May 19, 2013
Interviewed by: David Snow
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The Private Equity Overhang: Overblown?

What’s the real impact of the private equity overhang, just how big is it, and how worried should investors be? Stefanie Langer of Independence Capital Partners; Michael Elio of the Institutional Limited Partners Association; and Andrea Auerbach of Cambridge Associates define and discuss the overhang as part of Privcap’s ongoing performance series.

What’s the real impact of the private equity overhang, just how big is it, and how worried should investors be? Stefanie Langer of Independence Capital Partners; Michael Elio of the Institutional Limited Partners Association; and Andrea Auerbach of Cambridge Associates define and discuss the overhang as part of Privcap’s ongoing performance series.

The Overhang: Over-Hyped?
Private Equity Performance

David Snow, Privcap:

Today we are joined by Stefanie Langer of Independence Capital Partners; Michael Elio of the Institutional Limited Partners Association; and Andrea Auerbach of Cambridge Associates. Welcome to Privcap today, thanks for being here.

We’re talking about performance; big topic, important topic, possibly the most important topic. There is a term that’s been floating around the industry for years that people invoke when they want to inspire fear or perhaps anxiety about what might happen in the private equity market, and that is the overhang. We’re going to define the overhang and talk about what it means and whether we should be worried or not.

But first of all, I’d like to learn about how you would define the overhang. What is it briefly, for people who maybe have heard it but don’t exactly know what it means? Maybe, Mike you can walk us through the definition.

Mike Elio, ILPA:
Overhang or the amount of committed capital that has not yet been drawn down for investment, it tends to build up over time as the industry is growing. And that overhang number is something that is watched very closely by investors as an indicator of supply and demand. And if that overhang number does build up to a large number, then the worry is that GPs will be pressured to invest that money and overpay for deals in a very hot market.

Snow: So we hear about the overhang a lot, I wonder if it is being overhyped, what do the numbers tell us and I know Andrea, that Cambridge Associates has done some research into this. Can you share with us some of the kind of headline findings about where we are right now with regard to the overhang?

Andrea Auerbach, Cambridge Associates:

The overhang, I feel like the overhang is looming larger. It had waned over the last couple of years as the bulk of capital that was raised in the ‘07/’08 timeframe has gotten worked down. So the overhang hit its peak, we would say, in 2009. And right now the total dollars as of the third quarter of 2012 for the overhang, tagged in around 363 billion. So that’s down a fair chunk.

Snow: What was the number at the height?

Auerbach: At the high, it was 454 billion dollars. It’s not small change here, right? It’s down a healthy amount and I would say the reason why I would characterize it as looming larger is because the fundraising environment is getting healthier. And so more capital has been raised year over year and every time you raise a fund, it adds to the overhang. So I feel like the overhang is coming up off of its own nadir and is starting to crest again.

Snow: Stefanie, are you worried about the overhang. What is your view and is it a real consideration that LPs should take into account when they think about whether or not to invest in the current environment?

Stefanie Langer, Independence Capital Partners:
It’s something that LPs should consider whenever they’re investing in any private equity fund. I’m a big believer in cycles existing throughout life and throughout the world, and the private equity industry is no different. So as a consequence of capital inflows and outflows, never being fully correlated or aligned. There will always be some inefficiency and I think we want inefficiency in the market. I’m a believer that this is no different than the last time there was a cycle like this and it will probably work itself out.

Auerbach: What’s interesting about the overhang to your point Stefanie, is that there’s some amount of capital should overhang the market otherwise managers would invest all their money and then constantly be fundraising and we don’t want that. So normally I would say you would to see, … if I may, a four to five year supply of capital overhanging the market, because you want something generally the length of an investment period to think about.

And right now, I think in certain pockets of the overhang, it’s kind of come into that range of maybe a five year overhang is sort of the finger in the wind sort of sense right now. But with the fundraising environment building, I’m a little nervous for what that might mean in certain pockets of the market.

Snow: Well when the overhang was at its peak in I guess 2009, was there evidence that GPs were acting on perverse incentives to put capital to work in the wrong way?

Elio: Well, I have to say, limited partners were definitely on edge that that was going to be the case. So that raised flags for them to pay a lot more attention to the deals that were happening. To the GPs’ credit, that pressure didn’t turn out to be true though I have to say they were pressured to do it and a lot of extensions came in for investment periods. So that was a way to alleviate it.

Auerbach: One interesting observation in looking at, sort of pulling that overhang apart by different vintage years, in some ways the situation and conditions you’re describing, we’re about to hit the end of the conveyer belt if you will for the ’07 and ’08 vintage years. And 170 billion of that 360 billion number we just talked about is in those vintage years.

And so I think we’re about to either probably be met with a wave of extension requests or motived behavior possibly from those vintage years is that capital needs to burn off one way or the other.

Snow: Has there ever been a case in the recoded history of private equity of a fund simply getting to the end of its life and maybe they didn’t spend all the money and they just kind of give it back, or is that just not an option for many GPs.

Auerbach: That’s happened before, certainly.

Langer: Like, on one hand.

Auerbach: On one hand, it’s happened, yeah.

Elio: It’s almost an urban legend.

Langer: The anecdote I would offer of the font end of this period in the ‘07/’08 period, at least some of the groups that formed my organization were slow off the mark to do deals, were very mindful and thoughtful about how they were deploying the capital.

But because in the case of smaller funds, they had less pressure, they’ve been able to execute their strategy in a judicious way over a four to five year period. So I haven’t seen it my organization but I think it certainly exists in other parts of the market and particularly if you have a much larger fund, that’s probably the case.

Snow: Well Andrea, you broke down the overhang sort of by vintage year, are there other interesting ways of looking at by size of fund? I mean, you can kind of count all fundraising numbers together or you can maybe segment into mega versus middle market. Do we see any interesting trends when you look at the overhang that way?

Auerbach: Yes. And generally speaking in looking at the overhang, it kind of sorts itself out in a 40-40-20 proportion to funds of five billion and up, usually forty percent of the overhang and that ebbs and flows as you would expect.

Funds between one and five sort of take up the other forty percent, and then twenty percent is generally left for funds of a billion and under. And believe it or not, that billion-dollar threshold is the median fund size. That’s coming down right now, but for a long time, that was the median so below that is sort of half of the capital.

And what’s interesting to Stefanie’s observation is that a lot of love has been shining on the middle market over the last couple of years. And so their overhang, that overhang for funds of a billion and under has climbed up by seventeen billion in two years. And what that means is … a couple things. The transaction volume in the middle market has generally stayed business as usual, so it’s kind of regulated itself very well.

But with institutional investors continually looking and committing capital to finds in the slower middle market, it may have a shade more capital than it normally has to dole out in a regulated manner if you will. So we’re watching for signs of multiple expansion in that space.

Snow: Which would worry you?

Auerbach: Yes.

Elio: Well the upper middle market could also be seeing some of the funds at the larger end of the market entering that space to deploy that capital that they have that’s running out in the short term.

Langer: And we’ve seen that pattern before, folks reaching down or sideways to other industries where they need to deploy capital and they can execute a similar strategy, albeit with a slightly smaller company or a company in a particular investor space that they haven’t had before.

Auerbach: And also I guess swiveling away from the lowest portion to the highest portion of the overhang, sort of that large-cap overhang, if just ten funds raise ten billion or twenty funds raise five billion, you’re right back up to peak overhang levels. And what will depend on that capital being deployed within a typical period of time, will be if the large transaction market comes back in any type of volume.

And it kind of went away after ’07 and there are signs that it’s coming back. If that large transaction market opens up then it will be interesting to see what happens with funds of that size raising capital and their ability to dole it out in a compelling manner.

Snow: Right, and one informs the other, right? If we see a number of Dell size deals come along then it’s going to be easier for some of these larger funds to raise larger amount of capital because the opportunity is clearly there, right?

Auerbach: Yeah. In fact, I was looking at some deal logic information before coming in today and in the middle of the peak of the market in the ’07 timeframe, the average large transaction trended at around six billion in enterprise value. Right now it’s trending at about 2.5, 2.6. So you have a shrinkage in the general size of the big deal and if those deals start to expand in average size, then you’ve got that overhang whittling away.

Langer: I’ve got a question for Andrea, a corollary question to what you just said. What happens if some of the better known large cap firms have gone on record recently saying that they’re not interested in doing club deals. What will that do to transaction values at the large end of the spectrum.

Auerbach: Very interesting question. Obviously part of the appeal of maybe buddying up is to being down the price and competition. And so I think a lot of managers who might be saying that I have LP capital to avail themselves with to compete for those deals, it’s a great question. And I think we’re going to watch the answer play out over the next stretch and see what happens.

Elio: Right. The amount of LP capital that’s going into co-investments has really replaced the club deal of years ago. So it’ll be interesting to see how much of that void LPs will take versus them actually partnering up in the future.

Auerbach: And there’s one other sort of interesting piece on the overhang. So this overhang that we’re talking about is on traditional private equity funds that have raised capital. What we’re not including to your very point Mike, is to that shadow overhang of I intend to invest alongside my private equity managers in co-investment opportunities. And the number of institutions that have capital sort of earmarked for that could very well swamp this overhang and also create interesting dynamics in certain pockets of the market.

Snow: Right, you mentioned if ten mega firms raised ten billion dollars funds, well if ten sovereign wealth funds set aside ten billion each, that’s the shadow overhang, right?

Auerbach: Yeah, yeah.

Snow: Why don’t we follow up with one quick crystal ball question, which is sort of where we think trends are going? So if you take the current trends and you kind of put them on a trajectory forward, what does that say for the overhang and what does that therefore say for the dynamics in the deal market. Maybe starting with Andrea, if you follow trends forward, where do you see the overhang going?

Auerbach: As we just discussed, there are several different vectors on this. I think if the transaction market stays where it is, which is significantly below peak volume, then the overhang will continue to build and it will be interesting to see what happens with purchase price multiples as we roll that overhang forward. So I predict episodic imbalance, so I predict some volatility to that overhang and really hinging on transaction volumes returning in scale, particularly for larger deals. But I do think it’s going to grow, yes I do.

Snow: Mike, do you agree?

Elio: I agree with her. I do think that the overhang will continue to grow, but I think the components of the overhang will change. I think as a lot, LPs in general are not enamored with the mega fund model, so if those investment period extensions come through and they’re not approved, they’re not likely to turn around and put that money right back into the mega space. So that would be to her point, watch out for the middle market if too much money is pouring in there or how much money of that gets earmarked for co-investments going forward. So we’ll see how that structure is going forward.

Snow: Stefanie, thoughts on the future of the overhang?

Langer: The overhang is a codependency issue. So I think relative to how LPs want to deploy capital and how GPs want to deploy capital over time and whether or not those agendas are aligned will dictate the size and the episodic spikes, but I would expect it to continue.


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