Private Equity: Elevated Valuations Warrant Elevated Caution

 | Oct 31, 2016 | 2:00 PM EDT
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Stock quotes in this article:

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apol

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outr

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oak

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It was a busy weekend for me. Friday night I went to my very first World Series game in Chicago and Saturday I took my very first Uber ride back to the airport. I am becoming less of a fan of these short, in-and-out trips as I get older, but all that airport and flying time does provide a chance to catch up on my reading. On this trip I continued digging through conference call transcripts from some of my favorite private equity and asset managers.

One the transcripts I reviewed was the call from Apollo Global Management (APO) . The private equity firm had another solid quarter and was the biggest buyer of the big four, by far.

Apollo put about $5 billion to work as it was able to find businesses it likes at very low EBITDA multiples, even in the currently extended pricing environment. The firm was a buyer of out-of-favor companies such as Redbox-owner Outerwall (OUTR) , time-share company Diamond Resorts (DRII) and beleaguered Apollo Education (APOL) at prices it believed offered the potential for strong long-term returns.

Co-Founder and Senior Managing Director Josh Harris talked about the firm's ability to get deals done, telling investors on the call, "We understand some of you may be wondering how our funds have successfully deployed this level of capital in a market where valuations remain elevated given our value-oriented approach. As one of the fundamental tests of our investment style, I am pleased to note that we believe we have maintained our value-oriented investment discipline through this period of heightened activity. The average creation multiple of Fund VIII remains at less than six times adjusted EBITDA, significantly below industry averages."

Harris was quick to stress that it was Apollo's attention to the price value metric, and not the broader market pricing, that was allowing it to get money to work saying, "In terms of value creation though, at the end of the day, and I don't disagree that the equity markets are fully priced and the private equity market is significantly priced. The average transaction EV to adjusted EBITDA trailing in the private equity markets was over 10, approaching 11 times EBITDA. And we are sitting here buying stuff at six times EBITDA or below."

Bruce Karsh, Chief investment Officer at Oaktree Capital (OAK) took a similarly cautious stance on the firm's call Friday remarking that, "Looking ahead, how do we view the current market risks and uncertainties in the context of prices that in many cases strike us as elevated? Among the risks is the chance that the market is leaning the wrong way by assuming capital flows into U.S. assets will remain strong. Those flows could reverse of course as central banks outside the U.S. begin tapering asset purchases or in other ways start trimming their monetary stimulus. Other risks are around possible economic weakening in Europe post Brexit or in China where ongoing currency devaluation could trigger another downturn in commodities." Karsh once again described his firm's approach as moving forward with caution.

Oaktree CEO Jay Wintrob added some color to its outlook telling investors that, "It is natural that a strong realization environment will not simultaneously offer plentiful bargains and thus we're maintaining our move forward but with a cautious investing posture. That said, our teams continue to be resourceful in identifying attractive investments ... but overall we are a net seller in the current environment."

I find it very interesting that all of the big-four private equity firms and one of the most successful distressed and alternative asset managers on the planet are telling us the same thing. Markets are richly priced right now and while there are some things worth doing at the right price, it is a time for elevated caution when approaching the markets.

The four PE managers and Oaktree have a great deal of dry powder on hand to take advantage of opportunities when pricing improves, but for now they think asset pricing is at the high end of the scale.

This is consistent with I have been saying and doing for months. I am finding some community banks at attractive prices, in addition to a few small REITs and special situations, such as Unisys (UIS) and Volt Information Sciences (VISI) , but bargains are hard to find.

I am holding a lot of cash and suggest that more individual investors should do the same with the market priced for perfection in an imperfect world.

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