By Francisco Bolota, Maria Mikolajczyk
Looking back at the PE industry in 2019, despite the worsening macroconditions, one can observe a definite strong deal activity. Although 57% of private equity fund General Partners (GPs)1 think the economy has reached a cyclical peak, they continued to make deals, find exits and raise even more capital than ever. Increasing returns during ongoing fiscal and geopolitical uncertainty pushed top executives from PE firms to maintain focus on value and digitalization, and a commitment to developing the organizational and business models of their portfolio companies. However, stiff competition and rising asset prices resulted in the closure of fewer mega-deals. Following the more flexible regulatory policies in the US, debt markets kept enhancing GPs’ willingness to make deals, with an increasing frequency of covenant-lite bonds, which allowed highly leveraged debt to grow as a share of overall debt. Deals with debt multiples higher than 6x EBITDA comprised 75% of the total. Asset valuations were pushed to record highs, with EV/EBITDA multiples reaching 11.5x in the US and 10.9X in Europe. A growing trend of taking public companies private has emerged and hit the highest level since the previous boom (8 out of the 10 largest buyouts were P2P). In addition, new records were reached in the number of co-sponsor deals and in the size of accumulated dry powder stockpiles.
Investors had to struggle with even more demanding fundraising competition, with capital returned being barely higher than the capital called. With the incoming recession in mind, investors with high-quality assets were likely to sell for premium prices, which resulted in the lowering of the average holding period of fund hold portfolio companies. On the one hand, the average spread between entry and exit multiples has plateaued and could possibly start to diminish at some point in the future. On the other hand, and in response to the high demand for alternative assets (buyouts in particular), Limited Partners (LPs) remained willing to provide more capital to the industry. Fundraising in 2019 totaled $894 billion in private capital, with $361 billion explicitly raised by the buyout asset class (40% of total Private Capital, the highest level since 2006). Almost 70% of the buyout funds reached their capital target in less than 12 months, yet the “best” and most successful firms outperformed the others. This resulted in more capital flowing into fewer firms. With mega-funds, sizeable sovereign wealth and pension funds distributing large chunks of capital, the disparity between significant players and the rest of the field kept growing, urging firms to start creating a differentiated go-to-market strategy. In the near future, substantial funds will require more profound diversification, not just across activities, but also across markets and asset classes while minor firms will need to avoid looking at the entire value chain and focus instead on high growth niches. It will become likely to see an even more explicit separation between huge firms and smaller companies.
Private equity firms arrived in 2020 armed with a record level of cash. Firms have accumulated almost $1.5 trillion in unspent capital, more than three times the total amount of last year’s private equity deals ($450 billion according to Bloomberg). With all that in mind, little has changed to ease the fundamental challenges that GPs have to face in the coming decade. The competition over a limited number of high-quality assets remains robust – higher amounts of dry powder for the main industry players may cause PE firms to offer higher multiples in order to surpass the competition from peers and, consequently, deals that can yield lower returns due to the excessive acquisition prices. Since paying high multiples also adds pressure to obtain results, thoughtful consideration can be crucial when considering how to use these record levels of dry powder efficiently.
Convergence on the 10Y returns in the US market
Investors have been benefiting from the private equity industry – in the past decade over $2 trillion were poured into PE deals. Although public equities are more liquid at a lower cost, some investors prefer to receive a premium and decide to commit their money for a period of years with the objective of earning higher returns. Thus, investors expect managers to increase performance through original value-creation strategies and leverage. Yet, recently public equities have converged with the private returns in 10-years return in the US market (Figure 3.2).
According to Bain researchers, the situation is likely to persist. The current upward momentum can be explained by several factors. First, the implemented monetary and tax policies led to a slow but steady expansion that produced the lowest level of unemployment in half a century. Second, bad news in Europe (Brexit, the threat of recession in Germany and Southern Europe…) drove the investors towards the US securities. And finally, the convergence has not occurred in Europe, only in the US. Hence, there is little reason to believe it will persist over the long run. Private equity investors acknowledge this and continue to trust in the reliable, long-term performance that buyout funds deliver.
So what should we expect from the Private Equity industry during the 2020s?
The industry currently represents less than 5% of total global assets under management and less than 2% of total investable capital worldwide, leaving plenty of room for the industry to grow. With underachieving companies obliged to focus on bolstering balance sheets, well-positioned private equity firms can take advantage to embrace new investments. Analyzing the occurring trends in the industry, Bain & Co. did annual research2 and defined some of the top ways PE firms should follow to step up their game.
- Technology sector
Although there’s a very high risk of the market correction of the most inflated tech assets (looking back at the examples of highly overvalued IPOs) there are reasonable grounds for PE firms to invest in the sector. Past deals prove that investors avoid the most hyped tech segments as they value more the companies that prove to be resilient when facing a downturn. Within public capital markets, the main focus by investors is on the consumer software and hardware sector (63% of total invested capital), whilst the majority of the PE investors (72%) allocate their capital to enterprise software and services since companies in this sector often have strong revenue growth and solid fundamentals because their customers are constantly digitalizing to stay competitive. Moreover, the number of opportunities is growing due to the transition of many cloud and mobile technology companies from venture and growth to mature stages. Born-on-the-cloud software and services companies3 are attracting more and more investments (in 2018 over 50% of software LBOs targeted companies transitioning into the cloud, compared to under 10% in 2014). Funding such enterprises also has its drawbacks: lower margins or even losses as well as massive investments in product development, sales and marketing. Managers use the rule of 40 for the evaluation purposes of software companies, the sum of revenue growth and profit margin should exceed 40% (a business growing at 8% should yield a 32% margin). Nowadays, operating in the enterprise software sector opens many more doors, such as the development of human capital management software or investments in cybersecurity, which arise in response to the threat of security breaches. Another big chance for the tech ecosystem is brought by DevOps (development operations), a system that automates the processes between operational and IT teams. Given the fragmented nature of the market, many of the most promising targets are still in the growth stage, hence not on the PE radar. Then again, venture capital investors do not lose their sight and invest increasingly in the sector of growing significance. Evidently, the situation is evolving, and companies across the economic spectrum should not stay in the old mindsets if they want to remain competitive. PE firms should focus on implementing digital competencies and trying to achieve digital transformation at scale to support portfolio and target companies when opting to adopt innovative policies, developing new products and services and acquiring new assets for better operating efficiency and competitive effectiveness.
- Payments sector
Investors are slowly shifting their attention to smaller, more innovative companies that combine payments with a range of other business services. The attractiveness of the sector comprises mainly its fast growth and superior returns. Since the payments sector is a complicated business, the key to success is breaking the payment process into its constituent parts: merchant services (acquiring), buyer services (issuing) and networks. Up until now, PE investors had focused mainly on merchant services by acquiring divisions from large banks, especially in Europe. Nowadays, there is an observable shift towards the B2B payments sphere and the growing power of integrated payments. Larger issuers pulled back from the debit and prepaid markets after the Durbin amendment financial reform, which limited the transaction fees imposed upon merchants by debit card issuers. It proposed to restrict these interchange fees, which averaged 44 cents per transaction based on 1% to 3% of the transaction amount, to 12 cents per transaction for banks with $10 billion or more in assets.
This created an opportunity for start-up fintech companies that, sponsored by smaller banks, were able to build a business without getting crushed by the legacy players. Till now, PE investments were concentrated mainly on creating scale leaders in specific domains of merchant services. In the coming decade, the activity is expected to be dominated by deals involving companies offering tailored, value-added integrated payments solutions in all three segments: acquiring, issuing and closed-looped networks.
- Value-creation through pricing strategy
At first sight, placing a pricing strategy as the main objective of a deal seems like a trade-off for growth to many investors. Yet, implementing a sustainable and repeatable pricing model might complement growth strategies and even accelerate them. Pricing strategies shift the focus from external considerations to the capabilities of the management team. In case of huge stockpiles of dry powder, this could unlock vast amounts of value that is not yet implied in deal multiples. As a result of the ever-growing progress of data and tech, companies can price more precisely and deploy strategies more surgically. According to Bain, building new pricing capabilities and improving leadership around pricing can add 200 to 600 basis points to a company’s bottom line.
- Disruption assessment in due diligence
Meticulously assessing disruption in due diligence is another solution that can lead to success. Few industries these days are safe from the impact of technology-fueled innovation. However, it is possible to apply an organized approach to due diligence that can help to identify disruptive patterns in any industry and understand how they can impact investments. Identifying the sources of disruption and focusing on the development of the appropriate response should allow for the determination of the tipping point of the upcoming disruption. This can be obtained by observing competitors, start-ups and incumbents as well as detecting the patterns in VC spending. Innovation often feels like it appears out of nothing, but that’s rarely the case. Modelling and rationally evaluating risks and opportunities evolving from disruptions in highly competitive markets might be the key that makes the difference.
Another area that can shape the way businesses will evolve during this decade is the impact that decisions on Economic, Social and Governmental practices will have on enhancing the social and business value of firms. As direct and indirect global employers of millions of workers, firms ought to embrace their role as well-rounded value creators and as devoted industry supporters. Good corporate leadership will be essential, while greenwashing continues to concern investors. To prove integrity and reliability, managers should focus on putting forward a collaborative effort to include ESG metrics into their investment methodologies and indicating to investors the financial value that arises from these approaches. It’s not just about “just doing good” anymore, there is growing evidence that ESG programs can actually improve returns and limit risk. (More on the topic in one of our previous articles.)
In conclusion, given the increasing rate of change, incremental improvements will no longer be sufficient. Firms will be forced to tweak several transformation levers at the same time – inside their organizations and among their portfolio companies. They will need to reflect profoundly and creatively about how to attract and retain the skills required – and mostly about whom they want to be. The ambitious, fast-paced culture that attracted the brilliant minds over the last two decades will go old-fashioned unless firms find a way to revitalize and reshape it for a new generation. Leaders should identify digital innovations such as business intelligence, big data analytics, machine learning and business processes automation to help companies evolve and gain the skills needed for better performance and outpacing the competitors. Besides, they should develop career paths to design the firm’s digital competencies and provide the required innovation edge. Putting together teams that are more diverse in terms of background and knowledge will be critical.
With vast amounts of money to spend and an eagerness for making deals happen, it is arguably one of the most exciting times for private equity. There is a high probability that the market will face even higher growth during the next ten years.
Editor: Štěpán Koníř
Authors: Maria Mikolajczyk, Francisco Bolota
 Worldwide survey conducted by Preqin
 All of the company’s assets are and always have been in the cloud; it has never owned physical servers