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  1. Home
  2. / Investing
  3. / Energy

Private Equity's Watchwords: Cash and Caution

A new report indicates that conditions are changing for private equity firms.
By TIM MELVIN Dec 30, 2015 | 03:00 PM EST
Stocks quotes in this article: TCRD, AINV, KKR, CG, BX

Among the many reports I have been trying to catch up on as the year winds down was the PitchBook 2016 Crystal Ball Report. While the report starts by saying forecasting is always difficult (I think it is impossible), it made some observations about conditions and expectations among private equity investors that may help us make money in 2016.

The last couple of years have been a party for private equity firms, and they have been selling companies and assets purchased in the depths of the crisis for huge profits at high enterprise multiples. We have seen a lot of exits and IPOs in private equity land and some pretty large incentive checks have been cashed. Now there are signs that conditions are changing.

After talking to participants on both the buy side and financing side of the private equity industry, the report noted market participants' concerns for 2016. Major worries included divergent global economies, volatility in high-yield markets and a devaluation of the Chinese yuan. The current high level of deal multiples was also a major concern, as was the potential for higher rates going forward. The report also noted that "what appears to be a fully valued market doesn't ease matters much either, as the S&P 500 currently trades at around a 21x P/E ratio."

PitchBook did note that it expects the energy industry will be very much in play in 2016. Oil has continued selling off in 2015 and while lots of energy-specific capital has been raised, not all that much of it has been deployed. There are literally tens of billions of dollars available to private equity firms to use to acquire assets very cheaply as we move into the New Year. Unless we see some sort of short-term energy spike, we will see increasing levels of distressed opportunities in the sector as good-company, bad-balance-sheet situations begin to develop.

There should also be increasing merger and acquisition activity as companies combine to gain some sort of scale over costs. Traditional financing sources will be less likely to lend to energy companies and this will create some opportunities for P&E firms willing to step into the energy sector. There is also no shortage of good companies that have the potential to be great companies when oil prices are high, and that's going to attract the attention of some buyout-oriented P&E firms.

PitchBook also noted that it is going to be tougher to finance deals in 2016. It noted one major credit provider to the industry, THL Credit (TCRD), said that, "In our opinion, we are at or nearing a peak in the credit cycle based on high leverage and low default rates." Banks are continuing to step back from riskier lending, and with the new regulations regarding capital levels and lending requirements, I do not think they will return in a big way for an extended period of time. This creates a huge opportunity for business development companies, especially those with close ties to a private equity firm like Apollo Investment (AINV).

PitchBook thinks we will see deal volumes decline and deal multiples recede for most transactions. Top-tier companies and assets may still demand higher enterprise and price to book multiples, but for the average deal, especially mid-market, we could see much lower transaction multiples. We will almost certainly see fewer private equity IPOs because all the good stuff has already been sold. The report concluded that, "In short, 2016 will continue to exhibit trends similar to what we saw this year, but with a greater degree of complexity in the deal-making environment. We expect increased volatility, slightly declining valuations and volume likely subsiding to a greater degree than many expect."

Private equity firms are still sitting on an enormous amount of cash, measuring in the hundreds of billions of dollars. They have been doing a lot more selling than buying for the past two years and fundraising has continued unabated. They have shown extraordinary discipline and most of them have resisted the urge to deploy capital in any extended markets. They are in pretty much the same positions I am in as we approach the New Year, with lots of cash and high hopes of a weaker market that allows us to deploy our cash on advantageous returns.

I think we will start seeing some of the money raised for energy companies invested this year, especially if oil prices continue to slide in the first quarter of 2016. Cash and caution seem to be the best description of private equity right now, and I fully agree with the exception that since I don't have a few hundred billion to worry about, I can add community banks to the mix and capture excess returns not available to the big guys.

Tracking the filings of private equity firms will be more important than ever in 2016, as will be reading the earnings releases and conference-call transcripts of the publicly traded firms like KKR (KKR), The Carlyle Group (CG) and Blackstone (BX).

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At the time of publication, Melvin was long CG, KKR, BX, AINV and TCRD, although positions may change at any time.

TAGS: Investing | U.S. Equity | Energy

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