Facing low yields in the bond markets and high valuations in global equities, investors poured $804 billion into private investments globally in 2017. But future returns may be a bit lackluster, a new report from Moody's warns.
That's because the supply of capital is simply outstripping the number of promising deals, the ratings agency finds. "New investments are likely to underperform given competition for assets and high purchase prices, just as rates are beginning to tick higher," writes Neal Epstein, senior credit officer at Moody's, the report's author.
According to data from PitchBook through June 30, 2017, the most recent available, private equity funds reported a 19.3 percent internal rate of return on a one-year horizon. Private debt funds reported only a 3.1 percent IRR. As of the second quarter, funds-of-funds, debt, venture capital, and private equity funds returned between 7.4 percent and 9.6 percent over ten years, according to PitchBook. Secondary private equity funds were an outlier, returning 15.3 percent over ten years.
Moody's reports that private equity funds have more than $1 trillion in cash available that has not yet been invested. "Private equity investors could acquire over $2.2 trillion of assets by leveraging this 'dry powder,' based on recent acquisition multiples and leverage ratios," the report said.
After a lull in 2017, the firm expects private fund managers to start selling some of their underlying holdings in 2018 to take advantage of the high market prices available and returning capital to investors. At the same time, they'll try and invest some of the fresh money they have accumulated, even at the risk of paying too high a price for assets. It's a challenge, according to Moody's.
"To achieve the returns their investors desire, managers must enter investments at a reasonable price, with a view toward the value they can add to an investment, through active management and restructuring," writes Epstein.
In 2017, private equity and private debt funds raised $560 billion, 10 percent above what was raised the year before. Real estate investors, however, got the message that valuations may be stretched. Fund raising for property declined to a level last seen in 2013.
Asset managers are looking at initiatives to reduce their reliance on constant fund raising. Moody's reports that private asset managers hope to grow so-called permanent capital funds, including business development companies, insurance vehicles, and co-investments. Managers are also raising longer-duration specialized funds, such as those that focus on energy, infrastructure, and real estate. Both Blackstone and KKR have launched long-term funds that use their own balance sheet money in partnership with a few outside institutional investors to acquire companies.
Private equity firms also are increasingly interested in managing assets for the insurance industry. Apollo has been employing this strategy since 2009 through Athene Holding. Last year, Blackstone formed an insurance group and said it intends to raise $100 billion.