As sun sets on investment cycle, some wonder what to do next

Private equity investors, holding piles of cash returned from their managers, will have to figure out how to invest it all in 2016, in the twilight years of this investment cycle.

“One of the key areas of focus is: Are we getting long in the tooth for this cycle?” said Andrea Kramer, managing director at Hamilton Lane Advisors LLC, an alternative investment consultant and money manager in Bala Cynwyd, Pa.

”It's been an interesting time,” she said. “We've had seven years of zero percent interest rates.”

While hold periods are longer — up to 5.5 years from 2.1 years — higher valuations have led to portfolio company exits, even in older pre-crisis portfolios, she said.

Meanwhile, private equity firms are raising capital faster than they can invest it. Managers are sitting on $1.3 trillion of unspent commitments as of June 30, according to Preqin, a London-based alternative investments research firm.

Dry powder for buyout firms grew 12% so far in 2015 to $275.1 billion, exceeding the previous highs in 2006-"07, noted EY in its mergers and acquisitions outlook. This is not counting co-investment and other so-called “shadow capital,” which adds to managers' cache of unspent commitments.

Peaking valuations pushed up by growing competition for deals, a tightening debt market and rising equity markets are challenging the general partners' ability to close transactions, said Jeff Bunder, New York-based global private equity leader at EY, in a written statement.

Debt for deals and to make additional investments in portfolio companies will be more expensive in 2016, EY's outlook noted.

“Corporate access to the debt markets is still robust, but pricing will increase as spreads widen, leverage levels will be challenged and covenants will start to shift back to the lender,” the EY report noted.

The slow-growing economy is expected to put pressure on the debt side of the private equity business, Ms. Kramer said. “We see more volatility leading to more pressure on exiting (by private equity managers).”

It will also make it more difficult for private equity managers to raise additional dollars to support portfolio companies through leverage, she said.

At the same time, corporations are expected to continue offering private equity firms stiff competition for deals, said Mary Carroll, Miami-based partner and chairwoman of the national corporate practice group of law firm Akerman LLP.

Corporations are making acquisitions part of their corporate growth strategy, she said. Corporations have cash to spend and can pay more than private equity funds because their goals are different.

This competition for deals will keep prices high, she added.

Mr. Bunder expects private equity firms “to further expand their sector and geographic focuses, and consider minority investments and growth capital investing opportunities.”

Private equity firms in 2016 will continue to pursue “buy-and-build strategies” in which portfolio companies expand by buying other companies, he said.

Meanwhile, investors are sitting on a pile of cash from private equity distributions that they need to invest — roughly $500 billion in combined distributions they received in the past several years is waiting to be put to work, Ms. Kramer said.

“We are going from a dry powder cliff to a distributions cliff,” she said.

At the same time, managers have older private equity funds — vehicles closed in 2005 or earlier — that are still holding a combined $115 billion worth of assets, with $54 billion in 2005 vintage funds alone, according to Preqin. The vast majority of the managers with unsold portfolio companies in old funds have gone on to raise new funds. Only 19% of managers of 2005 funds with unrealized assets have not closed a private equity vehicle since 2008.

Still, investors have more choices of investment strategies under the private equity umbrella than ever before and they are expected to continue plowing capital into private equity — at least in the early part of 2016, industry professionals said.

“It's been a mix of strategies and certainly a robust fundraising year,” Ms. Kramer said. “It's been a very busy year with a lot of dollars into the space. That will continue in the first quarter.”

It's been the busiest December for active due diligence since 2006, when private equity strategies were more limited with most firms doing buyouts, she added.

Private equity firms closed on $391 billion in 760 funds in the first three quarters of 2015 — the most up-to-date data available — up from $389 billion in 888 funds closed in the first three quarters of 2014. Some 35% of the total capital raised this year was in the third quarter, with $137 billion in 178 funds, Preqin data show.

Next year, Hamilton Lane executives expect investors to invest increasingly in private equity in Europe as well as the U.S.

They also expect to see investment opportunities in non-performing loans, mostly in Europe, Ms. Kramer said. While much of the non-performing loans in the U.S. have been worked through, the new European regulatory framework should lead to opportunities on the Continent. “Banks will slowly sell out portfolio positions. It's not the same framework as the U.S. Europe has multiple countries with multiple systems,” she said.

There will also be interesting opportunity in buyouts in Europe, she added. “The United Kingdom will probably continue to be one of the key markets even though there is a fair amount of competition.”

The newly rekindled investor love affair with venture capital could wane in 2016, industry executives said.

“VC is a private equity asset class to keep an eye on heading into 2016,” said Eric Zoller, co-founder and partner at Sixpoint Partners LLC., a New York investment bank working with middle-market private equity firms. Between 2014 and 2015, venture capital delivered the best returns of any private equity strategy, and investor appetite has reached new highs because of that, he said.

Venture capital firms raised $30.8 billion in all of 2014, the most since 2006, according to the National Venture Capital Association and Thomson Reuters' third-quarter venture capital fundraising report. In the first three quarters of 2015, venture capital firms raised $22.8 billion, the report noted.

“The growth in investor appetite for venture capital should temper in 2016 with concerns over valuation and the (initial public offering) market impact on exits, Mr. Zoller said.

“Investors are becoming wary of increasingly high valuations for rounds being raised by top brand-name companies (such as Uber Technologies Inc. and Square Inc.) and are selecting the funds they invest in carefully,” Mr. Zoller said. “The recent volatility in the public markets has investors concerned about how this may affect the most volatile alternative asset class of all (venture capital).” n