The US buyout market faces a challenging environment of rising purchase price multiples for high quality companies while in Europe, GPs have found sources of capital amongst sovereign wealth funds and public fund managers willing to bridge the pre-IPO gap.
This is according to the new report, Ten Challenges facing the private equity sector, by Altius Associates.
The report also reveals that private equity flow in China, Peru and Colombia is set to boom while private credit strategies have begun to attract the attention of LPs as funds focussed on distressed and primary issuance of debt emerge.
Altius highlights asset pricing and over ambitious fund managers as key challenges facing the infrastructure market. However Altius believes the secondary market, which is on track to challenge the record fundraising year of 2009, should mature and become more efficient in the future.
1. European buyouts
The challenge for European buyout managers is and will be to find a profitable way to exit the boom year deals. Altius believes that of the three established exit routes (public markets, trade sales and secondary sales), the IPO market remains largely closed with financing almost certainly not available for financial sponsors to be realistic buyers in a secondary transaction. Indeed a full trade sale of one of these large businesses is theoretically possible but problematic given the current economic environment in Europe and with vendors wanting to receive cash rather than paper.
Charles Magnay (pictured), partner at Altius, says: “In many cases the clock has reached the five year mark and is very definitely ticking. GPs have been forced to become increasingly innovative in seeking liquidity and, thankfully for the asset class, have been successful in this regard in a number of cases. They have looked for ready sources of capital and found them amongst sovereign wealth funds and public market fund managers willing to bridge the pre-IPO gap – often corporates from Asia.”
2. US buyouts
Altius believes the US buyout market faces a challenging environment of rising purchase price multiples for high quality companies, which over the last year have hovered at around 9.0x earnings before interest, taxes, depreciation and amortization (EBITDA) and sometimes more. This is as a result of an increasing number of private equity firms competing for high quality deals, the efficiency of a more intermediated market, and the improvement in accessing debt for leveraged buyouts.
Altius cites improvement in bank financing and capital markets that have allowed debt multiples to increase from an average of 3.0x in 2009 to 5.0x EBITDA thus far.
3. Secondary market
Altius believes the challenge for the secondary market will be to find attractive opportunities in an increasingly transparent and crowded market. In the first three quarters of 2012, an aggregate of USD15.7bn was raised, which is on track to challenge the record fundraising amount achieved in 2009. However Altius believes that an inflow of large amounts of capital into a segment can often create issues.
Chason Beggerow, partner at Altius, says: “The high level of fundraising has been supported by an equally high level of secondary transaction value. Currently there is a good supply of deals, as European financial institutions have started and are still looking at shedding private assets from their balance sheets due to regulatory concerns and public pension plans are utilising the secondary market to actively manage their private equity portfolios and exposure. While the supply has been good, sellers are more strategic and as a result, pricing has remained firm.”
4. Real assets
Altius cites a number of challenges facing investors today within the infrastructure market. Asset pricing is one issue, especially for core brownfield assets as the asset class is seen as a “safe haven” with the promised yield viewed as an attractive replacement for low-yielding fixed income securities. As a result, capital is rushing into the space, pushing up asset prices and reducing future returns.
5. Private credit
Altius believes private credit strategies have attracted the attention of LPs and more broadly, the investor community.
Elvire Perrin, partner at Altius, says: “Investors are looking at ways to enhance their returns on traditional credit and fixed income portfolios, which have displayed very meagre performance over the last couple of years due to the very low interest rate environment in most of Europe and the US. The market dislocation created by the increasing regulatory pressure on banks has created a space for non-traditional debt providers as well as opportunities for distressed credit sales. Indeed, the conditions attached to bank rescue packages by the European Competition Entity and the new regulations being implemented are forcing banks to exit or decrease their level of activity in private equity and leveraged lending.”
6. Emerging markets
Nearly all emerging markets have a need for healthcare, infrastructure, education and basic technology that facilitate business. Altius believes that the more attractive regions, such as Southeast Asia, politically stable countries in Latin America such as Peru or Colombia, and the emerging African countries like Kenya or Nigeria have increasingly younger populations with increasing levels of disposable income that will drive consumerism.
7. Asia private equity
Altius believes that as financial markets in China are slowly liberalising, China has emerged as the largest private equity market in Asia during the last couple of years. Foreign investors have long had only access to the Chinese market by off-shore constructions, as private equity investment by local investors only became possible in 2005 when new legislation to facilitate this was implemented.
The RMB market includes industries and industry sectors not accessible to foreign investors and offshore funds; conversely for local investors, it is difficult to make commitments to offshore funds. Private equity has, therefore, become increasingly popular with local fund raisers as well as with local investors, mostly large and cash-rich sovereign funds.
8. Compliance and regulation
Compliance with various levels of governmental regulation is an eternal challenge for the industry; but Altius believes that the coming year will be an annus horribilis in this regard with too much regulation happening too fast to be fully digested and absorbed by the industry. Amidst the sea of regulatory proposals facing the industry are: i) Solvency II, a fundamental review of the capital adequacy regime for the European insurance industry; ii) Basel III, a long term package of changes to the original Basel Accord on the strength, soundness and stability of the international banking system; iii) MiFID II, the expected update of the Markets in Financial Instruments Directive; iv) consultation on the EU Pensions Fund Directive (IORPII) which could have far reaching consequences for both the funding of pension schemes and the way in which they are managed.
Most significant perhaps is the fact that in July 2013 the Alternative Investment Fund Managers Directive (AIFMD), the main new piece of regulation affecting the private equity industry, will become effective even though the European Commission only published its draft implementation measures just before Christmas, leaving most firms little time to prepare for implementation.
9. Client Services/reporting
Altius believes there is an increasing need for transparency across GPs and private equity advisors. Standardised capital call and distribution templates, which were released by Institutional Limited Partners Association (ILPA) two years ago, are taking root in the industry and several leading GPs have begun to adopt them. The level of uptake has been promising so far and has been led by several institutional LPs. There has been a complementary movement on a standardisation in fund reporting, with an increasing number of GPs either adopting industry body templates, or moving closer towards more investor-friendly forms of reporting with regards to their fund structures and holdings.
10. Investor relations
Altius believes that a major shift in GP-LP relations in the private equity world is taking place. Stung by the abrupt valuation shifts and mark-to-market losses through the financial crisis, LPs now demand more information, with greater transparency and on a more regular basis as the price for continuing to support their GPs.
