Private equity pulls back in 2015
The challenge of cash-rich corporates and vaulting valuations has led buyout firms to exercise restraint in the first half of the year. The number of private equity buyouts was down to 398 in H1 2015 from 456 H1 2014. Buyout deal value was also down, falling 25 percent year-on-year to US$58 billion.
The figures suggest that financial sponsors are holding back. Investors are still cautious as they emerge from the financial crisis and have balked at high valuations unless they are investing in an asset of exceptional quality.
Competition for good companies has also increased, making it tougher for firms to make investments.
“Stock markets have been strong for the better part of 2015, and a number of potential private equity targets have opted for an IPO instead,” says White & Case partner Oliver Brahmst. “We have also seen corporates return to M&A and when a strategic buyer is hell bent on doing a deal, private equity generally has a difficult time being competitive.”
The competition at large-cap PE firms are facing from strategics has had an impact on the activity of mid-market players too. Large-cap buyout houses are increasingly looking to do smaller deals, which has meant that mid-market players are facing tougher and more competitive auctions.
In order to compete, firms are focusing more on the operations of potential targets and portfolio companies in order to deliver strong returns when buying companies for high prices. They are also working harder on due diligence in order to identify steps they can take to improve company performance and grow revenues. Buyout firm Clayton, Dubilier and Rice, for example, runs a team of operating partners who all have direct industry experience and focus exclusively on improving company performance. These operating partners, which include former senior Unilever executive Vindi Banga and former General Electric CEO Jack Welch, will work on transactions pre-deal to identify what operational improvements a buyout firm can make if it invests.
As Tate Pursell, managing director of US private equity firm Unlimited Horizons, said in a recent interview: “Private equity groups had to change from financial engineering to building value. They had to sharpen their game.” (See the sidebar “Management compensation in a hot M&A market” for details about how these dynamics affect how portfolio company managers are compensated.)
Brahmst adds: “Private equity firms cannot simply rely on financial engineering. They need to focus on operations to increase returns. We see firms acting like quasi-strategic investors by investing in companies, then supporting their add-on acquisitions. It is also still the case that investors will favor a private equity buyer if it reduces the antitrust risk.”
The private equity industry is, however, at the beginning of a new fund cycle, so firms can afford to maintain discipline and refrain from investing for a while.
US private equity exit figures are also down, falling from record highs in 2014. On a year-on-year basis, exit numbers fell 21 percent in H1 2015, with exit value down 42 percent. For many firms, the pressure to realize value for investors has eased after the strong run of exits in 2014. Private equity has made record distributions to investors at good multiples.
According to Preqin, PE firms returned US$444 billion to investors globally in H1 2014. These distributions have been made at good returns. A Bain & Company analysis of public pension fund median returns over a ten-year investment horizon shows PE outperforming all other asset classes.
Private equity firms also sold many of their very best assets in 2013 and 2014 to support fundraising efforts. Now that new private equity funds have been raised and portfolios exited, there is a smaller number of companies that private equity firms need to sell.
“Private equity had a very successful run selling companies in 2013 and 2014, with these exits fetching high valuations. After selling so many companies, there has been a pause of breath,” says White & Case partner Oliver Brahmst.
Management compensation in a hot M&A market
Alignment of interests is the cornerstone of the PE model—not just between firms and their investors, but also between buyout houses and portfolio company management teams.
White & Case’s Henrik Patel notes that PE firms have always been willing to offer management teams attractive financial incentives in order to drive returns. “Firms do worry about whether they are compensating management too generously, but if a deal delivers returns, PE sponsors are happy for management teams to share returns,” he says.
Experience suggests that management teams are typically in line to receive a relatively healthy return of between 10 and 20 percent of deal proceeds, assuming that the PE sponsor makes a return of two to three times the money on the investment.
In the current market, however, where the contribution of leverage and multiple arbitrage to overall returns is shrinking and operations have become more important for generating alpha, buyout firms have moved to sweeten deals for management teams even further.
“Salaries and bonuses are in line with the past, but something we have seen more of this year is a focus on incentivizing homerun deals,” Patel says. “If a management team knocks it out of the park, with returns of above 3.5x, they may get another incremental piece of the pie. Management may earn another 5 percent of the deal returns above an agreed multiple.”
Patel adds that in order to differentiate themselves from management teams, PE sponsors may offer to structure deals as partnerships rather than corporations, so any management returns receive the more favorable capital gains tax rates.
PE sponsors are also paying more attention to non-compete terms in contracts, to protect them from managers leaving to work for rivals. Firms are also insisting on terms that prevent managers from voluntarily departing and being eligible for severance and special treatment of their equity.
In addition, financial investors are insisting the management teams reinvest in deals, in order to maintain alignment between the firm and management. “Buyout firms will typically expect management to roll over between 25 and 50 percent of the after-tax value of what management would receive in a deal,” says Patel.
Private equity had a very successful run selling companies in 2013 and 2014, with these exits fetching high valuations. After selling so many companies, there has been a pause of breath.
Oliver Brahmst, Partner, White & Case
▪ Private equity exits down after stellar 2014 ▪ Buyout volumes also down ▪ High valuations and cash-rich strategic buyers challenge the private equity sector
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