James Gelfer January 09, 2014
We recently had the opportunity to conduct a Q&A session with Jeff Bunder, the global private equity leader at EY, who provided analysis of private equity activity and offered insight into what is in store for the year ahead. For complete coverage of PE activity in 2013, check out PitchBook’s 2014 Annual Private Equity Breakdown Report here.
Q: What will be the main drivers of PE deal flow in 2014?
A: Confidence in the global economy is at a two-year high. Our recent Private Equity (PE) Capital Confidence Barometer—a regular survey of senior executives from large funds from around the world conducted by EY and the Economist Intelligence Unit (EIU)—indicates that the majority of our respondents (66%) believe that the global economy is improving, up from 23% last October and 21% in October 2011.
Companies have weathered a prolonged period of minimal growth during which time they strengthened their balance sheets and optimized their capital structures. Having warehoused cash for a number of years and with a ready access to credit, leading corporates are in a strong financial position to do deals—they now have more confidence but time will tell if they will pull the trigger.
This does not mean we will see a return to the peak deal-making that occurred in 2006 and 2007. That was unsustainable —but so is the M&A recession we have experienced since 2009. For many companies, operational efficiencies and a focus on cost cutting can no longer deliver on the growth agenda.
More corporations are planning acquisitions over the coming year. Improved economic growth prospects, better access to credit, improved corporate earnings and positive outlook for stock markets underlie the increased interest in M&A activity. Additionally, dry powder amounts are once again rising. Financing also remains widely available for a wide range of deal types—refinancings, new acquisitions, dividends, and others. Although M&A valuations are expected to increase, corporations and PE firms alike expect an improvement in the number and quality of deals, as well as the likelihood of closing deals.
How do you think that recent changes to regulations and/or taxes will impact PE deal flow in 2014?
2013 was a year with a number of significant regulatory developments for PE firms. In the U.S., the Volcker rule was finalized and the SEC made changes to allow for increased public marketing of PE vehicles. In Europe, PE firms are working to implement the various provisions of AIFMD (the Alternative Investment Fund Managers Directive). Across the emerging markets, regulations are changing rapidly and often without significant advance notice. Successfully executing on the compliance requirements and building the infrastructure to maintain compliance is one of the key challenges currently facing PE firms. However, firms that are able to effectively navigate the rapidly evolving environment could find it a key source of competitive advantage.
Add-on acquisitions outpaced platform buyouts for the first time ever in 2013. What drove this trend and do you see it continuing in 2014?
PE firms continue to focus on growing their existing portfolio companies, and the increase in add-on deals is a reflection of that. Additionally, the credit markets have been a key source of capital for a wide array of deal types, including refinancings, LBOs and dividends. While this is largely positive for PE, it’s also responsible, along with record-breaking equities markets, for driving valuations higher in many industries. As a result, many PE firms are momentarily focusing on smaller add-on deals to existing investments rather than large platform investments. While there is clearly a trend towards a greater number of PE add-on deals over the last several years, if rising interest rates drive valuations lower over the next several quarters, this dynamic could moderate over the near term.
In addition to more add-ons, we have also seen a higher proportion of minority transactions in recent years. What do you think is behind this?
This trend demonstrates PE’s ability to apply a flexible investing model and invest opportunistically. We are seeing more growth equity investments as there are an increasing number of opportunities on the radar.
While unable to exercise outright control, PE firms are nonetheless able to create significant value by partnering with entrepreneurs and family owners to grow the business. They are able to strategically exercise influence through board seats and robust shareholder rights agreements while also retaining the right to veto or hire for certain key positions, and often define a key set of criteria for the exit.
Fundraising rose sharply in 2013, both in terms of capital raised and the number of funds closed. It was a particularly strong year for mega-funds of $5 billion or more. How has the fundraising climate changed in the past year and what does 2014 look like?
GPs’ increasing confidence about fundraising is linked to the improving outlook for the global economy and the availability of credit for transactions. According to our PE Capital Confidence Barometer, two-thirds of PE firms (66%) are optimistic about the current environment for fundraising, up from the 47% reporting this sentiment in April and 41% in October 2012.
However, many GPs realize that in the current low-growth environment, the ever-increasing fund sizes that characterized 2005 to 2007 are behind them. Nearly three-quarters of GPs say that the funds they are currently raising are the same size—or smaller—than their current funds.
In the U.S., low yields on fixed income and rising liabilities are expected to drive continuing investment from public pension funds into the asset class. Additional drivers will be the emergence of emerging market LPs. Public pensions in markets such as China, Peru, Nigeria and others are increasingly being allowed to invest in PE. In China alone, this represents a new funding source of more than $100 billion.
Exit activity started slow in 2013 but accelerated throughout the year, with IPOs being a particularly popular exit strategy. Do you see the recent surge in exits continuing in 2014, and how much longer will IPOs be an attractive exit option?
Yes, the majority of GPs are intending to undertake more exit activity in 2014 in a bid to clear the backlog of exits that have built up over the last few years and to lock in returns as the global economy expands. This will be especially true for GPs that have requested, or are requesting, fund extensions from their LPs as they have a limited amount of time in which to realize exits.
We expect to see an increase in exits in North America driven by a robust IPO market, an increase in corporate transactions and a stable level of secondary deals.
The IPO markets have become an increasingly important driver for PE firms. In 2007, PE firms accounted for 10% of global IPOs; in 2008, they accounted for just 6% of global IPOs. In 2013, companies backed by PE accounted for 19% of firms that went public globally. Moreover, they tended to be larger; PE-backed deals accounted for 35% of all proceeds raised in 2013.
Performance of PE-backed IPOs has had a strong track record. PE-backed IPOs on average delivered a 13.0% first-day increase from their offer price. Through Dec. 12, 2013, they were 18.6% above their offer price on a weighted-average basis. We expect this trend to continue. PE firms are filing for IPOs at an accelerated pace. There are currently nearly 60 companies in the PE-backed IPO pipeline, which could raise more than $14 billion in total.
Despite hold times remaining at all-time highs and PE firms continuing to sit on large stockpiles of dry powder, the number of secondary buyouts was down significantly in 2013. Why do you think this is, and do you anticipate a rebound in 2014?
Secondary buyouts have been a powerful trend in recent years and will continue to be an important part of the industry model. As PE firms increasingly focus on operational improvements, they often bring specialized expertise to bear on their portfolio companies. As a result, successive PE owners with different skill sets are able to add value in new ways to portfolio companies acquired from other PE firms.
In 2012, secondaries accounted for a record 36% of total PE deal value—in 2013 however, such deals accounted for just 25% of total PE deal value. There were significant regional differences. In the Americas, secondary buyouts as a percentage of total buyout value fell by half, to 20% of total activity. In Europe, secondaries fell slightly, from 38% to 36%. In the Asia Pacific, secondaries increased to 61% of total buyout activity—this could be from under-reporting of investments sourced from strategics, and a trend toward secondaries as an alternative to IPOs, which have been effectively blocked as an exit route in China for the last year.
Please feel free to add any additional comments or insight on topics we may have not addressed.
There is also a developing trend in sector-focused funds. We are increasingly observing GPs create new funds focused on real estate and energy, as these sectors are targets for both GPs and LPs. Additionally, GPs continue to focus on specific sectors and sub sectors as they become more specialized and look to exploit this expertise in the acquisition of companies and the creation of value post-closing.
Jeff Bunder is EY’s global private equity leader and is responsible for driving the delivery of a comprehensive service model, including transaction, audit, tax and advisory services, to private equity funds and their portfolio companies globally. Jeff has more than 25 years of experience leading due diligence engagements for both private equity and corporate acquirers.