Last week Matthew Hose equity funds analysts at Jefferies brought out an excellent short note on the private equity sector. For much of the last few years, most fund researchers have been very upbeat on the listed private equity space – Charles Cade over at Numis, for instance, has been consistently rating it one of the top conviction plays of the last few years. And true to form share prices have shot up.

I’ve also been fairly bullish about the sector but over the last few months, I have grown slightly more cautious. Hose has nicely articulated many of these concerns, not least fairly chunky valuations for portfolio private businesses and the sheer weight of capital raised in the recent cycle.

Here’s Matthew’s executive summary – think he’s probably about right in his overall tone. Note also how he’s downgraded some popular players in this space such as Hg and ICG Enterprise. I suspect we might be reaching peak valuations.

“The wider industry trends of higher buyout entry valuations, and also higher debt multiples, have led us to take a more cautious view on the listed private equity sub-sector. Here the widespread use of subscription lines by underlying funds is a new risk for investors to consider, while we also scenario test the impact on NAVs of a contraction in valuation multiples. Lastly, having reviewed our recommendations, we d/g each of HGT, ICGT and LTA from Buy to Hold

Increasing caution on private equity: With industry-level buyout entry multiples now exceeding the prior peak in 2007, there are concerns that private equity is paying too much for deals. Entry multiples are typically the best predictor of vintage year performance, signalling the potential for lower prospective returns. An abundance of cheap debt amid a low interest rate environment has also facilitated rising debt multiples, thereby increasing financial risk. We are not attempting to ‘call the top’ here from a listed private equity perspective. Instead, increased caution as we move further through the cycle seems prudent

Wariness of subscription lines: The use of subscription lines by private equity funds to bridge finance investments is now widespread. Despite certain advantages for both GPs and LPs, we are somewhat wary of this additional source of leverage. While the gearing effect is transitory, we see the risk of immediate capital calls (potentially from multiple underlying funds) should a situation arise where banks have to withdraw the lines. Several listed private equity vehicles (APAX, HVPE, ICGT, LTA, PIN) will have exposure to subscription lines via their underlying funds, but disclosure of the quantum of this bridging is still relatively limited at this stage. We would therefore encourage its inclusion within regular reporting

The state of listed private equity: The pattern of rising industry valuation and debt multiples is unsurprisingly reflected within our listed private equity universe. We also find some evidence of erosion in levels of commitment cover, although in almost all cases (Altamir being the exception), not yet to uncomfortable levels. What feels like a structural discount for listed private equity funds, together with current cash holdings, results in some attractive look-through portfolio valuations though

Scenario testing valuation multiple contraction: The heightened valuation environment entails that it is worth thinking about what the impact on NAVs would be should weaker market conditions result in a bout of multiple compression. We therefore test such a scenario by using the EV/EBITDA and net debt/EBITDA ratios to calculate the potential decline in the (equity) value of the portfolios. We then factor in cash holdings to show the anticipated NAV declines. The overall result is a sector average NAV decline of 25% for 2x valuation multiple contraction but, understandably, also considerable variance between the individual fund results

Recommendation changes: Within the note we review our recommendations for the peer group. As a result, we downgrade Altamir (LTA), HgCapital Trust (HGT), and ICG Enterprise Trust (ICGT) each from Buy to Hold. On Altamir, our downgrade is driven by thin commitment cover, together with an elevated share price following the recent announcement of Amboise’s tender, and the uncertainty over the liquidity and ownership structure of the fund post-tender. For HgCapital, a build-up of portfolio liquidity and a tight discount are by-products of the fund’s ongoing success, but will limit the scope of further share price gains. While on ICG Enterprise, despite several positives to draw on since the manager change, a recent re-rating in the shares bodes for a more balanced overall view”.