By Philip Kurzrock and Markus Maier
On Wednesday the 27th of February, Bain & Company published its annual Global Private Equity Report 2019, presenting the main events and trends of the industry in 2018 and giving insights into its future developments. The industry continued its strong growth in 2018, displayed by a high number of deals and a high total amount of invested capital invested in buyouts.
The private equity industry is able to continue its growth on its way to a mature industry
While the deal value in 2018 grew to the second highest level since the financial crisis, deal count decreased compared to 2017 due to the added competition and scarcity of profitable investment opportunities. The market share of deal count and value of buyouts within the M&A industry maintained its level of the last years, showing that this development is not an effect exclusively ascribed to the private equity industry. The increased pressure on the traditional primary market for private transactions leads sponsors to seek out other opportunities, resulting in a steep increase of public to private investments in the US and sponsor to sponsor investments in Europe. Investors find value in public companies as difficult business models are often undervalued in such an environment, and therefore may offer greater value when taken private. Sponsor to sponsor investments on the other hand show a decreased risk and equal investment returns compared to standard transactions, helping investors to protect their downside in years of high valuations. Overall, the increasing competitiveness in a more mature market has led to a decrease in returns, which have come closer to, although still higher than, public markets on a net basis.
This competitive market environment is driven by the huge amount of dry powder of $2 trillion – almost twice as much as in 2008. Even though the fundraising was slightly weaker than in 2017, it was still the second highest ever, and this environment may continue for years to come as limited partners are unable to invest enough capital into private equity to maintain their target allocation.
The oversupply of capital has led to never-seen-before levels of multiples, with the average Purchase Price/EBITDA multiple almost maintaining its record value of 11.0x. In this environment, sponsors desperately seek for value drivers, and they find one in leverage. Profiting from the looser regulatory environment favoured by the Trump administration, debt levels have risen to pre-financial crisis levels of over 7x EBITDA for 40% of the investments in the US. However, even though this environment increases the challenge of finding good deals, it offers many great exit opportunities for sponsors, reflected in the highly positive cash flow for limited partners and the rise in shorter term investments of 3-5 years. However, there is a creeping sentiment among general partners of a weakening economy which could destroy the current environment for exit opportunities, and force them to liquidate investments in a market of significantly lower multiples.
Private Equity firms apply different strategies to get an edge in an increasingly competitive market
The most important strategy employed by funds today is the so-called “buy and build” strategy. This strategy consists of the acquisition of a stable platform company for a moderate to high multiple and then the subsequent acquisition of several add-on companies, which can be bought at significantly lower multiples due to their smaller size. This is backed by empirical data, suggesting significantly lower multiples for smaller companies (below $ 500M in value). After integration of the add-ons, the whole company can be sold for a multiple on the level of the platform company. This is a valuable strategy as it offers a clear path of creating value before an acquisition is made, as long as the sponsor can identify fitting add-ons and is able to integrate them efficiently.
In addition to multiple expansion, the strategy offers potential economies of scale, increasing the margins across the board and in the process improving investment performance. Whether such a strategy is successful depends predominantly on the industry, as it needs to offer enough targets (preferably in a fragmented market), and an exposure to suppliers and customers such that bargaining power for the platform company increases as the strategy is implemented.
Besides the buy and build strategy, sponsors have also sought out platform companies to merge with an equally big company, a strategy that has yielded strong payoffs. However, the strategy is quite difficult to execute and needs experienced managers for the post-merger integration period (PMI). Bolstering of this strategy requires the integration team to be present during the due diligence, both to advise the investment team and to better identify synergies that can enable the firm to make more aggressive bids during the bidding process later. It is the role of the integration team to precisely implement the business plan in the PMI.
Regarding strategies in the capital deployment side of the business, firms have started to diversify with products that complement those of their core buyout funds. The most relevant products are long-hold funds that have a holding period of up to 15 years and a target IRR of only 12% to 14%, compared to the 20% that is targeted on traditional buyout funds. Additionally, there is a growing number of growth funds targeting earlier stage companies with less leverage. Furthermore, PE firms increasingly show strong interest in targeting specific sectors or concentrating on mid-market investments as shown by an increasing number of funds with these focuses.
Will PE firms need to adapt for high multiples long term?
Most trends in the PE environment are heavily influenced by high prevailing investment multiples, supported by an oversupply of capital stimulating the high demand. This trend may sustain with no obvious end in sight for the inflows of capital. Additionally, PE investment opportunities are currently almost exclusively available to institutional investors, and there are attempts to open the market for retail investors creating the possibility of more inflows. The increased relative importance of the private market can be seen in the decrease of IPOs. There is no certainty about the development of the two markets, but it is a strengthening possibility that multiples remain at elevated levels, and the spread between multiples in private and public markets will decrease as investor appetites adjust.
- Add on acquisition: A bigger company buys smaller competitors, suppliers or customers
- Drypowder: Capital that is already committed to financial sponsors, but not yet invested
- Public to private transaction: an investor takes over a public company and in the process takes it private
- Sponsor to sponsor transaction: a private equity fund sells an asset to another private equity investor
Author: Philip Kurzrock, Markus Maier
Editor: Stefan Larsen
- Bain & Company – Global Private Equity Report