Background

Global private equity market continues its ascent. Buoyant leveraged global buyout activity is being sustained generally by a combination of: 

In 2018, we saw the largest number of private equity backed buy-out deals in the past 10 years – over 5,100. Dry Powder in 2018 amassed a total of US$1.14 trillion¹ and high levels are expected to continue, with no imminent slowdown. 

The total capital committed to the funds that closed over the last 12 months fell by 28% to US$358.25 billion in 2018.² Despite this, there is certainly cause for optimism on the fundraising front especially given the inherently cyclical nature of the private equity market.

While observers are pointing out to a number of headwinds that could impact and diminish private equity investment in 2019 such as trade frictions, slowing worldwide growth, high purchase price multiples, volatile equity markets, the dramatic slow-down in Chinese external investment and the rise of regulatory restrictions in cross-border investments, most of these headwinds were at work during 2018. There are, however, some new issues: the very real possibility of a "no deal" Brexit and some fairly significant tremors in the credit markets. Given the continued low interest rates, the dry powder waiting to be invested and to a large extent, the absence of other higher yield alternatives for credit investors, we still expect private equity to be active and robust during 2019 though perhaps not at record levels.

While we continue to be optimistic, high valuations combined with record amounts of dry powder means it remains a struggle to put that capital to work effectively and in turn, requires a more creative approach by sponsors to investing money. Funds are increasingly looking to deploy different pockets of capital for different purposes and in doing so are transforming relationships with portfolio companies.

We are seeing this creativity in a variety of ways:

Platform Acquisitions and Specialization

Funds are turning to a mix of tactics and strategies to source deals. Private equity firms are increasingly turning to creative deal structures as a means to cope with competition for deals and the need to pay higher multiples. 

GPs are being more selective and gravitating towards platform deals and thus add-on’s for several reasons. Funds can use them to execute buy and build strategies that turn smaller companies acquired at lesser multiples into a large enterprise with a premium valuation. They allow funds to take advantage of synergies to underwrite higher asset prices and can give management a bigger remit to manage. 

Corporate carve-outs accounted for around one in 5 deals in the US and Europe over the past few years. This trend should continue to provide steady deal flow for private equity funds generally as:

• there have been a number of large scale vertical mergers announced (AT&T as an example) which usually means non-core assets will be ultimately sold or assets forced to be divested by regulatory authorities;

• activist corporate shareholders call for disposal of non-core assets; and

• companies’ own decisions to rationalize and get smaller and more focused.

Increasingly private equity firms are placing calculated bets in areas aligned with their knowledge and will go one step further in creating their own start-up businesses with their own bespoke management teams. Funds are not just managing and adding value to existing organizations, they are now creating their own strategic players in the market place (i.e. Blackstone and GIC’s investment in Thomson Reuters Financial and Risk business now rebranded as Refinitiv).

Minority Investments 

In another response to the heightened competition for deals, we have seen an increase in joint ventures and minority investments. 

Conventional funds who were once focused on control are now willing to take minority positions alongside existing owners, sometimes as a bridge to full control or as a strategy for a future IPO. While such arrangements do not give private equity full control over purchased assets, they give the portfolio company capital to grow their operations enabling PE to return that value to investors at a later date. Given increased specialization by private equity funds, non-control investments can potentially pave the way for a full acquisition at a later date. The PE funds can build relationships with fellow shareholders and management by pooling their sector knowledge and can therefore influence corporate decision making going forward. 

Co-Investment Transactions

While GP’s have typically joined forces on the larger deals to (i) meet valuation expectations and share risk, and (ii) reduce auction competition, we expect to see more corporate/PE collaboration and traditional Fund LPs’ take advantage of a growing direct co-investment market. 

Institutional investors commonly pursue the direct co-investment strategy to reduce management fees and carried interest payments, and the sheer demand for certain funds, which have limited space for capital commitments, makes co-investments a fitting solution. It also means that funds collaborate with their own investors, valuable long-term partners, rather than with competing buyout houses as they have historically done in the past. However, there are growing examples of former LPs re-modeling themselves as conventional buyout houses, in some cases circumventing GPs and representing a new source of competition. 

Long Term Hold Funds

Another trend taking hold in the PE market is the growing popularity of long-hold funds,³ a strategy employed in recent times by firms including Blackstone, Carlyle and CVC Capital Partners together with new players such as Core Equity Holdings and Castik Capital. Due to the limitations of traditional fund structures, fund managers are often forced to sell well performing, familiar assets within seven years (or sooner) in order to distribute proceeds to LPs and to raise follow-up funds. 

Long-term funds, meanwhile, can hold assets for upwards of 10 years, and offer more flexibility, as GPs can consider deals that conventional funds may not have the appetite to invest in, particularly where value creation is expected to be protracted.

Secondly competing with corporate buyers, funds may need to act more like corporations and extend the duration of their investments. Doing so would give them more time to integrate add-ons and transform the assets. 

Finally gone are the days of investing passively and simply trusting management to get the job done. Given current asset prices, rapidly changing markets and the need to transform the value of assets acquired, funds are now getting more involved in the management of the businesses and they will have to if they are long term fund plays. This close attention is more attractive to founders wanting a long term partner.

Conclusions

Private equity firms that were once focused on generating value from a limited range of activities now have a much wider variety of strategic options to choose from. This is helpful in a global market which does not appear to be slowing down (both in terms of committing capital and valuation expectations). 

Private equity funds are acting more and more like entrepreneurial corporations across various sectors to better understand the business opportunities and challenges within the sector in which they invest in. They want to hold assets for the long term rather than playing “pass the parcel” with other GPs. Founders are generally more receptive to this long term view. GPs are far from just asset management entities and will work hard to create value by being a “partner of choice.”

For private equity then this is an exciting time. In 2019 we expect to see private equity funds continue to be creative in the manner in which and where they are investing capital in the corporate structure.