U.S. buyouts: Achieving attractive returns in a high price environment

One of the main challenges when investing in U.S. private equity today is determining which managers will be able to generate attractive returns in the current high-purchase-price environment. Manager selection — always of paramount importance to the success of private equity programs — is even more critical in today's highly competitive and very expensive marketplace. Limited partners need to look at myriad characteristics of general partners to assess which managers are best positioned to deliver outsized returns going forward.

It is no secret that purchase-price multiples have returned to, and in some segments exceeded, the peak levels of 2007. This is primarily because of the increased number of private equity firms competing for a limited number of high-quality deals, the increasing efficiency of a more intermediated market, the high level of dry powder and the current favorable access to ample debt. One positive aspect of high multiples is that GPs are able to exit portfolio companies at attractive valuations, often with a fair amount of multiple-arbitrage helping to amplify the returns; however, GPs and their investors cannot expect this situation to continue indefinitely. Prudent GPs should plan for some degree of multiple contraction in the exit planning of companies purchased at today's high multiples.

The opportunity still remains for GPs to pay fair multiples for companies, especially at the less intermediated, smaller end of the market.

GPs with a certain “edge,” such as experience with a similar company, a well-developed relationship with management or sector expertise might also be able to “win” deals on factors other than just price.

For those GPs without obvious purchasing advantages, there is still an opportunity to generate acceptable private equity returns in a high-priced environment; however, GPs must be sure their investment thesis is solid, as the higher prices leave little room for mistakes or delays in hitting milestones. Higher purchase multiples might also be justified by finding high-growth companies that can grow even faster with the help of a private equity sponsor. A good general partner must be able to make meaningful improvements to portfolio companies while using leverage effectively to balance risk and return. Private equity firms that have a superior ability to source companies, a good investment thesis, and the operating resources and expertise to grow those companies will still be able to outperform even in this environment.

Some limited partners might choose to sit out the private equity market under the assumption that the current vintage years are unlikely to generate commensurate risk-adjusted returns. This is potentially shortsighted in light of the long-term nature of private equity investment programs. Maintaining a steady exposure to private equity by selecting top-quality managers helps to ensure LPs have capital committed to funds that have the ability to generate returns in any market environment.

Accurately predicting a market turning point is difficult, and capital deployment in private equity is almost always challenging. Maintaining commitments to quality managers can position LPs to capture value on the buy-side when the pricing environment returns to more favorable levels.

William Charlton is partner and head of U.S. investments at Altius Investments Ltd., Richmond, Va.