The Smell of Dry Powder in the Morning

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William Blake, the English poet once wrote, “In seed time learn, in harvest teach, in winter enjoy.” By Blake’s rule, fresh data suggest that the winter has set in with subzero temps and that there’s much to enjoy as private equity emerges from a record $73 billion in first-half buyout sales. In seed time they learned well one of the oldest lessons on the Street: Buy low, Sell high. It’s always wonderful when it works. The real question is what the kings of Wall Street have learned as they prepare to plant the next season’s crop? Will restraint rule the day? Or will the siren call of untapped fees be too much to resist, prices be damned?

News that private equity is cashing out is unabashedly good for investors. Limited partners, as private equity investors are known, agree to lock up their money for the better part of a decade in funds run by general partners. In exchange, limited partners rely on the promise of outsized returns when the companies that have been taken private are harvested via an initial public offering or a sale to another entity. Distributions, the crop harvested, is cash plus profits — and critically, net of generous fees.

According to a recent Triago report, fund managers distributed a record high $477 billion to their investors last year. That’s up 39 percent over 2013 and a shocking 215 percent above the six-year average.

This year’s distributions, an estimated $503 billion, are on track to surpass that of 2014. One trillion dollars over two years matters given the asset class totals $4 trillion in equity investments and commitments.

Did limited partners stuff their distributions under the mattress? Not hardly. In 2014, reinvestments and fresh commitments pushed annual funds raised to a post-crisis high of $438 billion. Not to be outdone, 2015 is shaping up to take out last year’s high with fundraising up 11.4 percent.

Traditional funds raised, when a limited partner commits to invest in a fund structure, tell only part of the story. Some $113 billion in new “shadow capital” commitments were also made last year through structures other than funds, such as co-investments, separate accounts and direct investments. Once again, 2015 is poised to unseat the record high for shadow capital commitments. Forget the post-crisis years which began in 2009. If the record paces hold for reinvestments, fresh funds and shadow capital commitments, 2015 could mark a historic high for new commitments to private equity.

The risk: there’s not a healthy enough fear of commitment moving forward. Despite record distributions, private equity is sitting atop a record heap of $1.2 trillion in dry powder, an industry term that captures committed capital that has yet to be deployed. It’s easy enough to comprehend why private equity is selling high. It’s much more difficult to explain how managers approach today’s investing landscape with the stated goal of buying low.

Judging by last year, the challenge is growing. In this year’s first quarter, the money called by fund managers to make new investments declined to the slowest annualized pace since 2009. The contrast between then and now is striking. In 2009, there was blood in the streets. The stock market was trading at its cheapest valuations since the early 1980s as the financial crisis raged on, taking down 200 victims that year alone among companies defaulting on their publicly-traded bonds. Today stocks are trading at over twice the valuation levels as 2009 thanks in part to the wide-open debt markets that have helped finance record share buybacks. As for defaults, though companies do fail to make due on their obligations from time to time, the quenchless thirst for yield largely prevents most companies from resorting to default. Such is the appetite for new issues of debt with any kind of a coupon.

The Federal Reserve’s zero-interest rate policy has done much more than facilitate record bond sales and share buybacks. Record low borrowing costs have also helped private equity cash out: bond sales for the express purpose of paying the company a one-time dividend were all the rage until last year when issuance fell off. That’s a good thing as piling debt onto an over-indebted company’s balance sheet tends to end badly for bondholders. On a more subtle level, the implicit floor under the stock market has allowed buyout firms to place 97 stock offerings in the three months to June, yet another record pace.

And yet, leveraged buyout volumes have fallen by 47 percent to $28.9 billion versus $54.1 billion a year ago. This suggests private equity firms recognize their weak position competing against merger-famished companies that are even more desperate to off-load some of their huge cash positions. The latest estimates places the global corporate cash cache at $4.2 trillion. If only easy money could get out of the way and in doing so lay the groundwork for investing this cash in organic growth and job creation rather than Monkeying With Your Balance Sheet 101!.

It stands to reason that leveraged loan volumes have fallen by 43 percent over the same time as the need to finance risky deals has cooled. Alongside the decline is a similar falloff in “covenant-lite” bond issues, in which bondholders are denied standard protections they’re given in a less frenzied issuance environment. Finally, bond sales by the weakest-credit issuers have fallen to half of last summer’s crazed pace. The reckless late-stage credit cycle behavior would appear to be ebbing.

It would be great news if this story ended there, on a prudent note. But the fact is, dry powder earmarked for buyouts is $450 billion. Meanwhile, debt issued to fund mergers and acquisitions is on the rise and approaching 2007’s peak levels. At some point, private equity may succumb to the gravitational pull of the credit cycle that has plenty of room left to run in no small part becausethe buyout kings have yet to unleash their purchasing power. The alternative would be returning committed capital to investors and foregoing the rich fees attached to it. The denial of the earth being round would soon follow.

All sarcasm aside, there’s never been evidence of humility in the DNA makeup of the self-proclaimed smartest guys in the room (the heads of private equity firms are the current titleholders – net worth is the yardstick that determines the reigning champions). Returning dry powder to limited partners would thus go against the very nature of the gentlemen who run what just 23 years ago was a cottage industry with $50 billion under management.

The alternative: spend the money, come what may in the pricing arena. After all, distributions enrich the general partners to a greater degree than their fee-laden limited partners. In other words, the kingpins of Wall Street have made so much money (the highest paid individual pocketed nearly $700 million last year alone) that they can afford to be price agnostic because they’re playing with someone else’s money.

Of course the Fed could step in and attempt to pull away the punch bowl. But that would too be out of character. The current generation of central bankers insists that their role is akin to that of a clean-up crew called in after the police have already been called by the neighbors.

It’s difficult to envision what the next harvest will yield. If the power of buyout capital is unleashed, knowing full well that private equity always juices their deal structures with leverage, then the current credit cycle has room left to run, and then some. As for the debt market’s cousin, the equity market, math dictates that the reduction in aggregate share count produced via buyouts will necessarily boost stock prices. Hence, despite lofty valuations, between corporations and private equity firms flush with cash, there may be more than enough buying power in the kitty to inflate both the bond and stock markets to untenable levels. The smell of dry powder in the morning may simply be too much to resist.