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Why buyout firms will keep piling up cash

Private equity firms are on track to post another banner fundraising year, building momentum that may be irresistible even as debt becomes more expensive and valuations continue to soar.

As of Aug. 1, private equity funds worldwide had raised $275.6 billion, well on the way to besting last year's record of $388.1 billion, according to data from Preqin, an information provider on the alternative assets industry.

The federal funds rate sits at a range between 1.00% and 1.25%. With U.S. Federal Reserve officials projecting median longer-term rates to run around 300 basis points, "we've never been in as friendly an environment as we've been in now," said Alan Pardee, managing partner at Mercury Capital Advisors, an investment advisory firm, in a phone interview.

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In fact, the industry is on a streak not seen since before 2007. "We've had five years in a row that have been peak years," Pardee noted.

Not only is total fundraising up, but the biggest managers are breaking their own records. Last year, Advent International Corp. was seeking $12 billion and raised $13 billion after investors wanted to put $20 billion into the fund, Bain & Co. Inc. noted in its Global Private Equity Report 2017. This year, Apollo Global Management LLC raised $23.5 billion its biggest fund ever – according to the Wall Street Journal, while KKR & Co. LLP closed a $13.9 billion fund.

But expansions lead ineluctably to contractions. Though private equity firms on the hunt for deals in the U.S. and Europe were willing to pay more than 10x EBITDA for acquisitions by the beginning of 2016 according to data from S&P Global LCD, "every month brings us closer to what many consider an inevitable next recession," Bain noted in its report.

"People looking at multiples of EBITDA could easily ask themselves – is this the top?" Pardee said.

Though private equity firms can find lenders willing to do deals with an average debt/EBITDA multiple of more than 5, that's down from the average multiple of 6 that was tolerated in 2007, according to data from S&P Global LCD.

The debt factor

Debt – the main fuel for private equity deals will become more expensive if the Fed and other central bankers continue to tighten monetary policy as the financial crisis recedes into history. That dynamic might cause problems for portfolio companies and lenders, but should do little to dent buyout firms' ability to raise funds.

For example, as rates move higher, private equity-backed companies could struggle to meet interest payments and may be pushed closer to default.

And not only has speculative debt tied to leveraged buyouts been readily available, issuers have been able to demand – and get – so-called covenant-lite loans, which are loan agreements without the usual protections for creditors, such as requirements that a borrower demonstrate its ability to satisfy certain EBITDA ratios.

In 2016, $244.8 billion of covenant-lite debt was issued, according to S&P Global LCD, representing almost 73% of all loans issued. Issuance this year, as of Aug. 3, stood at $228 billion, representing 67% of total issuance.

In addition, the amount of junior debt subordinated to the covenant-lite loans has fallen to 22% in 2016 from an average of 33% before that, said Moody's analyst Julia Chursin in a phone interview. In general, the more cushion firms have at the lower levels, the more protection for investors in covenant-lite loans because the junior debt takes the hit of a corporate reorganization or bankruptcy first, she noted.

In the aftermath of the financial crisis, the default cycle was shorter than the historical average of about four years because of the "huge liquidity injected by the Fed," said Moody's Senior Vice President David Keisman.

That history may provide some security to investors in the debt private equity relies on to do deals, even as the Fed enters a tightening phase, including gradually reducing its $4.5 trillion balance sheet.

The Federal Open Market Committee "would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate," Fed Chair Janet Yellen said in her semiannual address to Congress last month.

The perpetual search for yield

Despite the headwinds, it's not clear that institutional investors will retreat from private equity. California Public Employees' Retirement System said its preliminary net rate of return for the 12 months preceding June 30 for its private equity portfolio was 13.9%. CalPERS is the largest U.S. pension fund with $323 billion in assets as of the end of June.

While that return was bested by the 19.7% return in its public equity program, it outdid the 7.6% return on its real estate investments, CalPERS said.

Institutional investors are even having trouble parking the money they've allocated to private equity. Washington State Department of Retirement Systems, which had $82.5 billion in assets as of June 30, had unfunded commitments to private equity of $12.9 billion. That was up from $8.2 billion in June 2012, according to the Bain report. California State Teachers' Retirement System, with $208.7 billion in assets as of June 30, targeted 13% for private equity investment, yet had only allocated 8.7% as of the end of June, the pension fund said in its annual report.

That's one end of the pipeline: the limited partners' investments in private equity. The other end involves how much money private equity firms have available to put into deals – a measure known as dry powder – which hit yet another record of $1.47 trillion in 2016, according to Bain.

That kind of pressure is unlikely to change investors' willingness to put money into private equity or the power of the industry to do deals, even as monetary policy tightens around the globe.

"Short of geopolitical issues or a sudden change in economic sentiment in the world," Mercury Capital's Pardee said he expects investment in U.S. funds, as well as those in Europe and China, to continue apace.