January 30, 2023 – What do you think of private equity? Certainly, it is one of the investment business’s most highly debated Rorschach tests.
Skeptics believe private equity represents a leveraged small-cap value investing strategy, offered at exorbitant fees, that is marked-to-model to shelter would-be investors from its extreme underlying volatility.
Private equity allocators view it as “the purest form of capitalism”, offering superior investment returns with attractive risk metrics.
The data indicates that private equity funds no longer beat the broad-based stock market indices. Nonetheless, institutional investors still prefer private equity due to the volatility-smoothing effects of its mark-to-model accounting.
Irrespective of one’s opinion on private equity and its expected risk-reward profile, the industry is a behemoth, with total assets under management now exceeding $8 trillion.
Source: The Wealth Mosaic
The industry has been the victim of its own success, as institutional and retail investors have thrown money at private equity funds. However, with its rapidly increasing assets under management, the private equity industry has a problem deploying the capital as fast as it comes in. As a consequence, the industry’s “dry powder”, or committed but unspent capital, sits at record levels.
The leveraged buyout industry has approximately $1 trillion of dry powder, waiting to be spent on buying public companies or acquiring assets from competitors.
Source: Bain & Company
Capital allocators have bought private equity firms’ products (leveraged buyout funds) hand over fist over the past couple of decades.
Accordingly, private equity firms must produce the products that allocators bought – leveraged buyouts.
Given the absolute size of the $8 trillion private equity industry, its presence looms large over the U.S. equity markets.
Over the past decade, private equity buyouts have accounted for 22% of all public M&A activity in the U.S.
With approximately $1 trillion of dry powder that needs to be spent, we expect leverage buyout (LBO) firms to remain active in public company buyouts. We believe roughly one in four public M&A deals will be an LBO.
In a recent memo, The Passing Of The Torch, I discussed the expected result of this record dry powder:
“As private equity firms gather assets, the capital must be put to work in order to generate revenue and profits for shareholders.
Therefore, private equity executives are incentivized to find, and close, buyouts. They are now forced buyers.
It is this forced buyer dynamic that private equity firms now experience that has led to a sea-change in M&A in general and buyouts in particular.”
It is my working thesis that given the incentive of needing to spend dry powder to produce the product that allocators have bought (LBOs), private equity deals are now safer than strategic M&A transactions.
In this month’s Merger Monitor, I put this thesis to the test and evaluate the “safeness”, via deal completion rate, of private equity deals
Historically, 94.3% of public U.S. mergers and acquisitions closed successfully.
With respect to completion rate, size does matter.
Historically, smaller deals have had a much higher completion rate than larger transactions. Specifically, small-cap deals have a 4.4% termination rate, while large-cap deals have a 12.3% deal break rate.
Smaller transactions typically feature fewer conditions and tend to have an easier time clearing regulatory approvals such as antitrust and foreign investment evaluations.
Historically, leveraged buyouts have skewed smaller than the typical M&A deal.
In terms of transaction size, on average, private equity buyouts are 42% smaller than the universe of U.S. M&A transactions.
Over the past decade, there have been 358 private equity buyouts of U.S. public companies, compared to 1,613 total U.S. public M&A transactions. (And yes – I have analyzed every single one of these deals over the years and invested in several hundred of them).
Of these deals, 95.3% of U.S. private equity transactions have closed successfully compared to 94.3% for all U.S. public mergers and acquisitions.
The 4.7% deal termination rate of private equity compares favourably to the 5.7% for the average M&A transaction.
In conclusion, private equity’s forced buyer dynamic, combined with leveraged buyouts’ smaller-than-average size, give them a leg up in terms of their probability of completion.
Since private equity transactions are generally “safer” than the typical strategic merger, we have been increasing the Accelerate Arbitrage Fund‘s allocation to private equity deals within its merger arbitrage portfolio.
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.