Alex Lykken March 09, 2015
As part of our inaugural M&A Report, which publishes Tuesday, March 10th, we reached out to EY’s global private equity leader, Jeff Bunder, to get his take on the current PE market, including valuations and the slowdown in take-private activity. He also shared his thoughts on an evolution taking place in the PE industry, which has become much more “rigorous” in its approach to value creation.
How do you see the first half of 2015 shaping up? And looking back, what are some of your thoughts on PE activity in 2014?
2014 was a robust year for private equity. Exits reached record levels, emerging as the dominant theme in 2014 as strong stock markets, coupled with increasingly acquisitive corporates propelled more PE funds to sell their existing investments. IPO’s of PE-backed companies continued at a torrid pace as the number, value and percentage of PE-backed IPO’s of the whole increased over a strong 2013. Acquisitions clocked in at a solid level, exhibiting some variation quarter-to-quarter. There were quite a few large deals in 2014, though not as many as some expected, given the amount of capital available in the marketplace. Particularly public-to-private deals.
Fundraising levels have picked up over the last two years fueled by the large number of exits and the desire of LP’s to reinvest the returned capital back into the asset class. Dry powder has ticked up and we expect a continuation of this upward trend. In addition, the co-investment capacity standing behind newly raised funds is very significant, providing additional capital — in effect upsizing the funds. Allocations to private equity have been increasing recently and there is evidence of new investors coming to the table, which bodes well for 2015 in terms of fundraising opportunities. We are observing significant commitments flowing in from sovereign wealth funds, pensions and high net worth individuals/family offices. There’s a realization among LPs that in order to get the returns they’re looking for, a healthy allocation to private equity is needed supported by its outperformance over time versus other asset classes, including hedge funds, equities and bonds.
Looking ahead, we see more of the same. The activity levels will continue to be strong for the year although as always, not linear–expect peaks and valleys to occur. We are likely to see larger buyouts, as the abundance of dry powder, significant co-invest capital and receptive financing markets will spur larger deals. We also anticipate a number of corporate carve-outs coming to market, both in the U.S. and Europe. The larger global PE funds are focused on chasing carve-outs, which are a sweet spot for private equity, particularly the larger businesses which trade in the multi-billion dollar range.
Do you see a turnaround in public-to-private activity this year?
Public-to-private deals always garner a fair amount of interest although the count has been relatively low over the last few years. The primary reason is that they are complex to complete with many stakeholders involved even in the event the business is interested in a take-private. Working through management, boards and special committees comes with an extensive time commitment which has a high opportunity cost. In the completed take-privates it seems that activists have been involved, agitating for a sale of the company or a segment of the business. Activists have certainly played a role in providing targets for PE buyers, but we don’t expect there will be a more extensive trend in take-privates. The landscape, especially in the U.S., is one of high valuations, and buyers need to pay a significant premium to take those companies private, which tends to be challenging for any buyer.
There are also concerns out there about the regulatory environment for banks, more discretion around bank lending and leveraged lending. It definitely feels like banks are a little more restrained today in terms their underwriting standards. I don’t think there has been a material change in buyout financing availability but deals at the margin are impacted. If lending capacity declines further, PE buyers are either going to put more equity into deals or reduce pricing levels.
What are your expectations for valuations going into 2015? Do you see any signs of a slowdown?
It’s hard to predict but with the equity markets still trending positive, higher pricing will likely persist. There is a correlation of deal pricing to stock market valuations so to the extent the stock market stays elevated, we should see a similar pricing environment. Underlying the pricing equation is a very competitive market with a lot of players having access to capital and financing translating into aggressively priced buyouts. From a private equity perspective – they’re looking for great companies backed by strong management teams and to the extent they can find those companies, they’ll be willing to pay up for them. If growth suffers, or if financing becomes harder to obtain or more expensive, we could see some softening.
From a sector standpoint, Energy will continue to be a very active sector for private equity. The decline in oil prices has clearly changed the calculus but there is plenty of capital earmarked for energy and we expect a fair amount of deals in this sector. Having said that, many other sectors are in focus, including technology, industrials, consumer, business services and healthcare.
There’s some talk out there about the prices buyers are willing to pay, sort of like the price of Rembrandts and the Scarcity Theory. Everyone wants to own a premium asset when the markets are hot.
There’s some truth to that. What has changed over the last six to twelve months, however, is that corporates have really come back into the M&A market and have aggressively competed for businesses. They weren’t as confident prior to that – corporates weren’t as focused on inorganic growth and didn’t have the conviction they currently have. Now there’s quite a bit of corporate activity on both sides, for M&A transactions and for divestment of non-core assets. That’s been a trend that should continue into 2015 – corporates are aggressively looking to buy businesses in order to expand, maybe pulling back a bit on stock buybacks and dividends and looking to deploy their capital into growth opportunities such as acquisitions.
How do you see the strategic-versus-private-equity battle playing out in the near term?
I think it will be a competitive marketplace and in some cases corporates will be more aggressive than private equity. Corporates have plenty of cash and in many cases highly valued stock to use as currency, but private equity has access to substantial levels of debt financing at very attractive rates. In some cases, private equity will be the preferred buyer and will pay the highest price. In other cases the corporate may be the aggressor using identified deal synergies to underwrite a higher value. It’s a little uneven at the moment, with some corporates figuring out which businesses to shed while trying to be targeted buyers at the same time. On the buy side they are very focused on ensuring the synergy capture is validated.
For carve-outs and spin-outs, if corporates are deciding to get out of these businesses, I’m not sure other corporates will wholesale come in and buy a business that its competitor considers non-core. That’s a hard sell. In those cases, private equity is typically the buyer of choice. They’ve proven they can take those businesses, stand them up and convert them into a well managed private company with a growth agenda.
Over the past couple years, there’s been a lot of talk about PE buyers changing their strategies, incorporating more add-ons, minority transactions and more focus on the lower middle market. Is this a temporary reaction to current market conditions, or a more fundamental/structural change for the PE industry? Or a combination of both?
It’s a combination of both. Specifically many are expanding their deal formats to include minority investments and growth capital style models.
We’re used to the more traditional buyout model and we’re not necessarily accustomed to seeing some of the types of investments we’ve seen in the past year – namely minority investments. A good portion of those minority investments, though, have been deployed by a different types of fund vehicle. The larger global funds have set up “strategic opportunity funds” targeting non-traditional types of investments. These funds have a different mandate than the traditional buyout fund. In some cases they’re designed for debt investments or to provide “strategic capital” to businesses that are in need of it. At the same time, traditional buyout funds are also looking at minority investments through a growth capital lens, partly because it’s such a competitive environment that they have expanded their investment profile. Even if their fund construct is based on a control model, if they find the right situation and they’re comfortable with the majority owners, the management team and their ability to deliver growth, those firms (and their LPs) are moving forward with minority investments.
Part of this evolution is tied to the development of the disciplined sector model that a lot of PE funds have adopted. It is represented by strong and deep sector expertise embedded in the deal professionals and complemented by sector management teams and in many cases sector specific operating partners or operations teams. So when these minority investment opportunities come along, and they really know the sub-sector in question, they’re willing to do the deal because they know the industry so well and if they are aligned with management they feel it’s worth the risk to pursue without obtaining the traditional control rights.
PE funds are definitely expanding the types of transactions they’ll consider. It’s not a venture model – it’s a growth capital model. It’s not entirely unique though as it mirrors the investing model in the emerging markets, where funds have been taking minority positions in companies and helping them move up the growth and maturity curve. And in many instances, these funds are providing the capital to put the right infrastructure and governance in place to help those companies prepare to go public. PE funds are bringing that option to the table for entrepreneurs and family-owned businesses alike that don’t want to give up control of the businesses they created. So PE funds have been deploying capital with confidence in the form of non-control investments. They get comfortable by doing thorough diligence on the business and owners in order to achieve a certain comfort level consistent with a minority investment. They feel they have to establish an ironclad partnership on Day One.
With the current strength of the U.S. economy it seems like all PE investments are being made in great companies with built in growth attributes.
When the markets are up and the economy is expanding, there is a lot of focus on big companies and their earnings, and growth at the top end. But there are still companies in this environment that are challenged. Sustained growth is difficult to achieve, especially for some companies that lack sophistication or access to all markets. In some cases these businesses need capital or operational help, and that’s the other aspect that private equity is bringing to the table today in addition to capital. They’re bringing in operating partners, operational support teams and outside expertise to these companies, which may be treading water. They may not be looking to sell – they’re looking for smart, active capital that provides answers to the challenges their businesses are encountering.
If you go back fifteen years, private equity was primarily focused on getting the deal done, followed by pushing the management team to perform with an eye towards a relatively quick sale. They weren’t staffed with operating partners and they didn’t have the rigorous “value creation” focus, if you will. PE firms weren’t injecting their sector and operational expertise into their portfolio companies. That’s not the case today and private equity can be viewed in a different light. If a company needs capital, it should be asking, “What do I receive in addition to the capital I need? Shouldn’t we look for capital that can provide a lift for the business, that is proactive as opposed to passive?” So there’s a definite contribution aspect there that is very different than what it used to be with private equity funds.
It almost sounds like an evolution in the PE industry rather than an intentional, structural change in the model.
Yes, exactly. It’s a logical extension for PE firms. They’re not expanding into venture or other types of investing, like buying 3% of a company. They’re buying meaningful ownership levels, with the idea that they’re going to be an active investor in the business and they’re going to provide meaningful value to that company. Having said that, their primary business is buyouts and that will continue to consume most of the investing capital. The increased flexibility we are witnessing by virtue of this minority style investing is a good example of PE funds changing course a bit as they look to be opportunistic investors in this increasingly competitive environment.
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.
Featured image courtesy of Wikimedia user Thomas Hunt Morgan