Exit Overhang is a problem the PE industry is currently experiencing in the face of the financial crisis. While many of the pre-crisis investments have performed well, PE firms are reluctant to sell given the depressed market and likely lower return multiples they would receive.

Q. Another PE term that goes right to the core of the health of the industry.
A. Yes. There’s a bit of an odd dynamic going on for those “vintage” 2005-08 deals. In general, the PE firms did do an excellent job in managing their investments then — there were many fewer “busts” among PE -owned firms during the crisis, mostly because the PE firms were so active in cutting costs to keep the companies going. But, because the overall markets are so crummy, these “new and improved” companies are still being held. That’s the “exit overhang”.

Q. So, effectively, a lot of PE firms did do their jobs, but they aren’t really getting rewarded for it?
A. Right. A big part of it is multiple compression — the markets had been pretty frothy, so the multiples the PE firms had to pay were high. Now, they’ve improved the earnings, but the multiples are so much lower that the improvement isn’t showing up in the exit price as compared to the purchase price.

Q. So they aren’t selling because they can’t, or they don’t want to?
A. Some of both, of course, but a lot of it is: “don’t want to”. They’ve made enormous commitments of time, money and energy; and the got the improvements they sought. But if they sell now, the LPs aren’t going to get their investments back, and won’t be happy; and of course the incentive profits interest won’t kick in either.

Q. How does all this relate to the excess of “dry powder” that we talked about the other day? It looks like the firms not only have too many companies still in inventory, but also too much cash available for more deals.
A. Exactly. So, put 2 and 2 together and you get: PE firms buying and selling among each other. That way they can sell properties to realize at least some profits; and also buy to keep the cash at work so they don’t have to give it back to the investors and forego that 2% management fee. You might see that merry-go-round a lot until the economy starts to improve and the strategic buyers open up their wallets again