The rise of private equity

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Will the growth continue in 2019? Several local experts believe it will, with a few caveats.

Leigh-Erin Irons, co-chair of Fredrikson & Byron’s private equity group, said some recent data suggests that valuations and deal terms are starting to plateau, as opposed to continuing their upward trajectory.”

“Multiples of value are at an elevated level but there are no obvious signs that could be in jeopardy in 2019. Everybody has been predicting continued, robust activity,” Irons said.

The Twin Cities has a tradition of strong PE funds, led by familiar names like Norwest Equity Partners, Stone Arch Capital, and others, she noted.

Leif Gunderson, an alternative investments analyst with RBC Wealth Management in Minneapolis, said there are signs that the growth in capital committed to PE has been slowing slightly, but that is partly because a number of large funds have a lot of “dry powder“ — uninvested capital. He also has a sense that a number of fund managers are concerned about “where we are in the [equity] market cycle;” that is, relatively high stock market valuations.

Competition among funds has driven PE deal prices higher. “If other funds are competing for the same deals, that makes pricing harder,” Gunderson said. Higher multiples should give investors pause.

Much of the growth in PE has been due to more investment by sovereign wealth and public pension funds, “which is what really moves the needle for private equity,” Gunderson said. “If they decide to commit 2 percent more capital to private equity, that means billions more for us. There has been more evidence that private equity does produce premium returns.”

Another driver for the boom in private equity activity has been demographics: more aging baby boomer business owners looking for an exit, said Rick Brimacomb, owner of Minneapolis based venture fund Brimacomb Capital, and the advisory firm Brimacomb+Associates.

Private equity is one vehicle to consummate those transactions. “Back in the ‘old’ days, an exit might be to go public but going public now is more challenging and expensive; fewer companies are doing that.” Strategic acquisitions and private equity are preferred routes, said Brimacomb, who has past experience working in the PE sector. And, more institutional investors have been looking for ways to put capital to work in less risky asset classes, Brimacomb said. “Private equity offers an attractive risk-reward profile, so it has been intriguing to a lot of folks.”

Another trend has been an increase in the number of family offices — entities created to manage family fortunes that are moving into areas that were historically the turf of large companies or private equity firms. Globally, Ernst & Young estimates that there are currently 10,000 single-family offices, a tenfold increase since 2008.

The Twin Cities has long had a sizable number of wealthy individuals and families, some of whom have formed family offices to do direct investing, without the help of a limited partner, Irons said. Familiar, family names like Pohlad and Carlson have jumped into the market.

In an increasingly competitive sector, private equity funds have become more creative over time, Irons says. “When they are paying a lot for companies they have to figure out ways to generate value.” One way to do that is to buy several businesses within a given industry to create a bigger brand platform,” Irons said. “There is still lots of debt financing available to support the leveraged buyout market.”

Providers of outpatient health care services have been attractive targets for local private equity firms, Irons noted. One example is New York private equity firm Wellspring Capital Management’s recent acquisition of Center for Diagnostic Imaging, a local provider of MRI and CT scans with 122 clinics in 22 states, including 26 imaging centers in Minnesota.

Sector-wise, PE fund investment has become more diverse. “Technology used to be a sector, but now technology is about as diversified as you can get. Tech funds are now investing in technologies that touch every sector,” Gunderson pointed out.

How should investors who would like to get involved in private equity evaluate PE firms? To Gunderson, one of the key indicators is “what are they doing that is different than the exposure you could get in a listed public security? A lot of people overlook the fact that, over time, private equity funds do add 3 to 5 percent over the returns from owning an S&P index fund. That usually has something to do with their ability to better operate companies and sometimes gain ownership of smaller companies than individuals could get by investing in venture capital.

“Private equity teams should be judged on their proven ability to execute and their ability to add value.”

Because the holding periods that PE investors must commit are relatively long — 8 to 12 years — that enhances their ability to make strategic moves based on long-term growth rather than quarterly results, Gunderson said. “We can make harder decisions for the growth of a company because we aren’t under immediate pressure to sell.”

As in the mutual fund world, growing too large, too fast can be a problem for PE funds, Gunderson said. At any point in time, there’s only a limited number of good investment opportunities. Making sure that a PE fund has well-developed strategies to support its size is an important part of the analysis, Gunderson said. “If you raised $300 million in your last fund, and then you start another fund and jump to a billion, you better have a really good reason why.”

With a lot of money on the sidelines, that means PE firms have to open up their nets to find more deals to put more money to work, Brimacomb noted. One way they have been doing that is looking more closely at tech-centric companies, or those that leverage technology, according to Brimacomb.  “Ten years ago or more, more private equity firms would have shied away from tech companies” which, in the past were more likely to interest venture funds. “They would have done more deals for main street America businesses.”

Greater competition for deals has also been causing some private equity firms to move downstream to look at acquiring smaller companies, Brimacomb said. In the past, “they wanted to (work with) companies with at least $5 million EBITDA; now they are going to $2 million or even $1 million because there is more competition.”

Economic expansions never last forever. But, when there is a recession on the horizon and interest rates are rising, downturns also create opportunity for PE firms to strategically invest in debt or other distressed credits, Gunderson pointed out. On the other hand, higher rates “also take things away from them, like low-cost financing,” Brimacomb said.