In recent years, record inflows of capital have poured into PE, driving increased competition and valuations.
Since 2012, valuations have consistently increased, in large part due to the growing number of active funds and growth in the average fund size. Using data from Pitchbook, the number of funds in the US with at least $2bn in committed capital has increased from 37 as of 4Q’15 to 125 as of 3Q’20, with the median fund size increasing as well from ~$3.5bn as of 4Q’15 to ~$3.9bn as of 3Q’20.
2019 was a record year for fundraising – we saw 34 funds raise $2bn or more, building on strong fundraising years in 2017 and 2018. And, in 2020, we saw 18 funds raise new vehicles with $2bn or more.
Due to COVID, the number of investment opportunities shrunk but the available capital to be deployed remained at an all-time high; even more, the differences between high quality assets and lower quality assets became more stark, as certain sectors and businesses proved to be resilient, and even grew, during 2020. As a result, we saw an even sharper increase in valuations, especially for the resilient sectors and business models that we’re focused on at OMERS Private Equity.
High quality, resilient assets positioned to withstand the impact of COVID, and poised to grow longer-term, garnered valuations at least 2-3x higher, if not more, in the case of highly specialized, highly resilient, and tech-driven businesses.
Although Q2’20 saw a notable decrease in deal activity, Q3’20 and Q4’20 were very active periods. According to Pitchbook, Q4’20 saw the highest quarterly deal value for PE in at least a decade, and anecdotally we heard most advisors (from commercial to accounting) were fully booked through the period, while many of the lenders we frequently work with experienced a record in financing activity in Q4’20.
This paints a basic picture of the competitive environment we face today. In the face of this, I’ve found myself at times feeling frustrated and uncertain. However, this environment isn’t necessarily new and the uncertainty of it is no stranger as PE inherently deals in uncertainty – the uncertainty of long-term outcomes, the uncertainty of limited or imperfect data, and (importantly) the uncertainty of human emotions, especially in the face of competition.
This has pushed me to really focus on the influence of human psychology on the decisions we make as private equity professionals, and specifically the emotional side of investing – it’s easy to get caught up in your emotions and the will to win such that you pay “whatever it takes,” or succumb to confirmation bias by ignoring a diverse set of facts solely in favor of the positives. This can lead to poor decisions, investment paralysis, or “boiling the ocean” and spreading yourself too thin, so I’ve challenged myself on these feelings and have seen others fall prey to them.
We fully expect this competitive dynamic to continue in 2021, and likely for several years after. So, how can we effectively compete and win, and how do we manage the emotional side?
To do this, it’s important to have a clear set of objectives, an appreciation of the facts to form a full perspective, and a well-defined process with a clear set of criteria governing our investment activity, as well as a commitment to challenge our emotions and our egos. For me, this translates into three tenets that keep me focused and grounded:
Prioritize & build conviction – prioritize your focus areas, do your work early, go deep and be smart about your thesis and the value drivers for specific targets so that you can develop full conviction on opportunities.
Work through alternative investment scenarios
Break down and understand an industry’s and a business’ fundamentals – including each component of the revenue model and the factors that influence each piece
Employ the “five whys” (or similar) as you work through the merits and considerations
Frame “what we need to believe” to inform your screening criteria and thesis, and be clear about the upside opportunities as well as the downside risk
Be proactive and (appropriately) aggressive – PE is as much about people and relationships as it is about data and analysis. Through 2020, we saw funds assume a more aggressive posture and try to get in front of opportunities early, or even go direct to a potential seller with a very compelling offer. If you know what you like and have conviction on an opportunity, then you should explore and leverage every angle and relationship available to position yourself for success. At a minimum, you should be in market discussing ideas, sharing notes and learning so you’re well positioned ahead of a competitive auction.
Maintain discipline – this is probably the most important tenet and is aimed at addressing the psychological and emotional aspects of this investing environment. PE is a long-term asset class and we’ve seen funds in the past be aggressive and have conviction to pay up, but without discipline they ultimately falter through several bad investments. Although it’s tough to lose (or even miss out altogether) on an asset you like, it’s important to be disciplined and guard yourself against thinking “why not just stretch on valuation, or take that bigger bet?” So, I challenge myself to draw the line somewhere and be really clear about what we like, why, and how much we’re ultimately willing to pay.
These tenets won’t necessarily guarantee success, but they do help me manage the “emotional” side of investing, stay level and focused through this environment, and be clear about our objectives so we can achieve our longer-term goals. If I take a step back, this is an exciting time to compete and try to win. Plus, I think we at OMERS have the platform, the team, the long-term perspective and the framework to do so successfully. If we build conviction, be proactive and maintain discipline, then I’m confident that we’ll succeed.
