Alex Lykken July 03, 2014
Jeff Bunder, the global private equity leader at EY, took some time to talk to us about several topics in the PE industry, including fundraising, exits, the Volcker Rule and deal flow in the second half of 2014. For complete coverage of recent PE activity, be sure to download PitchBook’s 3Q Private Equity Breakdown Report, which will be published in our reports library and in the PitchBook newsletter July 9.
Q: What will be the main drivers of PE deal flow in the second half of 2014?
A: Accelerating macroeconomic growth is leading to new and interesting opportunities for PE firms, especially in the developed markets, and should lead to increasing activity. Additionally, a robust market for exits is driving an increase in fundraising, sending dry powder on the upswing after several years of successive declines.
Moreover, the lending markets remain accommodative for a wide range of deal types, and structures remain very borrow-friendly. This has been a key enabler of recent activity, and while interest rates are expected to rise in the coming quarters, funding for high-quality deals should continue to remain available.
Emerging markets could see continued near-term volatility as interest rates rise across developed markets. However, the long-term trends—a rising middle class; low PE penetration; a significant financing gap; and difficulty in achieving exposure through public market investments—will remain intact, and will continue to play out over the course of the next decade.
Lastly, the need to divest remains pressing for many firms, which will drive continued secondary buyout activity in many markets.
Despite sitting on a mountain of dry powder, PE firms are increasingly making smaller deals like add-ons and minority investments. Is this a result of sky-high valuations for buyouts, or are we seeing a fundamental shift in strategy for PE firms?
Over the last several years, we’ve observed a clear trend towards an increasing number of add-on deals. The trend really accelerated in the wake of the recession, when PE turned its attention from large platform investments to more buy-and-build type strategies. Lower company valuations, a lack of competition from strategic buyers and companies’ difficulty in tapping the public markets for finance as a result of instability in the IPO markets all meant that add-on acquisitions have been easier and cheaper for PE to source post-crisis. The recession also created opportunities for PE to consolidate in either fragmented industries or sectors where competitors may have been weakened by the economic decline.
With the improved macro environment, competition for platform deals has increased, and valuations have followed. As a result, add-ons continue to see traction among investors as a way to fast track growth, often for a lower cost than organic expansion.
Exit activity accelerated throughout 2013, topping out in the fourth quarter before pulling back in Q1 2014. Do you see exits recovering in the second half of 2014?
This is clearly an area where a lot of PE funds are focused right now. For the last several years, the concern has been that exit activity wasn’t sufficient to liquidate the portfolio that had built up during the boom years over a time frame that was consistent with the standard PE model. But right now exit activity is tracking well, and PE is really pulling itself out of the “danger zone” in terms of being unable to provide liquidity and distributions back to LPs.
Last year it was the IPO market that was driving exit activity, and it continues to be strong, but this year we’ve seen a lot of companies sold in trade sales, so the market is broadening for exits as strategics get more involved.
IPOs will, however, remain important to the market. We have seen a degree of softening in recent weeks attributable to investor fatigue. As a result, sponsors will have to keep a close eye on the window as we proceed through the next several quarters.
The median valuation-to-EBITDA multiple for buyouts jumped from 10.0x in 2013 to a lofty 11.6x in 1Q 2014. Even so, deal flow was solid in 2013 and is on pace for another healthy year in 2014. Are investors just looking past the price tags on some of these deals? What’s behind the resiliency?
The macro environment is obviously a lot more accommodative now than it was a few years ago. PE firms have a lot more confidence and visibility into revenues and earnings growth than they did even two years ago, and that’s enabling them to bid with a greater degree of certainty than before.
Moreover, PE shops have continued to build out their operational capabilities. Many firms are adding to their teams of in-house functional experts and industry specialists, and they have a lot more in their toolkit than they did a few years ago. That enables them to create and drive value in ways other than structuring and multiple expansion. A lot of firms are increasingly involving their operations teams in the due diligence phase of the investment—that too, enables them to bid with a high degree of confidence and make sure they’re paying an appropriate price.
An impressive 95% of PE funds hit their targets in the first quarter, according to our data. Looking back at 2013, $220 billion worth of funds closed last year, easily the best year since the buyout bonanza of 2007-2008. What do you think is behind the boost in fundraising, and do you think it will continue through the rest of 2014?
We’ve seen some significant acceleration in the fundraising market over the last year and a half. While we’re still nowhere near the highs of the boom years, fundraising is as strong as it’s been since the recession. That’s being driven primarily by the strength of the exits market. Distributions to LPs are at record levels, and that money is being steadily reinvested back into the asset class. In fact, what we’re seeing is that many LPs are temporarily underinvested in PE at the moment because of the level of distributions.
There are a lot of reasons to think that the outlook for fundraising will remain strong. In developed markets, in particular in the U.S., pension funds are looking to alternatives to close their funding gap. Moreover, in emerging markets, we’ve seen a great deal of interest in PE from institutional investors and family offices, and a lot of new entrants to the asset class. This is something that’s in its very early stages and is a real long-term positive for PE.
The Volcker Rule has been in place now for several months. How is the private equity industry adapting? Have you noticed any major impacts in deal flow since the new rules were finalized?
The Volcker Rule has been in the works for a long time, and so firms have had a lot of visibility into its likely impacts. They have also had a significant amount of time to prepare for its implementation, so at this point the aggregate impact on the industry is relatively muted. There are of course, a number of funds that are being impacted significantly, for example, funds that have spun out of large banks or are in the process of doing so. Here, the structure and go-to-market strategies are changing entirely, and while this presents a number of challenges in terms of fundraising, for firms that are able to make a successful transition, there are a number of advantages. We have seen instances of firms spun out from investment banks that were able to leverage those relationships to source very successful deals—that’s something that would have been prohibited, or much more difficult, under their prior structure.
Are there any sub-sectors or niche industries that PE firms are focusing on more lately? Relatedly, are there any sector-focused funds that LPs are expressing more interest in?
Financial services have seen a lot of activity so far this year, with a number of significant deals announced. Regulatory reform is a key driver, and PE firms are able to acquire noncore assets at reasonable valuations. The uptick in the global economy is making the business prospects for a lot of these companies a lot more attractive as well. The insurance sector has been a prime beneficiary, with a number of billion-plus dollar deals announced in the last several months.
Oil & gas remains an active sector for PE. The sector is an opportunity rich environment right now, and PE firms are aggressively raising funds and targeting opportunities across the upstream, downstream and services sector, driven by opportunities for growth and attractive investment returns. In particular, firms are making significant investment in startup ventures, many targeting shale opportunities in the U.S., which offer short investment time frames, a wide availability of exit options and attractive returns. Downstream, PE firms are looking to build competitive advantage through specialization as opposed to control over the full supply chain.
Our most recent numbers for the U.S. company inventory showed a miniscule increase in the total inventory between 2013 and 1H 2014, from 7,629 companies to 7,675. Has the U.S. inventory plateaued, in your view?
We think that over the near term, it likely has – valuations are limiting the number of new deals being announced, but at the same time exits are occurring at a record pace. Over the last several years, the concern has been that the pace of exits wasn’t high enough to spend down the PE portfolio in a timeframe that was consistent with the standard PE model. However, over the last 18 months, we’ve seen a huge revival in the exit markets – primarily first in the IPO markets, and more recently in strategic sales. As a result, the portfolio is much closer to equilibrium than it’s been in a long time, and PE is really moving out of the “danger zone” in terms of being able to provide liquidity for LPs. In fact, one of the emerging issues for LPs is how to reinvest all the cash that’s being distributed back to them – clearly, it’s a great problem to have.
You noted in EY’s recent report, Returning to Safer Ground, that hold periods remain elevated and the slow exit pace is dragging down returns. Obviously exits are very high right now, which should help, but what do PE firms need to do to bring hold periods back down to acceptable levels? .
Our study looks at exits between the years of 2006-13 and the ways that PE firms created value in the companies they owned. As you note, we’ve observed climbing average hold periods since 2009. Last year, they reached a new high, at 5.4 years. We believe there are a couple of things going on – one is obviously that the exit window was closed for a couple of years for these vintages of exits – and so everything was pushed back 1-2 years. The window is wide open now, and we’re on pace for a record year for exits, with strong activity from both IPOs and, increasingly, corporate buyers. This should clearly help to bring hold periods down. The other is more of a secular shift – before the crisis, a greater proportion of PE value creation came from cost cutting and balance sheet optimization, and that’s a much faster process than a lot of the operational improvements that are driving value creation now. So while we think we’ll see hold periods decline over the next couple of years as a result of the window being back open, we would also be surprised if they ever returned to the three-year range again.
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.
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