Traditionally, PE firms initially raised modest funds, made intelligent purchases, managed portfolios and later progressively exited positions to generate attractive investment returns. These profits were then used to secure larger funds, enabling managers to make bigger investments and target major institutional investors. However, current record high asset valuations render such practices obsolete
Conclusion of pre-crisis deals marks the beginning of a new era
Having exited nearly all pre-crisis deals, buyout firms are adjusting to a new paradigm that involves a longer holding period of approximately 5 years, compared with a historical average of around 3.5 to 4 years. In 2016, the number of buyout-backed exit deals worldwide fell by 19% and by 23% by value from 2015 and even further from record levels in 2014. Still, the industry continued to perform well posting its fourth strongest year based on a disclosed transaction value of USD328 billion from 984 deals. Moreover, this decline was not due to a worsening exit environment, but mainly fewer deals ready to be exited, since the industry had largely worked through its backlog of assets invested prior to the global financial crisis.
High asset valuations driving complex deals
PE firms are under pressure to invest their cash holdings but without compromising returns. For example, Irving Place Capital (formerly Bear Stearns Merchant Banking and, since 2008, an independent US PE firm spun out of JPMorgan) has lowered its buyout criteria from targets with maximum EBITDA of USD50 million to only USD15 million to identify hidden value. Increasingly, firms are focusing on complex situations that require more specialist sector expertise, engaging in flexible acquisition structures and establishing contrarian business improvement plans. According to a PE industry veteran, “If we choose to spend our time in this sort of environment, it will usually be because there are complex issues involved.” These may include underperforming corporate subsidiaries whose value cannot be maximized by a straight sale, which might be prepared to accept a minority investment. Many firms face challenging market conditions with average prices almost an entire EBITDA multiple or more above their corresponding level in 2015. Consequently, many PE managers have cashed out. Still, as firms have also raised new funds, the industry currently reports record unused dry powder.
Cautious approach to complex deals adversely affects buyouts
Currently, buyout teams are deciding not to buy otherwise well-run companies absent any means to realize hidden value. According to a partner at Clayton, Dubilier & Rice, “The pipeline for deal activity is very high, but we probably pass on 95% of opportunities out of the gate because we know we don’t have an angle. If it’s a good business – good management team, good asset projections and good outlook – we’re never going to win.” Consequently, buyout investment activity decreased in 2016, with the number of deals transacted down by 18% and their total value by 14% from 2015. Record-high asset valuations combined with stiff competition, particularly from corporate buyers, made it more difficult for PE firms to conclude deals and achieve targeted returns. During the third quarter of 2016, purchase price multiples for buyouts in the US rose to an average of 10.9x EBITDA.
Dry powder hits new highs
Difficulties in identifying appropriate, attractive investment opportunities, and continuing enthusiasm from investors for PE assets have led to the accumulation of record large sums of dry powder. Globally, dry powder available for investments as at 31st March 2017 stood at $842 billion (new industry record) and majority of available capital (63%) equal to $530 billion rests with Buyout funds. As a result, the competitive environment is challenging with present high prices inconsistent with relatively little economic growth.
“How” can modern day offshoring overcome challenges facing PE firms?
There has been a substantial increase in demand for research that incorporates greater sector specialization within a more flexible model framework. Currently, PE firms need to evaluate performing, non-performing and dormant assets to maximize corporate growth and distinguish returns. With the number of deals down in 2016 and dry powder at record highs, deep dive strategic research is in very substantial demand. Today, offshoring has developed to meet specific client needs. Offshoring partners can generate exponential value for PE clients. They can provide support at each stage of the investment life cycle, by working with portfolio companies to provide research and analysis of varying degrees of complexity within a highly interactive model framework.
At Phronesis Partners, we aim to provide complete flexibility and bandwidth to our clients in the Private Equity Industry and support them at each stage of the investment value chain starting with identifying high quality investment opportunities to enhancing their portfolio performance with the objective of deriving maximum value at the time of Exit.
Author: Prateek Gupta – Financial and Private Equity Research Services