Private equity funds continue to attract interest, despite rising deal valuations and high levels of leverage. We think there’s a way to get many of the benefits of private equity in public markets—without forfeiting liquidity.

It seems like nothing can stop the private equity boom. Yet after a record year of fundraising in 2017, big challenges loom. Private equity funds are sitting on more than $1 trillion of dry powder, or funds that have yet to be deployed, according to Preqin, a research group. Mounting competition for deals is having a profound impact on the market.

Leveraged Buyouts: At Any Price?

Deal prices and leverage reached very high levels last year. In the US, the multiple paid for leveraged buyouts, using enterprise value to EBITDA, reached a record 11.2x in the third quarter of 2017, according to S&P Capital IQ. Debt taken to fund these transactions reached 5.8 times EBITDA—about 1.4 times higher than in 2009 (Display 1). Deal multiples may rise further this year amid rising competition, in our view.

That spells trouble for private equity funds. It’s going to become much harder to source deals that can yield expected profits over the long term. And if exits become more challenging too, returns could take a hit. Investors who park their money in a private equity fund could end up stuck in a liquidity trap if tougher markets make it harder to cash out over time.

Avoiding the Headaches of Private Equity

Liquidity is clearly a growing risk, in our view. Bain & Co., a management-consulting firm, asked in a recent report whether it’s possible to replicate private equity returns in more liquid public equity markets to help investors “avoid the headaches of PE investing—including high fees, illiquidity and the challenge of securing allocations in funds of top-performing managers.” Probably not, the report said, because private equity investors have three investing tools that public equity investors lack: they can use debt to magnify equity returns; they can provoke corporate change to foster improvements in company performance; and they can select sectors that will outperform the broad market.