A primary motivation of investors who allocate into private equity is the hope that their capital generates a return greater than the stock market. Whether or not that holds true -- the broad PE index has not -- the fact is, private equity firms make lots of money. And that doesn't necessarily serve their clients.
Like all assets, supply and demand characteristics play a prominent role in affecting the price of an investment for an assumed rate of return. Well, it appears that marketing efforts have paid off handsomely because investors have poured money into the sector over the past three years.
Private equity companies use leverage to acquire companies and properties. The relationship between borrowing money and return on capital is an exacting practice: it leaves little room for error...especially if leverage becomes out sized and, among other consequences like increasing the likelihood of bankruptcy, inflates the cost of investing in the underlying asset.
In an interview with Barron's, Dan Rasmussen who runs Verdad Advisors and manages a small stock fund that has returned over 16-percent in the past three years. The fund is comprised of a group of stocks that each meet a pre-determined leverage ratio (between 3-4x). Rasmussen is sour on p/e companies because of their current valuations:
"The sweet spot for investing with leverage is companies with about three times net debt to Ebitda [earnings before interest, taxes, depreciation, and amortization]. Once you start going over six times debt, there’s a very disproportionate risk of bankruptcy. The entire private-equity market has been flooded with capital. Average purchase prices have been above 10 times enterprise-value-to-Ebitda since 2014.Just do the math. If you buy companies at 11 to 12 times EV-to-Ebitda, then lever them up 60%, you end up with a net debt of 6 to 7 times Ebitda. That is a zero-return prospect. People have been bamboozled by the marketing."
Private equity firms and hedge funds sell themselves as "smart money". Empirical evidence shows that while they may exhibit extraordinary returns in the short term, there is very little persistence over the long term. What is persistent, however, is that you pay handsomely for it.