign of trouble occurred fairly early in our burgeoning courtship. I wanted to see Top Gun. He wished to watch Poltergeist II: The Other Side. Not one for horror movies but already a big fan of righteous dudes, I pleaded my case. My date retorted that he wouldn’t spring for a movie where I might find the stars more attractive than him in his sporty “Sax Appeal” tee. Since I was not driving (or paying) I lost the debate. As Poltergeist II commenced I could sense something like anticipation from my date. Looking back, I’m pretty sure he was plotting the quintessential teen boy move: Take a girl to a horror movie and, when she gets scared, comfort her as a stand-in for making an actual pass. Sad to say it didn’t work. When little Robbie was attacked by his own braces in the film, I laughed my 15-year-old butt off. My first date and I never planned a second.

I did eventually go see Top Gun with girlfriends. It was everything I hoped it would be. Shirtless volleyball. Square jawed, gum-cracking wise-asses. And one of the more memorable lines in ‘80s film lore: “Your ego is writing checks your body can’t cash.” If I had only known how frequently that line would figure later on in my investment career, I probably would have cross-stitched it on a pillow in Home Ec or something.

The figurative check writer changes from day to day and year to year, but someone or something in the investment industry always seems to be full of great expectations that would be difficult, if not impossible, to meet. And right now, my money’s on private equity filling that role.

Sure, private equity has produced pretty astronomical returns in recent years. According to the Cambridge Associates Private Equity Index, U.S. private equity funds have returned an annualized 13.2 percent over the past five years, 10 percent over ten years, and a whopping 12.4 percent over the past 15 years. Check written. Check cashed.

But these admittedly stellar returns have caused investors to throw themselves at private equity funds like a young me pursuing a young Val Kilmer. Pension funds that were allocating a mere 5 percent of their portfolios to illiquid investments in 1995 upped that total to 20 percent by 2015. In July, Apollo raised the largest private equity fund ever, raking in $24.6 billion in commitments. July also marked a new peak in private equity dry powder, at $1.5 trillion globally, causing State Street to estimate that new commitments won’t be deployed for up to three years. In fact, Pitchbook reported earlier this year that some 80 percent of the capital committed to private equity in 2015 has yet to be deployed.

There are some signs that institutional investors may be getting a bit concerned that their private equity checks won’t ultimately be cashed. Private equity investments decreased year over year through February, falling from $8.9 billion in 2016 to $3.2 billion in 2017. Harvard Management Company announced in July that it is selling $2 billion in private equity, venture capital, and real estate assets to a secondary specialist. This move could shave up to a billion dollars from the endowment’s private equity portfolio, which accounts for 20 percent of its overall investments. What’s more, an informal poll of investors at a recent event showed return expectations for private equity at roughly 8 percent to 9 percent over the next several years, a far cry from the double-digit gains of yore.

And investors are probably right to be reducing their lovin’ feelings toward private equity right now. Private equity valuations are now higher than they were in pre-crash markets. Buyout firms reportedly paid 10.9 times earnings before interest, taxes, depreciation, and amortization (EBITDA) in the third quarter of 2016, compared with 9.7 times in 2007, the last time there was a private equity boom. While one should generally think about private equity multiples in the context of market multiples, it is also undeniably true that how much you pay for a deal affects how much you earn. Maybe that’s why the Cambridge U.S. Private Equity Index that performed so well over the last decade-plus posted a relatively anemic 5.86 percent gain in 2015.

Of course, I could be wrong about all this. The private equity markets could be entering a new normal that, like Poltergeist II, sounds threatening but really is a walk in the park. If I am right, however, as in any new market environment there will be winners and there will be losers. Private equity firms with a well-defined and successful niche, who are willing to walk away from overpriced transactions, who are patient and/or who have access to differentiated deal flow, will likely continue to perform well, if somewhat less well than in recent years. Those firms that just feel the need ... the need for speed, well, they and their investors might just end up watching something a little bit scarier unfold.

Meredith Jones researches and blogs about investing and is the author of Women of The Street: Why Female Money Managers Generate Higher Returns (and How You Can Too).