Private equity in focus
The buoyancy in the buyout sector towards the end of the year reflected the broader M&A market. After a slow start to the year, the value of deals surged in the second half despite a dip in transaction volume. Some US$122.68 billion worth of deals were sealed in H2, up almost US$40 billion on the second half of 2014, yet down 15 percent on a volume basis over the same period.
This rise in value coupled with a fall in volume was a hallmark of M&A in 2015, and the private equity sector has been no exception. Funds have plenty of money—US$1.3 trillion on a global basis, according to research firm Preqin—that they are looking to invest; and this has made conditions perfect for sellers in recent years, but more challenging for buyers.
“Private equity firms have a lot of funds to deploy. Vendors and strategics know this, and bankers are marketing bigger deals because they know that these firms have the appetite and assets to do deals,” says White & Case partner Oliver Brahmst.
Indeed, the competitive tension caused by the abundance of capital appears to be creating a disconnect between overall deal value and volume.
Join the club With asset prices running high, PE has been reviving one of its former strategies—clubbing together with like-minded co-investors. “Club deals allow PE firms to invest together to pay higher multiples and provide equity backstops that sellers are demanding,” says White & Case partner Carolyn Vardi. The largest deal of the third quarter saw The Carlyle Group and Singaporean sovereign wealth fund GIC take over Veritas Technologies for US$8 billion. Likewise, Solera Holdings was picked up by Goldman Sachs, Koch Industries and Vista Equity Partners for US$6.5 billion. Both companies sell software, a favorite sector among PE firms, and these deals helped to drive overall technology buyouts to US$41 billion in 2015, making it the top sector by value.
“PE firms are not looking at start-ups like Airbnb or Uber, but they like software companies and, they are trading at very high multiples right now,” says Brahmst. “Software companies have low capex, so PE firms don’t have to put in a lot of capital over time. And once they have proven technology, it’s possible to scale them up.”
The most noteworthy club deal of the year, however, featured a familiar name. Electricity transmission business Oncor was acquired for US$12.2 billion by a consortium comprising industry operator Hunt Consolidated as well as financial sponsors Anchorage Capital Group, Arrowgrass Capital Partners, BlackRock, Centerbridge Partners, the Blackstone Group’s GSO Capital Partners, Avenue Capital Group and the Teacher Retirement System of Texas.
Oncor was formerly part of Energy Future Holdings, which in 2007 became the subject of the biggest PE buyout on record when KKR and TPG Capital paid US$48 billion to own the energy business. It was also the industry’s largest write-off after the company succumbed to its US$42 billion debt load and tipped into bankruptcy. Now PE hopes to make a success of its investment in the Oncor unit with a club deal.
IPOs: Slow floats
Private equity IPOs in public markets have slowed substantially this year but they remain an important exit route
Private equity-backed IPOs dropped significantly in 2015, as might be expected from what was a down year in general for public offerings. Figures from professional services firm EY show that in the first nine months of the year, private equity firms raised US$38.5 billion in total proceeds from IPOs, a 60 percent fall compared to the same period in 2014. The 120 IPOs of PE-backed companies represented a 26 percent drop by volume.
Following market shocks in August, investors showed signs of caution that affected the sponsor-backed Albertsons IPO, one of the biggest IPOs of the year, both of which were backed by sponsors. In October, Cerberus pulled the sale of grocery store chain Albertsons after bookbuilders could only convince investors to pay US$20 a share instead of the indicative US$23 to US$26 range.
“Many investors are wary of highly leveraged companies, especially where profit growth is lacking,” says White & Case partner Colin Diamond. “For example, Albertsons is carrying debts of US$12 billion from its buyout.”
In the tech space, there is evidence of frothy valuations correcting themselves in the public arena. IPOs by Square, the mobile payment service, and Box, the online file-sharing company, resulted in valuations for these companies that were below those achieved in previous venture capital financing rounds. “Some analysts think that IPOs for many tech startups will effectively be ‘down rounds,’ resulting in valuations that are lower than they were in previous stages of funding,” Diamond says. “Nevertheless, it’s important to take a longer-term view and not put too much emphasis on how companies are priced on day one following an IPO.”
Unlike the process for doing secondary or trade sales, the IPO process is time-consuming and involved, requiring companies to spend many months of preparation culminating in two weeks of roadshow meetings with investors. In addition, funds are subjected to 180-day lock-ups before they can sell further stock. This lack of a complete exit can be a turn-off for PE funds. However, there is also the opportunity to benefit from further upside if the company appreciates in the aftermarket.
According to Bain & Company, the holding period before PE exits increased to 5.7 years in 2014 from 3.4 years in 2008, as funds concentrated on getting their companies through the crisis and waited to sell in rising markets. Some potential M&A deals, like Albertsons, are too big to garner interest from other PE firms and don’t offer enough strategic potential for corporates, leaving the IPO as the most credible exit option.
Sellers rule the market The current seller’s market—fueled by corporate and PE’s capital reserves and the revitalised confidence from deal-hungry corporates—and the curtailment of leveraged loans are the biggest obstacles facing private equity. “Funds are having to think long and hard about their strategies for an asset in order to rationalize accepting high multiples,” says Vardi.
Gone are the days when firms could rely on financial engineering for their returns, and regulators have had a hand in the shifting dynamics. The Fed’s guidance on leveraged loans, specifically warning Wall Street banks against lending that pushes companies’ debt above six times EBITDA, has influenced where the industry looks for debt financing.
Vista Equity Partners financed its buyout of software business Sovos Compliance with a loan from alternative lender Golub Capital. Vista was prepared to accept a higher rate in exchange for a leverage multiple of seven times EBITDA. With traditional lenders hamstrung by the Fed, private equity firms are prioritizing debt quantums above repayment costs.
Given the restraint from banks on leverage, and with seemingly little headroom for further multiple inflation, there is more pressure than ever on private equity firms to optimize operations to capture returns. This means putting more store in due diligence to identify cost savings and ways to consolidate markets through add-on acquisitions.
“Limited partners (LPs) are looking very hard at returns, and they are scrutinizing funds’ investment decisions,” says Brahmst. “Funds that overpay and can’t make the returns won’t be in business for long.”
Conversely, conditions have scarcely been better for vendors, who are taking advantage of pricing while it’s high. PE firms made US$200 billion worth of exits compared with US$190 billion worth of investments. As was the case in 2014, company sales are outstripping new investments, as sponsors avoid bidding wars with corporates and continue to exercise discipline.
Investors are keeping an eye on rate rises, but these are likely to continue to be incremental and, with continued positive signs in the economy, this is unlikely to put a dampener on the market. “Short of a recession, I don’t see what can hurt the industry right now,” says Brahmst. “Activity will continue, and the interest rate rise won’t change anything materially. It will help buyers rather than sellers, and that might not be such a bad thing.”
▪ 2015 surpasses 2014 in terms of buyout value ▪ Buyout volume falls ▪ Buyout value surges in Q3 ▪ Exit value and volume down compared to 2014 ▪ Industrials and chemicals is the top buyout sector for private equity volume ▪ Technology is the top buyout sector for private equity by value
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