Following the recovery from the global financial crisis, buying into private equity target companies has become significantly more expensive, which raises the question: should private equity investments be avoided in the current environment? In fact, the levels at which private equity managers can buy into companies are far more attractive than current stock market valuations.
In the small buyout transactions segment, the price paid is often lower by two to three times EBITDA. In addition, many private equity companies grow much more quickly and profitably. A private equity manager might pay, for instance, seven times EBITDA for a company that grows its sales at 10% and its EBITDA at 15% annually, while an equity investor often pays more than ten times EBITDA for a company that may even be suffering from shrinking sales and falling earnings. For fast-growing companies, stock prices are sometimes exorbitant. As every investor knows, selling or not holding an asset implies buying or holding another asset, which may sometimes simply be cash. The fact that an asset is expensive in itself and in absolute terms – or more expensive than in the past – therefore becomes less relevant. What is much more important is how the price that I pay for an asset compares with the prices that I would pay for alternative assets. And even more crucial is what I get back for the price of my investment. Therefore, investments should be made where the potential rewards seem most attractive in relation to the associated risks, taking into account the purchase price. Relative price signals are a decisive factor in financial transactions. These signals appear to favor private equity investments, even in the current expensive environment.
Many investors may see private equity returns as attractive in good times. But many might also ask how well placed they would be with private equity investments if, for instance, an excessive rise in interest rates resulted in speculative bubbles bursting. However, experience gives reason to hope that, even in the event of financial crises, at least the losses would be smaller than with, for example, equity investments. For instance, for many private investors, the losses incurred during the last crisis were barely half those suffered on the stock markets.
Author: Dr. Jürg Burkhard, Head PE Portfolio Controlling, LGT Capital Partners