That was my warning back in December, based on historical data that the worst-performing private equity funds were born of boom-years like 1997 and 2006. I also was concerned that deal valuations were being further inflated by firms under pressure to either "use or lose" capital raised several years ago (PE funds usually only have five years to build a portfolio).
I've raised that second point repeatedly at industry conferences, only to be dismissed by self-serving private equity pros. "We wouldn't violate our fiduciary duty to limited partners just because a fund is nearing the end of its investment period," one argued. "No one deal is worth damaging our reputation in that way."
Well, obviously I'm not talking about offering $100 per share for a company trading at $20 per share. I'm talking about putting an internal valuation ceiling at $25 per share, and then offering $26 or $27 in a final round of bidding due to fears of losing the deal (because getting the deal is more important than getting the best deal). Not the sort of thing most limited partners would be able to notice, let alone act on.
So I was pleased to learn that I'm not a solitary worry wart. Bain & Company -- a global consultancy now independent from PE firm Bain Capital -- today released its annual Global Private Equity Report, which included the following item:
With the pace of PE deal activity gaining momentum over the past year, the sheer volume of uninvested capital is not the foremost concern to the PE industry. The bigger worry is that much of the dry powder is in the hands of GPs that, facing increasing pressure to invest, may not do so in a disciplined way.
“The ultimate danger to returns for investors is not that GPs will not spend the money, it is that they do bad deals,” said a managing director at a PE firm...
Of particular concern are the GPs with weak performance in their current fund. Staring at limited prospects of raising future funds, they have a powerful incentive toinvest their remaining committed capital to extend the life of their firm and maximize their revenue streams.Nearly half of the pressured capital—more than $110 billion, or about one-quarter of all dry powder slatedfor buyouts, by Bain’s estimate—is held by GPs with below-average performance track records and at riskof overreaching to close deals.
Large amounts of capital in the hands of pressured GPs willing to take big risks could have spillover effectson the broader PE market, as these GPs compete fiercely for deals and drive up prices in the process. The actions of these GPs should give GPs at funds that do not feel the same urgency to invest further reason to remain on the deal sidelines—as many have done in 2010. However, there is a risk that the fierce competition could undermine the investment discipline of a broader group.
This is one of those theses that will be impossible ever to prove, since transaction announcements don't come with valuation justifications. But that doesn't diminish either its validity or its damaging consequences.