Pay Attention: The Private Equity Message To Investors

Bain & Company recently released their Global Private Equity Report for 2014 and its full of information of great value to individual investors.

Bain is a consulting company that serves the private equity industry. Although it was founded by former partners of Bain Capital and has a strong private equity fund, they are a separate company that provides advice to private equity and hedge funds. The report covers activity in the private equity arena in 2013 and looks forward to how the industry might shape up in 2014.

Most individual investors pay little or no attention to what goes on in the private equity industry and that is a huge mistake. Think about how private equity firms invest their money; they buy out-of-favor assets and companies and then hold them until they can be sold at a premium valuation in the future. They tend to hold their investments for five years or longer to realize the maximum value for their holding. They are not interested in making a percentage on their money and then flip out their holdings in a few months.

The goal is to earn returns measured in multiples of the committed capital, not just percentages. This is the reason they are one of, if not the, top performing investments of the last several decades. Investors would be wise to drop their attempts at short-term market timing and trading, and adopt a private equity mindset

Related: How To Follow The Private Equity Money Into The Energy Sector

The Bain report points out that the private equity firms have enjoyed a bonanza of exit opportunities. Rising public equity markets have given them a window to sell companies via IPO to the investment community. They also sold a lot of strategic buyers, as many companies are finding in a weak economy the only way to grow their business is to buy another company. Access to cheap credit is making this possible right now and private equity firms are reaping the benefits. This trend should stay strong in 2014, as long as the public equity markets do not experience substantial declines.

The improving economy and low interest rates are making it increasingly difficult to find opportunities that will deliver the type of returns that private equity firms expect, so it has been difficult to deploy all the cash coming in from the sale of assets. The amount of dry powder in the form of cash on the books is now $1 trillion. The report points out that private equity managers are keeping to their buy discipline so as not to hurt returns.

"Ironically, greater economic stability, buoyant equity markets and the easier availability of low-cost debt that might have been a launching pad for deal making all worked instead to further stretch valuations, in some cases beyond what private equity acquirers were willing to pay,” the report said.

Consider that statement for a second. The private equity funds cannot find opportunities priced low enough to provide the type of returns they want to earn on their capital. Rather than lower their standards or buy assets at unattractive valuations, they are instead holding cash even in the current low interest rate environment. That is the exact opposite of what most individual, and even institutional investors, are doing with their money right now.

No one wants to hold cash, and they are chasing returns with little regard to valuation levels.

Best Opportunities Going Forward

The report also addresses where the best investment opportunities will be found in 2014.

“While it is clear the opportunity to do deals is far from exhausted, the most fertile hunting ground will be in small companies. Bain estimates that about 15% of all businesses with an enterprise value of more than $500 million are already owned by private equity firms, compared with just 3% of companies valued at less than $100 million. GPs with large funds to invest cannot realistically put the capital to work by targeting $100 million companies.”

This is going to favor the smaller funds in 2014, as they can digger deeper than the big funds and get the returns from smaller companies.

This is also the exact opposite of what most individual investors are doing with money today. Individuals tend to own the more popular stocks that are constantly mentioned in the media, again with little attention paid to valuation levels. Most would be better served by finding the smaller companies with more reasonable valuations and greater long-term upside.

Bain expects the steady flow of PE-backed IPOs to continue. They point out that 41 companies have filed for IPOs as we entered 2014, and there is a huge shadow supply of deals just waiting to be registered. If markets remain healthy, Bain thinks this could be an epic year for private equity exits, saying “the prospect of robust, fully functioning exit channels that enable them to clear the big backlog of unsold assets could make 2014 a year to remember.”

What It All Means

In a nutshell, private equity firms had a strong few years and, to realize the value of their investments, are selling assets as fast as they can. They cannot find enough deals that pass their return threshold so they are holding record amounts of cash. The high return opportunities that do exist tend to be in smaller companies, where there is competition from larger funds that cannot bother with small deals.

Private equity investors are smart, patient investors who as a group have earned twice the public markets return over the past 10- and 20-year periods, according to the Bain report. It might be prudent for individual investors to re-read the above paragraph and compare it to what they are doing with their money right now.