As part of our 2015 Annual Private Equity Breakdown Report, which will be released January 9th, we talked with Carl P. Marcellino, a Partner in Ropes & Gray’s New York office, about trends in the PE industry and his thoughts on deal-making in early 2015. Be sure to check the PitchBook Newsletter this Friday to download your free copy of the report.
How do you see the first half of 2015 shaping up? Do you see any signs of a slowdown in deal flow? Or valuations, for that matter?
2015 looks very good right now. We’re not seeing a slowdown at all. Valuations remain high, and the capital markets remain active. We’ve actually seen an uptick in the number of new matters that have started up in December, anticipating a first quarter close. Often at the end of the year, we see clients attempting to push everything into the end of the year, and January is really just about the deals that missed that timeline. Interestingly enough, this year, we’re seeing a number of companies beginning their sales process now (and therefore activity on the buyside and sellside), as well as a number of businesses beginning their IPO process. Given that, 2015 looks very good in terms of activity, at least for the first few months.
Your PE practice includes work with some of the largest investors out there, including Blackstone, Bain and TPG. Those firms haven’t been in the headlines recently, with mega-buyouts and big take-privates all but vanishing over the past few quarters. What are your thoughts on the lack of activity in the upper end of the market, particularly with so much dry powder available? And do you anticipate a comeback of sorts in 2015?
While mega-deals may resurface at some point, we do think there are a number of factors that will prevent them from ever coming back with the same frequency as seen before the downturn. There haven’t been many mega-buyouts or go-privates this year across the market, and there are a number of reasons for that, which aren’t necessarily private equity specific. Larger deals are struggling due to high valuations and the recent restrictions from the Fed on debt levels. An increased amount of debt is needed to fuel buyouts at valuations being sought now, and the result is that fewer mega-deals are getting done. Within PE, we have seen certain limited partners push back on such deals, as they require many firms to partner in a “club,” which can dilute an individual sponsor’s control (if it’s a small member of a large club, or one of three or four large members) and increase risk for the LPs. As a result, while deals may come back, we think another seven-sponsor deal like SunGard is unlikely to occur with any frequency, and we believe even smaller club deals will occur only in limited instances.
What are your thoughts on today’s PE strategies, and do you think these are fundamental changes in strategy, or temporary reactions to the current deal-making environment?
We’ve definitely seen an increase in PE firms pursuing smaller deals and taking minority interests in deals. This seems more about finding creative ways to deploy capital in a market where valuations remain high and club deals are discouraged. The increase in minority deals is a particularly interesting development. It’s opening the door to investments in businesses that typically wouldn’t be looking for PE investments, but companies (and the advisors they engage to find capital) are beginning to see the benefits of private equity investors being part of the capital structure. PE funds bring operational expertise to the table – whether they own 10% of a business or 80%, they provide their portfolio companies with access to industry experts and vendors that many of these companies cannot get from standard venture investors. To get this additional expertise, we’ve seen companies agree to more downside protection for PE investors – redemption rights, IPO ratchets and minimum returns have all found their way in to transactions in the past year on a fairly consistent basis, despite the fact that years ago such terms were non-starters (particularly for highly sought-after companies). From the PE fund standpoint, they are getting this downside protection and are able to invest in businesses that are too big to acquire now, but also that wouldn’t normally be available to them until the businesses were more mature (and accordingly, even more expensive). A minority interest means less control, but if the PE fund is able to align itself with management and secure downside protection, the result is that its influence is still there and it is able to exert some minimum level of control over its invested capital. Given that, we think minority investments by PE firms will continue to be an option for them going forward.
Much of your work is also focused on the U.S. middle market, where deal flow has remained high despite multiples reaching historic highs. Why are your clients, and the PE market in general, focusing so much of their attention to the middle market?
The middle market is where the most opportunities are. You see businesses at all stages of development and within all industries. These aren’t fledgling businesses, but are instead more mature companies that have tested business plans. They are smaller companies, but can have higher growth rates and therefore more upside. There’s a tremendous amount of opportunity to invest in middle market companies for all types of PE sponsors. While large-cap funds had historically looked elsewhere in an effort to find opportunities to put more capital to work in a single investment, with recent trends moving away from large cap deals, these larger funds are looking to middle market opportunities. The large cap funds are seeing that they can compete well in the space – with their resources and ability to fund an entire purchase price with equity (i.e., to remove any financing risk from deals). That’s not to say, however, that the middle market funds are losing out. Many middle market-focused funds are acting more aggressively in the market to compete and secure deals for themselves – offering better terms and the ability to move very quickly. The result is that valuations are moving up, but within limits that the debt markets can still accommodate.
Carl’s practice focuses on representing private equity funds and their portfolio companies in a wide range of transactions and corporate matters. Carl has broad experience representing clients in mergers and acquisitions, leveraged buyouts, leveraged recapitalizations, preferred equity investments, PIPE investments, subordinated debt financings and securities offerings. In addition, Carl devotes a significant portion of his time to representing public and private companies in connection with the formation of strategic joint ventures, securities law compliance, governance, and other general corporate matters. Carl represents private equity sponsors such as Bain Capital, Fenway Partners, TPG Growth (TPG Capital’s investment platform for early stage and growth investments) and Welsh, Carson, Anderson & Stowe. He also represents a number of smaller venture capital funds.