The coronavirus has decimated global markets in recent weeks. And with PE funds competing to complete deals last year at record high valuations, the big question now is how managers navigate the threats of recession over the coming period. Many will be asking themselves: ‘How far might valuation multiples fall in this current climate and do we have the right risk protection in place for our portfolios?’
New research in McKinsey’s latest report, A new decade for private markets, reveals that while most fund managers consider cyclical risk as part of their due diligence and portfolio management processes, only a third have adjusted their portfolio strategy to prepare for a potential recession.
There is little doubt that PE has been the leading alternative asset class in recent years.
Last year, a total of USD555 billion in net new assets were raised by global PE firms, with megafunds of USD5 billion or more in AUM accounting for more than half of total buyout fundraising activity. North America enjoyed its greatest ever fundraising period, topping USD350 billion, with buyout funds making up US240 billion of that total.
Overall, this has led to the accumulation of USD1.4 trillion in dry powder, putting pressure on managers to put that committed capital to work.
Will buyout valuation multiples contract in 2020?
Last year, US buyout valuation multiples reached a 15-year high at 12x (compared to 8.8x in 2010). US buyout firms, in particular, will be watching the market dislocation very carefully indeed, and hoping that their operating models are suitably equipped to not only protect the value of their assets, but demonstrably increase them.
The coronavirus pandemic will, arguably, lead to a reduction in valuation multiples in 2020 and present managers with more attractive deal opportunities. Although part of the reason for why multiples rose last year was because overall PE deal volumes experienced a USD200 billion decline to USD1.47 trillion.
Those who completed deals last year at the apogee of the market will need to demonstrate to investors how they plan on protecting their portfolio assets from value erosion, should Covid-19 lead to a longer term shock to global markets and supply chains.
Commenting on deal volume in 2019, Matt Portner, Partner, McKinsey & Company, who co-authored the report, says: “There have been multiple years recently when we’ve considered whether we’ve hit peak deal volume. It’s always challenging to call a peak, but, with valuation multiples of 12x for US buyout funds and leverage rising, deal volume could start to plateau.”
Buying at the top of the market will always bring risk management into sharp focus, regardless of asset class, public or private.
At the time of writing the report, Portner says he saw no particular reason to think multiples would not continue to climb. The reality is there isn’t an infinite number of PE deals to be done and there is a ceiling.
“The plateauing of deal volume isn’t surprising to me as there are not an infinite number of attractive deals. But given the amount of capital that continues to pour in to the space and the growth in the number of PE firms, it’s hard not to see multiples rising higher. Prior to coronavirus, all of the fundamentals that would lead to multiples rising higher were still in place: demand for deals, coupled with a supply shortage.
“However, we are now facing a pandemic, which has caused many deal processes to freeze and will, in all likelihood, drive down deal volume, at least in the near term. Depending on the length and severity of the crisis, it is likely to put downward pressure on multiples as well,” suggests Portner.
This is currently a period of heightened deal risk. Managers have to be more certain than ever that they are selecting the right target acquisitions, confident in the knowledge that they have the tools necessary to deliver long-term gains for their investors.
Such is the competitiveness of the US buyout market that buying the same company in 2019 compared to 2010 would have cost a PE manager 35 per cent more.
And while multiple expansion is a primary driver of value creation today, it remains a mixed bag.
“Many GPs recognise that exit multiples are likely to be lower than entry multiples and therefore they are looking more broadly at value creation levers. In addition to the traditional post-acquisition value creation levers like procurement, many GPs are starting to look at commercial levers like pricing, as well as digital and analytics,” says Portner.
Megafunds deliver more consistent performance
This uncertain period we are living through applies equally to PE investors as it does the managers they turn to as stewards of their capital. Now more than ever, manager selection is key. Generating outperformance can result from being better than average at picking managers.
McKinsey’s research shows that for buyout vintages from 2000 to 2016, the median performance is comparable across fund sizes, from small-cap (less than USD1 billion) through to super-cap (more than USD5 billion). However, the dispersion of returns is far more pronounced in small-cap funds. This means it is far more likely for investors to end up selecting a bottom quartile manager, and, by default, much harder to find top-quartile performers.
The fact that megafunds offer a tighter spread of returns partly explains why they have become a more prominent feature of the PE fundraising landscape. Most PE firms launching megafunds have a longstanding track record of above average performance. This allows them to continue raising bigger funds, and is indicative of their existing investors choosing to re-up.
“Many of my LP clients re-up with their largest managers and that’s not just a function of returns,” says Portner, “it is a function of everything else they get from those managers; ie returns and lower risk of downside on those returns, co-investment opportunities, risk management, potential access to other asset classes (real estate, infrastructure), good ESG policies.
“These bigger managers are more like solution providers for the LPs, giving them a lot more than just returns.”
Performance deterioration relative to size
Over the 16-year sample period used in McKinsey’s report (based on data provided by Burgess Private IQ), it is clear that top 5 per cent performance has deteriorated within the global buyout space as a function of fund size; on average, a small-cap buyout delivered an IRR of 40 per cent, compared to an IRR of around 27 per cent for a super-cap fund.
McKinsey’s report says that one study finds that in buyout, “the individual is about four times as important as the PE firm in explaining differences in performance”.
VC funds, by comparison, have demonstrated more persistent performance, which is itself positively correlated to fund size.
“The distinction in performance between buyout and VC is interesting when considering fund size. In buyout, median performance is comparable across fund sizes, but smaller funds tend to have much wider returns dispersion. In VC, while returns dispersion is roughly the same across fund size, the largest funds tend to outperform,” comments Portner.
He says that persistency of decline has been well covered over the last few years “and it has certainly become a lot harder for investors to pick winners, which again is another contributing factor behind the growth of megafunds as they have a higher perceived consistency of returns, or at least lower downside risk.
“In this environment of high valuations and competition for deals, coupled with a huge amount of dry powder that needs to be put to work, it’s hard to succeed. It’s not simply a game of financial leverage. The downside risk in super- and mega-cap funds is less pronounced and as such the managers running these funds are viewed as a safe bet by investors.”
With uncertainty gripping global markets, backing the right PE firms that have proven to deliver long-term performance and have well-established risk mitigation strategies in place to protect their portfolios, has suddenly come into sharp relief.