If you factor in co-investments, separate accounts and direct investments – three channels investors are increasingly using to pump money into the private equity sector – 2017 is shaping up to be a record year for the asset class. The industry is on pace to raise a wallet-busting $691 billion in commitments this year, about 10 percent more than the previous high mark. That's on top of an estimated $1 trillion in dry powder already waiting to be deployed.
All this capital raising is good news, right? Maybe, because at the same time that cash is flooding into the sector private equity deals are getting smaller. Deals under the $25 million mark accounted for nearly half of activity thus far in 2016, representing the highest proportion since 2009. Observers chalk this up to a number of reasons, including rich stock prices and increased regulatory scrutiny, but our guess is that private equity firms are seeing better opportunity for returns at the smaller end of the market, where greater growth and operational wins are to be had.
Which takes us to a bigger point: it's getting tougher these days for private equity firms to source the types of deals they want. The problem is that flood of capital chasing smaller deals combined with more competition. During the 15-year period from 2000 to 2014, the number of active private equity firms globally exploded 143 percent to 3,530. Intensifying competition further is a migration of large buyout shops moving down market in search of yield amid today's low interest rate environment, and other kinds of entities with access to cheap debt, including sovereign wealth funds and pension funds with direct investment capabilities, entering the field.
To be clear, we don't mean to imply that private equity will run into a wall just yet – there are still plenty of opportunities be had, and the M&A market is expected to get red hot in 2017. But the historic amount of capital investors have entrusted with the sector, combined with a record number of fund managers competing for smaller deals, means that private equity faces its greatest test yet in the year to come, and arguably for a few years thereafter given the mechanics of the industry's long-term investment model.
