Competition for investment assets and a market flush with cheap money have prompted some private equity companies to hold back on buys or adjust strategies.
Private equity fund managers had $839 billion available to them by the third quarter of 2016, according to a report from the research company Preqin. The number of funds raising capital grew to 1,807 by the beginning of the fourth quarter, the largest number Preqin has recorded.
The year 2016 is closing with a sellers' market in which high valuations have continued a remarkable run, said Justin Abelow, co-head of Houlihan Lokey's private equity advisory practice.
"The duration and longevity of the sellers' market is beginning to seem exceptional," Abelow said in an interview.
With deal multiples soaring, private equity companies have held back on capital deployment with the decreasing likelihood that the asking prices could produce suitable returns. Publicly traded alternative asset managers have sounded a similar note.
Private equity sponsors have adjusted by tinkering with their models, zeroing in on particular industries to gain more expertise or lowering expectations for governance, Abelow said.
"A large number of more traditional buyout firms are displaying some willingness to engage in minority deals now," he said. The companies often join with like-minded buyers, companies or selling founders or family members.
Managers are also changing the size limits or minimums of companies in which to invest to seek out new kinds of deals, with smaller funds finding partners for larger deals and bigger funds buying smaller businesses. In both cases, the managers make plays where they believe they have an angle that differentiates them, Abelow said.
Insurance brokerages continue to be an attractive target for private equity investment. They have been reliable moneymakers and have been trading at 12x EBITDA for midsize and large brokerages, said Arik Rashkes, a Houlihan Lokey adviser for insurance deals. Some companies have changed private equity hands, often for the right reasons, Rashkes said in an interview.
"You'll see a smaller private equity fund investing in a small business, growing it to a certain size, [and selling] it to a larger equity firm that grows it to a bigger size," he said.
The private equity presence has prompted traditional broker acquirers such as Arthur J. Gallagher & Co. to adjust their strategies. J. Patrick Gallagher Jr., the company's chairman, president and CEO, recently likened private equity's presence as an insurance consolidating force to that of banks in prior decades. Arthur J. Gallagher's deals averaged in the $3.5 million range into the third quarter, a valuation zone where private equity competition is not as strong, Gallagher said, according to a transcript of his remarks.
Private equity funds continue to attract capital for investment returns that can improve upon the anemic performance of equity-based funds. Private equity returns have outperformed an index of public assets compiled by Cambridge Associates as investments that perform in similar conditions to private assets. Blackstone Group LP reported more than $14 billion of inflows in the third quarter as institutional investors have reached for better returns.
During that period, private equity funds were targeting $495 billion in funds to raise, hovering near the $504 billion all-time high that Preqin reported for the fourth quarter of 2015.
The economic expansion is growing old, and private sponsors have begun to prepare for a downturn, Abelow said. Assets whose growth does not correlate with the economic cycle, including healthcare, industrial technology and instrumentation certification, are attracting dozens of suitors when they go on the market, said Abelow and Kevin Salmini, who also advises private equity at Houlihan Lokey. Interest had begun to drift away from construction material until the election of Donald Trump to the presidency and his promise of infrastructure projects.
"Some sectors bounced back because of that element," Salmini said.
The end of 2016 and a new presidential administration have given rise to two classes of buyers and sellers, causing distortions in timing. Those anticipating tax cuts are inclined to delay, while managers expecting higher taxes on carried interest are rushing to close before the end of the year, he said.
The private equity sector also is watching the Chinese crackdown on capital outflows. Chinese investors have been major players as investors in U.S. assets.
"What's going to happen with Chinese buyers?" Salmini said.