Private Equity: How Successful?

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In Expert Q&A Paris Aden - Private Equity
Q:
To date how successful has private equity been in the context of returns to the managers and owners of private equity funds first in Canada, and second in the United States? In general, what have been the characteristics of the private equity funds deemed to have been successful?

 

A:

Private equity – how successful to date?

In general, private equity has been highly successful compared to other asset classes, and its share of the total global assets under management has increased. The reason that it’s been successful is because it continues to generate returns that on a risk adjusted basis tend to exceed the other conventional asset classes.

For example, if you look at the 10-year annualized returns for the private equity index, they were about 11.3% while the return for the S&P 500 was about 2.7%, and for the Russell 2000 – the small cap index in the United States – was about 6.3%.

The other important feature about private equity is that unlike public market fund managers the stronger private equity fund managers can consistently outperform over time. So in that same example, over that same time horizon, the top quartile internal rate of return for private equity funds over 10 years was just a shade under 40% – a very significant alpha.

Private equity difference between Canada and the United States

In terms of the difference between Canada and the United States, generally speaking, the Canadian funds have done particularly well compared to the United States for a few reasons.

Firstly, in a macro context, the Canadian private equity market is under-penetrated relative to the U.S.. For example, Canadian private equity buyout capital is approximately US$16 billion, or about 1% of Canadian GDP. In the United States, private equity buyout capital is about US$875 billion, almost 5% of GDP. We all know that the U.S. economy and population are roughly 10 times greater than are Canada’s. The relative size of the U.S. private equity market far exceeds these proportions. As a result the Canadian buyout market is much less competitive than is the U.S. buyout market.

Average valuations in our respective markets further illustrate the point. From 2011 to 2013, the average Canadian buyout multiple was 6.9 times EBITDA versus the U.S. average of about 8.9 times EBITDA (Source: Prequin). That’s about a 22% discount versus U.S. buyout averages. As a result of these lower entry multiples, Canadian private equity funds have generally done better on average than US equity funds.

We are continuing to see increased activity from U.S. funds in Canada and we expect that this gap will be further exploited by new entrants until an equilibrium is reached. A 2015 survey of U.S. private equity fund managers cited China and Canada as their top foreign jurisdictions for future investments.

In addition to the lower level of competitiveness for Canadian versus U.S. acquisitions, myriad factors influence this apparent valuation discount including deal sizes, credit markets and industry mix.

Overall private equity returns

In terms of the overall returns, I’ve mentioned previously that just prior to the year 2000 the average private equity internal rate of return was about 20% (compounded annually and prior to fees). Currently it is closer to the mid-teens.

The internal rate of return varies a lot by the vintage of the fund. For example funds that were invested during recessionary years, their returns tend to be much higher. Of course, those funds that are invested during peak cycle conditions tend to do worse than average. But generally speaking private equity is a successful and growing asset class because it’s been able to (1) take advantage of the lack of valuation transparency for private companies, versus listed companies that have real-time pricing, and (2) impose financial discipline and increase the velocity of value-enhancing initiatives with an urgent focus on planned monetization. These factors have driven outsized returns for the risk that they’re taking, relative to other asset classes.

Characteristics of successful private equity funds

To be successful private equity funds have to do at least three things: (1) source quality deals, (2) know how to surface value in those deals and contribute to business value growth, and (3) they have to know how and when to exit.

Paris Aden BA (Economics) CFA

Paris Aden is a Partner in Toronto and Montreal based Valitas Capital Partners. His investment banking experience includes working with clients at Morgan Stanley, Credit Suisse and RBC Capital Markets.  He has direct investing experience with private equity firm Clairvest Group and co-founded Alluence Capital Advisors, a mid-market M&A advisory firm. Over the past 20 years Paris has been involved in over 100 M&A transactions with an aggregate value in excess of $80 billion.

Paris lectures at the Smith School of Business at Queen’s University in the Master of Finance (MFIN) program, and is an instructor and facilitator for Moody’s Analytics’ Advanced Capital Markets Program for capital markets professionals.

You can reach Paris at paris.aden@valitascapital.com, or by telephone at 416 556 0887.

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