Private equity: capital deployment strategies
September 2019 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2019 Issue
In 2018, the global private equity (PE) industry continued to make deals, pursue exits and raise capital. Limited partners (LPs) remain committed to investment in funds and portfolio companies alike, and continue to provide fresh capital as part of new fundraisings.
Heavy competition across all asset classes has seen seller valuation expectations pushing deal multiples to historic highs. For general partners (GPs), putting record amounts of capital to work has led to the exploration of non-traditional asset classes and a requirement to be creative across capital structures while identifying targets and planning for the worst against the backdrop of Brexit and the tariff wars between the US and China.
Funds are therefore continuing to further diversify into credit, real estate, infrastructure and growth investments. Larger funds are creating more strategic funds with lower return expectations and longer hold periods, as well as smaller funds addressing smaller cap transactions. PE dry powder has been on the rise since 2012 and hit a record high of $2 trillion at the end of 2018.
More liquidity in the market, coupled with a limited number of attractive assets, means competition for assets is fierce. This impacts the acquisition process on any auction or bilateral deal. In order to successfully acquire attractive assets, PE buyers must transact within a tight timeframe and on seller-friendly terms, with limited seller recourse and more aggressive pricing structures. Consequently, PE funds have to be creative to ensure capital is deployed in a timely and effectively way.
Trends in the PE market
Buy and build strategy. Larger funds are beating strategic buyers at their own game by executing large-scale strategic mergers that create value out of synergies and combined operational strength and by implementing more ambitious buy-and-build strategies. Such structures allow GPs to justify the initial acquisition of a relatively expensive platform which can then act as a foundation for further strategic add-on acquisitions that can be acquired for lower multiples as part of a longer-term focused strategy. Further strategic acquisitions have the effect of reducing the overall acquisition cost of such platforms. However, optimising the implementation of a buy-and-build strategy requires GPs to adapt and diversify traditional investment approaches, as well as familiarising investors with longer-term hold strategies.
Portfolio equity minority stakes. Consistent with the need for PE sponsors to seek alternative opportunities for capital deployment and value, there has been a significant increase in the volume of minority investments and partnership structures by PE sponsors over the course of 2018 and this is expected to continue. Throughout this period, we have continued to see the invocation of alternative capital structures, from pure common equity investments with certain control or veto rights as well as preferred equity or debt-like structures with limited governance rights but with the ability to participate in equity returns, through warrants, for example.
A seller in a minority deal may be looking for more than a financial return and may be more interested in investment by firms that also have a deep knowledge and network to expand its business internationally and willing to cede certain control and veto rights in order to obtain the investment, particularly where there is the opportunity to potentially obtain step-up economic and control rights over a longer-term horizon.
In addition, the hunt for valuable assets has led to a renewed interest in founder-led and family businesses which often lend themselves to partnership capital structures. This trend has been particularly visible in central and eastern Europe and the Middle East where we have continued to see a growth in transactions of this type. The desire of founders to retain an ongoing interest in trophy assets over the long-term has also complemented the growth of funds focused on long-term holds and the continued increase in activity of historically passive investors, including pension funds and family offices.
The growth of strategic partnership investments is another example of PE using the capital structure and opportunities to take advantage of trophy assets and set themselves apart through expertise rather than just buying power.
GP equity minority stakes and LP transfers. We have seen in the past few years, GPs and LPs taking direct minority stakes in portfolio companies with increased frequency. In addition, traditional PE firms like Bridgepoint are selling minority stakes in themselves. Firms like Dyal Capital and Blackstone are raising billions for ‘fund of firms’ vehicles dedicated to buying portfolios of GP minority stakes. This market for GP minority stakes is a natural extension of a mature PE market. Selling GP stakes this way means firms can deploy further capital to fund growth initiatives. For the investor, striking a close relationship with a GP can result in better terms for the firm’s primary fund as well as direct co-investment opportunities.
In addition to the growth in transfers of GP stakes, we have witnessed an increased frequency of transfers of LP interests by PE sponsors. These transaction structures are being used creatively to allow sponsors to retain trophy and high-growth assets, avoiding potential negative investor sentiment regarding so-called ‘pass the parcel’ transactions, and to hold portfolio assets for longer periods and in order to ensure strategic alignment between sponsors and investors.
Co-investment opportunities. In recent years, PE funds have had to change tack in order to meet the demands of investors and give themselves a competitive edge. In the industry’s early years, it used to be that funds could rely on financial engineering to achieve returns. One of the most striking developments in recent times has been the collaboration of sponsors with strategic investors. This has come in two forms: (i) giving LPs direct access to deals as co-investors, thereby increasing a PE fund’s firepower and ability to complete larger deals; and (ii) bringing in corporate co-investors on buyouts, again increasing financial firepower and bringing valuable industry knowledge to the portfolio company and a potential suitor to exit to in the future. In addition, LPs have come to seek greater levels of co-investment as a means to improve investment performance by reducing management fees.
Direct lending and alternative capital growth. 2018 has been notable for the continued growth of transactions funded through leverage provided by debt funds rather than from traditional sources of loan finance. The ability of debt funds to offer more creative structures and leverage multiples in excess of those provided by banks, coupled with the increasing amounts of investor capital being deployed within debt funds, means that this trend is expected to continue. Given potential economic headwinds, the rise of direct lenders is expected to enhance momentum in deal flow, even if traditional financing sources become unavailable, or where the leverage available from such sources decreases.
However, the ability to obtain enhanced leverage, along with the ability of sponsors to cherry-pick advantageous debt terms in a competitive market could, in the context of significant economic upheaval, feasibly lead to an increase in defaults and associated work-out scenarios, particularly with regard to assets which have significant exposure to macroeconomic trends.
Take-private transactions. In the last two years there has been a considerable increase in interest in take-private transactions across Europe. We expect this to continue. More than half of the successful take-private transactions in the UK in the past two years have been sold to PE sponsors.
In the first quarter of 2019, key stock indices lost gains made throughout 2018, which will provide PE funds with an opportunity to focus on certain undervalued assets, particularly publicly-listed companies experiencing stock price decline.
While the requirement for the ability to control their investments will continue to represent a roadblock for traditional PE sponsors, the amount of capital available for deployment, together with the rise of non-traditional equity investors, provide positive indications of the potential for the return of strategic minority investments into public companies, so-called ‘PIPE’ investments.
Subscription lines. While subscription lines offer GPs the opportunity to act quickly in an auction by avoiding the need to wait for investor commitments through a capital call process before a transaction can be completed, the use of subscription lines, and the increase of the use of subscription lines for longer-term bridge financing purposes, continues to be a contentious issue from an investor perspective. This is where loans to GPs are secured against investor commitments and have the potential to improve returns through financial engineering rather than the quality of investments by the GP. The internal rate of return on which PE fund managers are commonly judged is sensitive to when PE investors’ cash is put to work. Subscription lines allow fund managers to draw down from their investors at a later date, improving the fund’s internal rate of return (IRR) in the process. Accordingly, it is expected that investor pressure for more rigorous control on the use of subscription lines in fund documents will increase and, with funds focused on long-term holding periods, for the use of multiple-of-money investor return metrics, alongside or in lieu of IRR metrics, to continue to grow.
Growth equity. The rise of growth equity in the past five years is striking. Since 2014, some $367bn has been raised globally for growth equity and for many larger PE funds this pool of capital offers a way to focus on fast-growing companies and achieve a return without the need for high leverage multiples. Growth equity occupies the space between buyouts which focuses on companies with years of proven cash flow and profitability, and venture capital which invests in start-ups that are generally yet to generate earnings before interest, taxes, depreciation and amortisation (EBITDA) and are still in development mode. Growth equity is closer to traditional leveraged buyout funds and this is why we are starting to see larger established funds set aside pools of capital for growth equity deals.
While fundraising trended down in 2018, in line with a weaker exit market and lower distributions to investors, the amount of dry powder available is at a historic high and must be put to work. As a consequence, this dynamic means that deal making activity is likely to remain robust and competitive into 2020, as managers continue to navigate a highly competitive and well capitalised PE market.
We should therefore expect the trend of increased asset prices and seller-friendly terms to continue, along with further diversification by GPs looking for new avenues in which to make returns from their increasing amounts of committed capital, even in the face of economic headwinds. That said, global events may also provide significant opportunities for investors to acquire distressed assets at advantageous valuations, as well as rewarding those sponsors who are implementing creative and innovative investment strategies.
Ross Allardice and Markus Bolsinger are partners and Mark Evans is a senior associate at Dechert LLP. Mr Allardice can be contacted on +44 (0)20 7184 7362 or by email: firstname.lastname@example.org. Mr Bolsinger can be contacted on +1 (212) 698 3628 or by email: email@example.com. Mr Evans can be contacted on +44 (0)20 7184 7384 or by email: firstname.lastname@example.org.
© Financier Worldwide
Ross Allardice, Markus Bolsinger and Mark Evans