Investors face allocation decisions as managers raise ever-larger funds

The private equity party of 2021 is expected to go into after-hours in 2022, with the asset class continuing to raise massive amounts of capital and valuations trending upward.

That is, if investors have the capital to invest in an environment in which firms are raising ever-larger funds, there are fewer years between successor funds and public market volatility could unleash the denominator effect in which a drop in stock and/or bond performance pushes private equity portfolios above their maximum allocation targets, industry executives say.

Should investors exceed their maximum allocations or receive less in distributions than they are making in contributions to their GPs, it could cause many of them to slow down, stop or cut future private commitments. A hike in interest rates could slow capital deployment and some exits, putting further pressures on investors' liquidity, they add.

At minimum, these dynamics could have a big impact on how investors commit to private equity funds in 2022. What's more, managers' growing stockpiles of capital allow them to pay more, pushing valuations and potentially lowering investors' expected returns.

"The (private equity) fundraising market has been very hot for a very long time now," said Adam Bragar, New York-based head of the U.S. private equity practice of Willis Towers Watson PLC.

So far, rising prices haven't dampened the interest, he said. "A lot of these prices are somewhat justified by increased growth in companies but they are also a function of the fundraising market," he said.

In its annual outlook, PitchBook Data Inc. predicts U.S. private equity megafunds — funds that amassed at least $5 billion in capital — will raise a total of $250 billion in 2022. If the company's prediction comes to fruition, capital raised by U.S. megafunds would surpass the combined $144.5 billion raised in 2019, the current 10-year high point. In 2021, 12 U.S. private equity megafunds raised $138.4 billion as of Nov. 30.

For example KKR & Co. Inc. raised a total of $102 billion in the first nine months of 2021, more than double the $44 billion in capital raised in all of 2020, "and that's with an active pipeline of fundraising initiatives as we look forward," said Craig Larson, a New York-based partner and head of KKR investor relations during the $459 billion alternative investment firm's Nov. 2 earnings call.

Also, the period between managers' raising their next funds is getting shorter and shorter, due to investor interest and ease of fundraising — from four to five years on average to about two and three years on average, Mr. Bragar said. For technology funds, the waiting period is only 12 to 18 months, he said.

The implication for investors is that fundraising is outpacing distributions, which will create liquidity pressure for the investor, he said.

"At some point, likely to be in 2022, there's going to be some ramifications in the market," Mr. Bragar said. "Either LPs will start cutting back commitment sizes, or committing less to fewer managers or committing less overall."

Private equity managers are aware that the contribution-distribution imbalance could break up their fundraising party. They also note that they only start raising new funds when their predecessor has spent a majority of its capital.

During Blackstone Inc.'s third quarter earnings call on Oct. 21, Jonathan Gray, president and chief operating officer of the $731 billion alternative investment manager, said that a number of its flagship funds had invested more than 50% of their capital. But, he said, in most cases, Blackstone executives wait until a fund has invested more than 70% of its capital before raising the next fund.

And Blackstone is raising funds more often, said Stephen A. Schwarzman, Blackstone chairman, CEO and co-founder, on the same call."Our active pace of deployment is leading to an acceleration of the fundraising cycle for some of our largest flagship funds," Mr. Schwarzman said. "The overall outlook for fundraising is incredibly strong."

Mr. Gray noted that Blackstone's growth as a firm has opened up new areas of investment in which the firm "didn't have pools of capital previously."

Blackstone invested $37 billion in the third quarter and had an additional $30 billion committed to pending deals, its busiest quarter ever, Mr. Gray said. The largest investments were in rental housing, transportation infrastructure, logistics and sustainability-linked businesses. Even so, Mr. Gray acknowledged investors' constraints. Blackstone had total net inflows of $47 billion in the third quarter.

"One headwind on fundraising that exists out there is that private equity has been such a strong sector that investors are in some cases overallocated," Mr. Gray said.

Blackstone had $232 billion in private equity assets under management as of Sept. 30.

Across the private equity industry, while the number of exits was in line with most prior years, the size of exits ballooned in the first three quarters of 2021, PitchBook data shows. As of Sept. 30, private equity firms exited 1,129 U.S. companies worth a combined $638.3 billion, a substantial increase from the 994 exits with a total value of $366.1 billion in all of 2020. However, the number of exits was similar to the 1,120 exits worth $323.2 billion in 2019.

The amount of capital available to private equity firms is having an impact on deal valuations, which are expected to rise in 2022. While rising interest rates could put a chill on transactions in 2022 by making buyouts that rely heavily on debt to be more expensive, the sheer amount of dry powder could soften the impact of higher rates, industry insiders said.

"I'm not positive that we'll see huge valuation jumps, but all indications that we're seeing — from pricing in the pipeline of deals we have before us as well as the market data we follow — indicate that current levels will continue to hold and are likely to continue to trend upward ... without abatement as they have been doing," said John LeClaire, a Boston-based partner and co-chairman of the private equity group at law firm Goodwin Procter LLP. The size of the valuation increase is hard to tell but will likely be bigger and more noticeable in certain sectors such as technology and health care/life sciences, Mr. LeClaire said.

Private equity deal value in the middle market for the trailing 12 months ended Sept. 30 was 50% higher than the next best 12-month period — the third quarter of 2018 to the second quarter of 2019, he noted, quoting data from PitchBook's third quarter U.S. private equity middle-market report. "That's pretty head-spinning. The questions are why is that happening and will it continue?" Mr. LeClaire said.

One reason is that there "is a ton of equity and debt capital," he said. U.S. private equity firms of all sizes had $841.1 billion of dry powder available to invest as of Sept. 30, the highest amount over the past decade, according to PitchBook. That's up from $766 billion in 2020.

"An increase in interest rates will affect capital structures and models, but it won't erase the sea of available capital," he said. "There is feverish demand for good and even pretty good assets." In this environment, the challenge for private equity is the managers' capacity and their adherence "to top-level standards of care, analysis and diligence while moving at high speed," he said.

Some of the surge in valuations and related surge in volume, at least in some sectors, appears to be caused by an accelerating pace of change and technological innovation that increases productivity, Mr. LeClaire said. The technology sector and its subsectors, such as enterprise software, health-care information technology and fintech, are driving dealmaking, reflecting the rapid pace of innovation in those areas, he said.

That helps explain why, for middle-market private equity deals, transaction value measurement has moved away from multiples of earnings before interest, taxes, depreciation and amortization to companies' annual recurring revenue-based valuations in certain sectors, he said.

The growing private equity portfolio company valuations means that in 2022, there will be "a noticeable increase" in the number of portfolio companies growing large enough to justify going public, including by merging with a special purpose acquisition company, Mr. LeClaire said.

Higher interest rates will be one reason why prices being paid for these deals may not continue to rise, Mr. LeClaire said. Inflation will put more pressure on portfolio company margins and again accelerate the need for managers to speed up the growth of these companies.

But industry executives say that valuations will eventually level off.

"It's always good to take the lessons of history into account when considering whether you are a player in a bubble carried along by forces greater than your own thought, will and prudence," Mr. LeClaire said.

Interest rates will have an impact on valuations, said Manoj Mahenthiran, Chicago-based partner and private equity lead at PricewaterhouseCoopers U.S. "Higher interest rates will be one reason why prices being paid for these deals cannot continue to rise," he said.

Jon Fox, New York-based president and partner at $14 billion private credit manager Varde Partners, said he expects a growing desire from institutional investors to "have a little more of a hedge, to be prepared for a turn in those (capital) markets and … at some point to increase their allocation to private credit."

Even so, credit managers need to watch out for increasing deal valuations. If the asset being purchased doesn't maintain its value, the private credit manager could end up with more leverage on the company on a loan-to-value basis than the lender had planned, he said.

These days, an increasing number of private equity-backed and other transactions are based on what Mr. Fox calls "unsustainable valuations" which add risk and "could plant the seeds of a future dislocation cycle," Mr. Fox said.