Private Equity Capital Overhang from a Middle Market Perspective

 

“For my purpose holds
To sail beyond the sunset, and the baths
Of all the western stars, until I die.
It may be that the gulfs will wash us down:
It may be we shall touch the Happy Isles,
And see the great Achilles, whom we knew”
-Tennyson “Ulysses” (1842)

From a high level, Pitchbook data[1] illustrates significant improvement in the general capital overhang[2] picture with the cumulative overhang declining over 25% to $432B in 2012 from its peak of $576B in 2008. Unfortunately, it is difficult to find general media outlets covering any such an improvement in the overhang picture or attempts to dig into the data.

201304_rock_overhangWhile I do not suggest that the overhang amount remaining is not a challenge – there are questions as to how pressing an issue it really is – and whether some sectors will feel it more than others. I believe the data on capital overhang points to good outcomes on both questions for the middle market. What is even clearer is that investors in private equity deals – from senior lenders, to junior capital providers, to equity co-investors – are well advised to ‘peel the onion’ on the overhang issue to see if, and how, it may impact their sector and ultimately their specific investment opportunities.

I would suggest there are three important questions that need to be asked from the perspective of the middle market investor:

  • Is the urgency implied by the capital overhang balanced across vintages?
  • Do the challenges of the capital overhang impact all sectors (e.g. mega buyout vs. middle market) in the same way?
  • How does this impact investing with private equity firms in the middle market?

In this first of three installments, I want to tackle the first question.

Is the urgency implied by the capital overhang balanced across fund vintages?

Even without knowing the breakdown of the overhang, an experienced private equity investor would guess that “no, it is not.” And that is the case. Using the Pitchbook data, just 5% of the overhang is located in 2006 vintage funds – add $67B of 2007 vintage funds and the amount climbs to just 15% of the total (see Figure 1). Why is that important? If one considers the typical 5-6 year investment window for a fund, these would be the vintages most under pressure to deploy capital before the window closes. Finally, add the vintage 2008 funds to complete the picture before the nadir of economic crisis, and the overhang increases to $193B, or 45% of the $432B total. One could argue that the overhang ‘pain’ is somewhat less acute, and certainly not uniform, across the vintages (e.g. this would be much more concerning if 75% of overhang were located in pre-crisis vintages).

Why is this important? Beyond just trying to gauge the relative urgency implied by the comparatively smaller dry powder in older vintages, it’s important to realize that fundraising has continued in the face of the media hysterics over the overhang. For example, one would reasonably believe that the LP’s are in the best position to make informed judgments on the attractiveness of investing in the asset class overall – and into the specific funds being raised.

Right?

Interestingly to that end, we’ve seen over $358B raised since the peak of the capital overhang in 2008[3]. Are LP’s ignorant? Or do they have experience, fund-level data, and perspective to look past the noise to the specific opportunities (funds) at hand?

While summary statistics are necessary and often convenient – especially if they have nifty taglines like ‘overhang’ – serious investors in the middle market need to dig into the broader data sets to see how it might impact their sector and the specific private equity investors in their deals. I strongly believe that there are significant opportunities as many funds have distinguished themselves across the cycle and are sailing in realtively fair winds – while there are rocky shoals ahead for some funds that did not fare so well. A key success factor will be figuring this out before jumping into the boat.

[1] Pitchbook The 2012 Capital Overhang and Fundraising Cashflow Report (Presented by RR Donnelly Venue)
[2] Also known as dry powder in committed funds
[3] Pitchbook The Private Equity 2Q 2012 Breakdown (Presented by Merrill Datasite).

 

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