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Old Hills September 2017 Commentary- the Problem with Powder

Since we work primarily with lower middle-market businesses, we generally keep our eyes open for insights into the private equity space inasmuch as the sector can sometimes be a good alternative for our borrowers down the road. But it was with some disbelief that we read a recent Bloomberg article stating PE managers are sitting on a colossal $963 billion – nearly a trillion dollars – in dry powder. That’s money allocated to them by their investors, but that they haven’t deployed into companies yet. 

 Nearly a trillion dollars. It’s a staggering figure, well in excess of previous pre-crisis levels. It is easy to see why so much dry powder has built up - fundraising in PE has been going gangbusters again this year after a stellar 2016, with Apollo raising a single-vehicle record of $23.5 billion in June and PE giants such as CVC, Silver Lake and KKR gathering billions for similar megapools of capital. A record 1,998 funds were in the market for capital at the end of the first half, according to Preqin, and some $88 billion was raised in just the second quarter. Investors, it seems, remain attracted to the long-term yield potential these buyout funds can offer.

 However, those returns only happen if the capital raised by a PE firm is actually invested, and that’s where things have started to veer off course. A little dry powder is usually a good thing – it means you can be opportunistic when necessary – but a systemically extraordinary amount (like $1 trillion) means a LOT of money is sloshing around looking for a home, and that rarely ends well. This scenario typically results in a couple of consequences: 

 

First, private company valuations rise. With $1 trillion in dry powder, it’s a seller’s market…and you’d better believe pricing power is significant. Indeed, with virtually every major PE firm sitting on far more dry powder than they’d prefer, bake-offs, auctions, and bidding wars result, and a vicious cycle of ever-higher valuations can ensue. Sound familiar (i.e. pre-crisis housing market)? 

Secondly, and what interests us the most, is that PE managers with too much cash on their hands risk lowering their investment standards. With significant pressure to get capital to work, discipline can suffer, and the consequences can be disastrous; at the peak of the last buyout cycle in 2007, KKR and Texas Pacific paid a whopping $45 billion for Texas utility TXU, only to see it go bankrupt in 2014.

Granted, a portion of the dry powder in PE is due to those same stretched valuations. Good managers vastly prefer sitting on the sidelines as opposed to chasing overpriced, risky deals. But not all, and the pressure is undeniably there. After two decades in this business, we can unequivocally state that at least some of this nearly $1 trillion in capital will eventually find its way into awful deals at insane valuations. When too much money is chasing too few deals, trigger fingers tend to get itchy.

Contrast this situation with that of asset-based lenders like Old Hill Partners. First and foremost, we are essentially paid to be patient.  We structure debt transactions with carefully defined maturity dates and coupons, and realize our income gradually over a number of years whereas a PE firm’s return is impossible to predict ahead of time and is realized only upon a sale of the company.

Moreover, our transactions are anchored on an asset’s discounted value and the borrower’s ability to repay. What we lend out is tied to that asset or the cash flow the asset produces, not our ability to sell the company down the road. It is a fundamentally different angle, and one that takes the pressure out of that dry powder conversation with investors. As a lender, return OF our capital is as important as the return ON our capital, and our investors know it.

Additionally, recovery rates tend to be better. To coin a phrase, we hope for the best and prepare for the worst. We do exhaustive diligence prior to committing capital, during which numerous scenarios are simulated and the borrower’s and/or asset’s ability to service our loan is stress-tested. Plus, our capital is senior secured and collateralized at reasonable loan-to-value ratios, meaning that even in the worst of outcomes, it is typically recovered. As equity holders, PE funds do not enjoy similar protections. Workouts almost always result in a firesale of all or part of the company in question – and the writedowns that result.

At the very least, the tremendous amount of capital on the sidelines of the PE space is a sign that good deals are getting much harder to come by. In turn, this means the risk of mistakes, poor judgments and/or impulsive decisions is also rising, leaving investors with the option of dead capital at best or risky, late-cycle Hail Mary’s at worst. In our corner of the market, the opposite holds true; meticulously researched and analyzed asset-based lending transactions can offer investors steady, attractive risk-adjusted returns over time, and in an environment where patience is a virtue.  Therefore, investors looking to allocate capital to private equity or have set aside capital to be deployed into private equity investments can temporally invest in private credit like asset-based lending offered by Old Hill Partners. Old Hill’s asset-based lending strategy has a shorter term that most PE funds, and investors engaged in it can avoid or delay committing to overpriced private equity - potentially creating a better entry point.