Private Equity Firms: Acquisition Costs Are Rising While Expected Returns Have Fallen
Private equity firms are facing new challenges as their industry changes with the times and the market drives acquisition prices higher and subsequent return percentages lower. We came across a recent piece in the IBJ about the current state of affairs for private equity firms, the amount of cash flowing in their industry, and how the cost of doing business (target acquisition) has been on the rise while returns haven't.
Private equity firms essentially utilize equity from investors as well as debt to purchase a controlling stake of a company, intending to hold the company for a period of time in which they'll improve their investment to sell at a profit. These firms may appeal to investors, as private equity firms tend to invest in established companies whereas venture capital firms invest more typically in start-ups. Years ago, after the tech bubble burst, many firms lost heavily on start-ups, driving the perception that established companies were less likely to result in similar financial losses. Investors who were wary of venture capital firms saw private equity as a safer and less risky bet.
In recent history, the 08-09 recession created the opportunity of many companies available at a lower cost to be purchased then sold during the 2012-2014 recovery. Many firms seized this opportunity to purchase companies at a lower price and sell them off once the recovery was established. New money has also dumped into the sector largely because private equity earnings have beaten stock market returns over the past decade. Institutional investors like banks, insurance companies, etc. have found private equity to be more attractive with the higher earnings than stock market bets. So past positive returns have encouraged more investors to work with private equity firms, meaning more money moving into the field...but more money flowing through the industry creates more pressure, too.
These investors go with a private equity firm and invest a set amount of money; however, that money won't go on to earn a profit if it isn't put to work. The pressure is on for the PE firms to make deals that are high quality that will then increase in value. Yet it's a seller's market according to many in the field. Banks have been freely lending which has not done the PE firms a lot of favors as far as their acquisition purchase prices go. By spending more on the target acquisition, the expected return percentage has dropped significantly over the past several years. Once firms could anticipate a 25-30% return, and now a 16-20% return has become the new normal due to the purchase price increase.
Currently there is a lot of money in the private equity field with many investors hoping their private equity firm finds a solid acquisition to earn a positive return. Yet with more players in the game helping to increase competition, and bank lending increasing the acquisition price, private equity firms are seeing costs rising and returns falling from previous years. The so-called “seller's market” favors the acquisition target and not the private equity firms or investors, although with the right high-quality deal there is still plenty of money to be made. Be sure to check out the in-depth IBJ article for a detailed look at private equity firms and the rising cost of target acquisition.