Private equity firms are on track to raise record funds. Big deals are on the cards and debt markets are open to fund them. Nevertheless, there are new challenges on the horizon – some of which stem from this record fundraising and others from the digital revolution that will affect not only what private equity buys, but also how it buys it. In the face of such challenge and increasing scrutiny, the PE industry will need to keep reinventing itself to stay on the comeback trail.
Fundraising hits new heights
I read a Financial Times’ column this week with the line: “private equity is making a comeback”. I am sure that many in the industry would dispute that it ever went away, but I can see where they are coming from.
- Prequin forecasts record $369b fundraising in 2017 and estimates $942b of “dry powder” – that’s just below the nominal GDP of Mexico.
- Apollo Global has raised $24.7b for its latest buyout fund, the largest ever and surpassing the GDP of all but the top 105 global economies.
- Cinven and Bain Capital have agreed the largest leveraged buyout of a European-listed company in four years, paying €4.1b for Stada, the German generic drug maker.
Add to this supportive debt markets, driven by a low yields, where investors are scrabbling for returns and you have an exceptionally accommodating capital environment – even by recent standards. In fact, there are increasing reports in European debt markets of “double dipping”. Nearly a third of leveraged loan deals in the first half of this year had both an ‘EBITDA grower’ and a ‘prepayment basket’, according to Debt Explained. These structures effectively allow borrowers to borrow the same again – twice over in some cases.
Last week, Moody’s rating service commented on “aggressive transactions and greater risk for investors” in general across new speculative transactions. Free cash flow to debt, which measures cash flow after investments, interest and dividends, is at less than 4% for the first half 2017 cohort. And this isn’t due to extra investment. Average ratings haven’t declined because of the “improving macroeconomic conditions” – which begs the ‘what if things change?’ question that we’ll return to later.
…as does competition…
The more immediate problem for PE – as the FT points out – is that these conditions are creating greater competition for assets, both from within and outside their sector, whilst also helping to push equity markets to record highs. When funds dramatically increase, so do valuations – as European football clubs know all too well! PE returns are so dependent on starting valuation that this is obviously a pressing issue. Assets are now being acquired on multiples of 10 times (measured as total enterprise value as a multiple of underlying earnings), beyond the previous peak of 9.7 times, registered in 2007 before the financial crisis.
The competitive game has also changed in terms of companies learning from and adopting the traditional efficiency enhancing and cost cutting strategies of private equity – in some cases, encouraged by the efforts of activist investors. More companies are also setting up corporate venture funds, or CVCs, to provide an attractive environment for targets who don’t want to be subsumed within a large, impersonal organisation.
…to this add digital…
It’s becoming cliché to bring in digital at this point – but it’s ubiquitous for a reason. The most obvious implication is the need to assess current and future portfolio companies’ vulnerability to digital disruption, from marketing, sales and customer care to the supply chain to intellectual property and data and security requirements. There are three basic questions to ask:
Who is doing to come in and disrupt this business?
What technologies could destroy profit across the current value chain
Should I exit or double-down?
With regard to the final question, organic digital initiatives can take years to reach the bottom line, so PE needs a proactive strategy to protect their investments. For this they also need to think about how they attract digital targets when they’re up against corporate competition, including CVCs. Finally, PE firms also need to think about their own business and its digital strategy. Many have a focus on their own portfolio, but not their operations. PE needs to consider privacy concerns, cyber security threats and investor demands.
So, where in the cycle?
Thus, the cycle may feel ‘late stage’ in terms of capital and multiples, but I don’t think we can’t think exactly in 2005-7 terms. The capital environment is very different, for one. Ultra-low interest rates provide a big cushion. They also encourage hubris; but the industry has learnt lessons from the crisis in some areas at least . Deal volume and value is still much lower than 2005-6. Club deals are back, but in 2016 these were about a third of the level of 2006 with participants seemingly paying regard to the risks and lessons learnt. Similarly, public-to-private deals are back, but not to the point that we were before where almost no FTSE 100 company was considered off-limits.
Of course, there is a risk that greater hubris or current high multiples will cause problems further down the line. Rising share prices and falling credit spreads have boosted returns since the end of the financial crisis. Stronger growth needs to take up the slack as these diminish and for deals to keep flowing to maintain returns. In this, we may have some help. Brexit clouds the picture for the UK, but there are stronger tailwinds building in the rest of Europe. The broader macro backdrop may help in other ways with M&A volumes and target availability sustained by the need for companies to keep rethinking their portfolios and business models in the face of big forces like aging populations and digital disruption.
There are other risks to this outlook. Monetary tightening is now on the near horizon giving the potential for economic slowdown – alongside other geopolitical and protectionist concerns – although this may also temper valuations. The PE industry may also be subject to further regulation and scrutiny – especially if we see more high profile sector insolvencies.
Putting all of this together, there is a risk that the comeback is tempered in the next year or so. But, if PE is good at one thing, it is transforming itself as well as the companies it buys. Our recent report on ‘Positive Equity’ draws on interviews with PE’s industry pioneers. They have a clear message: the sector must bring something new to the table and focus on innovative value creation to stay competitive.
PE firms are now increasingly looking to take on more of a consultancy-type role: giving firms in their portfolio the deep strategic expertise they need in order to keep transforming and thriving in a fast moving world. It’s all about transformation now.