U.S. Buyout’s investment-to-exit ratio, the number of investments divided by the number of exits for each time period, has trended up over the past decade. A ratio of one means a general partner (GP) is making one investment for every exit. This upward trend suggests that GPs have been more willing to deploy capital into new, promising investment opportunities rather than take money off the table by selling existing portfolio companies. This dynamic has created a challenge for limited partners (LPs) and GPs alike.
LPs, who believed their new commitments would be funded largely through distributions from their prior fund commitments, now must fund new commitments to a larger degree from other sources of capital. GPs, who have held onto portfolio companies for longer and longer periods of time to optimize their value prior to exiting, are put in a position to defend themselves from restless LPs.
There are several reasons for this dynamic, including increasingly larger funds being raised over the last 10 years (contributing to the numerator in the investment-to-exit ratio) and portfolio companies being held longer (contributing to the denominator of the ratio).
According to PitchBook, U.S. buyout funds raised over $400 billion of capital in combined calendar years 2019 and 2020 — and $77 billion in Q1 of 2021 alone. Incredibly, the average U.S. buyout fund size more than doubled over the past decade from $534 million to $1.1 billion. The increasing amount of capital raised by the industry has led to a corresponding increase in the number of portfolio investments.
This is, at least in part, a byproduct of the increased LP demand. LPs have increasingly turned to private markets investing due to the difficulty in reaching their return targets through traditional investments (stocks, bonds and cash) in the face of near-zero interest rates and seemingly fully valued public equity markets.
GPs can also share some of the blame in that they often move up-market to compete for larger assets and are forced to pay higher multiples for their businesses because of increased competition for those assets. There are also obvious economic incentives to managing a larger pool of assets and generating higher management fees.
The growth in industry assets under management shows no sign of abating — and with the combination of larger funds and a defined investment period (typically four to five years after a fund’s initial close), it is difficult to see the investment pace coming down as LPs expect their committed capital to be deployed. The decision about when to sell a portfolio company is never straightforward — and the value of a given company often lies in the eye of the beholder. That said, holding periods for portfolio companies have tended to increase over the last 10 years as GPs have been reluctant to sell companies that they believe have not yet reached their full potential. The global financial crisis (GFC) of 2007-08 certainly contributed to the increased holding period as it caused a sustained drop in asset values, leading GPs to hold on to many of their portfolio companies to allow them time to recover.
GPs tend to be much more operationally focused now than they’ve been in the past, relying much less on leverage as the primary driver of return. These operational improvements often take years to be realized. Additionally, exits tend to be correlated with the broader market’s willingness to buy a given company. Therefore, it is more favorable to sell certain types of companies at certain points in time. Those windows may or may not present themselves over a typical portfolio company holding period.
The strongest LP-GP relationships are based upon trust and communication. LPs and GPs need to work with one another to ensure that both parties understand what the other seeks to achieve from the partnership. LPs and GPs must be on the same page for many items such as capital raises (e.g., frequency, fund sizes, hard caps), fund terms (e.g., the appropriateness of the investment period/fund terms for the given strategy) and portfolio liquidity (e.g., expected holding period, exceptions to expectations and use of nontraditional liquidity options such as secondary sales). Ultimately, LPs will benefit from a clearer cash-flow expectation picture as they work on their capital budgeting — and GPs will benefit from a better-aligned investor base that will continue to support it in future funds.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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