Garrett Black, Nizar Tarhuni November 23, 2015
Meghan Neenan is a Senior Director in Financial Institutions at Fitch Ratings. She recently took some time to chat with us about the private equity industry's hoard of uncalled capital, current valuations and more.
Fitch recently revised The Carlyle Group’s rating outlook downward, citing a “lack of progress on core fee-related earnings”. Looking forward, do you anticipate further difficulty for not just Carlyle but additional fund managers in reducing elevated leverage ratios given current amounts of dry powder?
We think the deployment of dry powder will actually aid the industry’s ability to de-lever as fund investment periods will begin and a portion of uncalled capital earns fees once the capital is invested. Conversely, if the realization cycle remains robust and investment opportunities continue to be scarce, fee-related earnings could decline along with a contraction in fee-earning assets under management.
Are private equity firms finding difficulty in putting dry powder to work primarily because of the level of competition nowadays as well as high valuations, or do you think there may be a lack of flexibility in terms of buyout shops’ adaptation to the current environment?
We think the scale, diversity, and global reach of the industry’s largest players have enhanced their ability to adapt to the current environment. The amount of capital deployed has declined more recently, due largely to high valuations, but several firms have been able to leverage their relationships, structuring capabilities, and deep pockets to find non-traditional opportunities to invest.
In which sectors do you think there are opportunities in terms of dislocations for PE firms that they are not currently exploiting?
With flexible capital and deep market intelligence, Fitch believes PE firms are well-positioned to take advantage of most market dislocations. While there are no glaring absences, there may be some geographic locations where the large firms have less of a presence, like Latin America, but we believe that will likely change over time.
Do you think that PE shops will begin fundraising with an eye toward even longer investment lifetimes, much like a few prominent fund managers already have, in response to current market cycles?
Yes, Fitch has seen a marked increase in the focus on permanent capital vehicles, which provide managers with more operating flexibility and management fee stability through cycles. Several firms are also considering launching ‘core’ strategies in private equity and real estate, which tend to have longer investment horizons and a current income component, which may be attractive for certain investors.
KKR announced a shift in its capital management strategy on its last earnings call, announcing plans to begin paying a fixed quarterly dividend rather than a variable distribution, a share buyback program, and an intent to make balance sheet investments alongside its buyout funds. These initiatives are geared towards helping boost its stock price, which the firm believes has been undervalued due in part to a lack of understanding from analysts on the street.
Taking into account concerns such as the elevated dry powder levels and frothy valuations mentioned before, how do you think this strategy plays out? Do you see other publicly traded PE firms shifting capital management strategies as well going forward?
KKR’s strategy has always been differentiated and Fitch believes the firm has been successful using its balance sheet to fund co-investments, seed new strategies, and generate incremental yield and dividend income for the firm. While the increased liquidity provided by a decline in firm distributions must be carefully managed, particularly in the current environment, KKR has a track record of strong balance sheet returns and prudent capital management.
As to whether peers will follow suit, we think it depends on the equity market reaction to the change in KKR’s distribution policy, as measured by its valuation multiple. If the reinvestment of earnings and/or share repurchases is valued more highly by the investor community, other PE firms may follow the same path.
The press release citing Carlyle's rating change touches on the threat of continued pricing elevation due to a scarcity of deals relative to the amount of capital chasing those deals. We’re likely set to see diverging central bank policies between the U.S. and Europe. Further, we’ve all seen increased weakness across China and various emerging market economies.
How do you see the global economic environment affecting the market as we move through the next year? Do you see these negative implications able to significantly bring down transaction prices, despite elevated dry powder capital chasing fewer deals?
We think valuations are the most elevated in the U.S. and that is not likely to change materially heading into 2016. However, divergent economic and regulatory environments are expected to continue to create opportunities to invest abroad, particularly in Europe and Asia. Direct lending, special situations and real estate are expected to be areas of focus in those geographies. As for the emerging markets, Fitch believes strategies will be more targeted and the deployment of capital will be measured.