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Business Insights From Conway MacKenzie
July 26, 2017

Warning Flags Rising for Private Equity Firms

This post was written by Brian Connors

Private Equity (PE) firms and their limited partner investors could face significant headwinds in the coming years due to high company valuations, record levels of dry powder to invest, and more exit transactions akin to rearranging deck chairs by selling holdings to other PE funds rather than creating IPOs or arranging sales to strategic acquirers.

The good news: investment money has never been easier to obtain from private and public pension funds, college endowments, foundations, high net worth family offices and individuals seeking higher yields. Similar to the public equity markets, the low interest rate environment is contributing to this increased appetite for PE investment despite the risks.

The bad news is this brings added pressure for PE firms to find and execute successful investing strategies. This environment does not bode well for the current or recent vintage funds. More than ever, PE shops are getting into earlier stage tech companies and taking more risk that used to be only funded through venture capital. When PEs competitively bid and win on a highly valued company, they have to fund much more through equity, thus depressing the opportunity for higher leveraged returns they have experienced in the past.

And, more trouble is brewing for PE firms when you consider last December’s PE investment reduction announcement by California Public Employees Retirement System (CalPERS). Their PE investment allocation will be lowered to 8 percent, down from 10 percent due to the high valuation and limited upside on returns.

Additionally, legal trouble is on the horizon. The SEC is currently investigating several General Partners of PE firms for insufficient disclosures of their fees and expenses charged (management, transaction, etc.), as well as potential conflicts of interest. General Partners who are serving as Board members and interim managers of their portfolio companies are being closely scrutinized. The potential negative publicity coming out of these investigations could hamper future fundraising efforts and/or trigger a call back of invested capital by angry and skeptical investors.

The sand beneath some long-standing PE firms is beginning to shift. In the coming days we’ll see more General Partners and firm founders retire, allowing for a transition in ownership to the next generation and minority investors taking a stake in their firms. These factors can undermine the original mission and strategy leading to uncertainty.

Just as the non-performing second and third generation middle market family owned businesses were the source of many turnaround, restructuring and wind down opportunities in the 1990’s, aging Private Equity firms overpaying for their assets and dealing with transition issues could be the new source for the current generation of restructuring advisors.