Malcolm Wren, a director in our Corporate Finance team, gives six observations on the outlook for the London Private Equity (‘PE’) market. Against the spectre of Brexit, a combination of available data and popular opinion all support London remaining the dominant financial hub in Europe.
Despite an uncertain domestic socio-economic and political climate, corporate balance sheets in London are strong and there’s a record level of ‘dry powder’ in the PE market. Factor in PE firms’ need to put capital to work within a pre-defined investment period and everything points to sustained deal volumes and plenty of competition for attractive targets in the deals market.
1) Record fundraising levels for PE
Looking back on a year of deals, it is clear that there is a huge amount of available capital in PE in particular. The last three years have all been record fundraising years for PE, with European focussed funds raising Eur €74bn in 2016 alone, according to Invest Europe.And at the end of 2017, available capital is estimated to be 40% higher than it was at the end of 2014.
This has been driven by a benign fundraising market fuelled by investors’ desire for yield, which they are seeking through investment in alternative asset classes, although there are signs this may now be tightening for some UK focused funds in light of Brexit. Some have recently been forced to make investments on a ‘deal by deal’ basis after they have failed to secure the necessary commitments to raise a new fund.
2) These trends are driving PE firms to focus on different parts of the market
PE firms are raising not only bigger funds, but additional funds that cover different or specific sectors of the market. Examples include Inflexion’s Enterprise Fund, Bridgepoint's new Growth Fund and, at the other extreme, CVC's Special Situations Fund, which is looking for 10+ year holds with much lower return requirements. Some might cynically say that this is just a ploy to drive up management fees, whilst others might say they are addressing a real need in the market.
The unpredictability of the market is being fuelled by the emergence of new investors, in the shape of family offices, new funds, funds doing deals on a fly-in basis, European and US funds opening London offices and bigger funds, dropping down to aggressively do smaller deals as a means of deploying capital. Clearly this cannot be sustainable unless there are genuine opportunities to deploy further capital for these bigger funds.
3) Capital is also available to support follow-on acquisitions
A portion of these unspent funds are for the use of existing portfolio companies to help fund their growth and there is renewed focus on buy and build as a means of driving value. This may be through acquisition but may also be through funding organic growth or geographical expansion - think Audley Travel opening its Boston office to attract US outbound traffic or Hillarys, the window blinds business, moving into carpets.
4) Pricing pressures are also evident
There is an ocean of capital chasing a limited number of good quality investment opportunities.This is driving up pricing, particularly given current strong debt markets which are themselves increasingly underpinned by credit funds. According to CMBOR (the Centre for Management Buy Out Research) average EBITDA multiples for UK buy-outs valued between £10m and £100m rose from 9.7x in 2015 to 10.9x in 2017.
On pricing deals, investors are reluctantly looking at scenarios where exit multiples are lower than entry, reflecting the current level of high pricing. The knock-on effects of this are likely to be lower returns on some recent vintage deals and longer hold periods to drive money multiples - which is ultimately what the Limited Partners want.
The competitive environment is also leading to firms making early "bets"- making an early call as to whether it's a deal they really want as well as a deal they can win. If you have a lack of conviction, at best you will come second. This is leading to even lower mid-market funds doing early work around market dynamics with an increasing propensity to commission commercial due diligence ahead of a process. It's all part of building conviction.
5) The economic outlook is also driving behaviour…
There is still clearly a nervousness around Brexit, FX and future consumer demand. This is leading some funds to focus on Continental European geographies and robust sectors - think contractual earnings rather than discretionary consumer spend. At the very least, investors will focus on any perceived FX risks or exposure to discretionary consumer spending as part of their due diligence. The balance to this is back to the weight of money point, doing nothing is really not a medium term option if you have raised a new fund or if you have the tail end of a fund to deploy.
6) There are also implications for management teams
Despite “squeezed returns”, management deals are still strong. The flip side may be longer term hold periods and management teams having to wait longer for a payout. The compounding effect of the loan notes over a longer time period can potentially impact managements’ equity returns. Management succession is also something that is having to be actively embraced given the combination of secondary/tertiary buyouts and longer hold periods.
The New Year is bringing new opportunities for the PE sector, with plenty of capital available to deploy on new investments and in follow-on investments for existing portfolio companies. The challenge is to make the most of the opportunities in a competitive and fast evolving marketplace.
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