Private equity (PE) in 2015 turned in a solid year against a backdrop of slowing global economy, increasing volatility in public equity markets and feverish competition that drove investment multiples to new highs, according to Bain & Company.
The firm’s seventh annual private equity report reveals that new PE deal-making ground on steadily in 2015, as it has every year since 2010 – the start of this remarkably durable PE cycle. Deal value for announced global buyouts totalled USD282 billion, a shade more than in 2014, and deal count dropped 14 per cent – a tad lower than last year. Yet, PE firms face intense pressure from continued competition and ferocious deal-making, requiring a mandate to differentiate.
In the last 10 years, the PE industry has been through the throes of volatility, but has proved itself to be remarkably resilient, particularly over the decade's second half. By 2015, limited partners (LPs) enjoyed a fifth consecutive year when distributions outpaced capital calls, generating strong net positive cash flows. For general partners (GPs), sharpening their focus on deal sourcing, investment thesis articulation and post-close value addition have never been more important, and they are hurrying to raise their games on these and many other fronts. The past year also saw the best environment for fund-raising since the pre-crash boom.
"It's been a dramatic decade in private equity, but as we've seen time and again, the smart investors find ways to overcome market challenges, make money for their constituents and earn the right to make more money to fuel their continued growth," says Hugh MacArthur, who leads Bain's Global Private Equity Practice. "This 'at all costs' mentality will be even more essential in 2016 as the shadow of interest-rate increases in some markets and the risk of recession loom as tricky prospects."
Last year, the USD175 billion that GPs attracted for commitments in new buyout funds came in 11 per cent below the amount GPs had raised in 2014. Despite this, GPs setting out to raise new funds in 2015 saw one of the best fundraising environments since the last boom, despite overall numbers that were down slightly from last year. According to Bain, PE funds with top-quartile predecessors closed faster and raised more money than ever before – among buyout funds, a full 40 per cent closed in six months or less. Further, the per centage of funds that hit or exceeded their fundraising targets was higher in 2015 than at any time since the pre-crisis boom of 2007. The supply of LP money has been so great that even funds succeeding fourth-quartile funds on average met their target for fundraising last year. Still, LPs are looking at new ways to put money to work, including co-investment opportunities and using the secondary market to meet their allocations.
By region, 2015 buyout activity grew in North America, largely reflecting stronger economic fundamentals in the US, but dipped in Asia and Europe. Reported buyout deal value totalled USD282 billion globally – the strongest year since the global financial crisis – as dry powder increased to a near-record USD460 billion. Asset valuations, already high as 2015 began, rose to 10.1 times EBITDA in the US.
The aggregate value of buyout-backed exits came in slightly below the record USD456 billion posted in 2014. But with USD422 billion in realisations and 1,166 deals reported at year-end, asset sales were just shy of their all-time peak. Exit activity was vibrant in all regions around the world, led by a healthy North American market, where buyout-backed exits hit USD223 billion. Exits in the Asia-Pacific region came in at USD85 billion, in line with the region's performance over the past five years. Even in Europe, beset by sovereign debt and currency woes, GPs pulled in USD143 billion in asset sales – an amount surpassed only twice over the past 20 years, in 2014 and in 2007, the peak of the last PE cycle.
Yet, this continues to be a tough deal environment, said MacArthur. Dry powder and the need to put money to work is creating increased competition between funds for new deals. On top of this, corporates are using lower capital costs to fund an M&A boom and vying with funds for new deals. As a result of this intense competition, multiples are at all-time highs in the U.S. and near highs in Europe, exacerbated by some turbulence in the debt markets, particularly towards the latter half of the year, as spreads increased and some deals struggled to secure fundraising.
Bain anticipates that recent investment activity, far below that of the peak period between 2005 and 2010, will lead to a falloff in exit activity over the coming five years and smaller cash distributions flowing back to LPs. This period of 'normalisation' follows two massive deal spikes in 2006 and 2007, which the industry has finally digested.
Within the next 10 to 20 years, the industry can expect more of a readjustment. It is likely that third and fourth quartile funds will find it harder to raise money. Particularly in developed markets, the challenge for PE funds will be to understand – before they buy an asset – what they can do with it, particularly amid dense competition. If they cannot dramatically influence a given asset, PE firms are unlikely to realise attractive returns on their investment.
With today's favourable fund-raising conditions expected to slow in the next few years, GPs will need to be able to demonstrate to LPs that they have a sharply honed and differentiated strategy for achieving superior performance. LPs will also shift their priorities with many increasingly looking to concentrate their investments in a smaller number of top performing funds. More than ever, a strong strategy will be important for fundraising as the supply/demand balance shifts back to LPs. There are various ways to do this, and many are testing novel, promising pathways, which will become increasingly important in the years ahead.
Firstly, some firms are sharpening their focus on their investment sweet spots, enabling them to zero in on deals with characteristics that best match the firm's unique strengths, capabilities and past patterns of success.
Secondly, other PE firms are developing thematic investment insights to capitalise on broad macro trends and gain an investment edge. They are applying their in-depth understanding of key trends to identify and evaluate businesses and sectors that will see long-term sustainable growth.
Finally, more PE firms are mobilising their talent and resources to develop repeatable approaches for creating value across their fund portfolios. They are adopting value-creation models that reflect their firm's unique philosophy and distinctive investment preferences while ensuring that their methods for enhancing the value of their portfolio companies are consistent and focused.
MacArthur cautions that as the industry tries to find value in investment opportunities with stubbornly high prices and return thresholds, repeatability will play a key role in post-close activism, helping to realise more value from a deal, even once it is complete.
"It used to be that you could take the deal model, trim it by 15 per cent and still wind up with a reasonable return," he says. "Today, the need to transform the value of the assets is more acute than ever – sometimes you need to get the year five number in year three to realise an attractive payoff."
The time for PE firms to prepare for a downturn is before the storm hits. Portfolio assets acquired within the past two or three years are particularly susceptible to buffeting by economic turbulence. Purchased at prevailing high multiples and under sunny economic skies, many of these holdings were set up for exit sooner rather than later. GPs that remain stewards of their assets for longer than they had expected will want to weigh how best to insulate them from economic headwinds and to set them up to prosper when conditions improve.
"The onus will be on GPs to outperform their peers," says MacArthur. "This will cause a renewed requirement for strategy. You can't do that in the moment, when it happens. You have to put it in place now."