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For private equity, last year was a rocket ship. Five years of record-level fund-raising left the industry flush with capital: So called dry powder – uncommitted funds sitting ready to invest — hit a record high of $1.7 trillion. And for good reason. Even if PE firms found something to buy, chances are it was pricy: Buyout purchase price multiples rose to new highs. Meanwhile, with nearly 8,000 PE firms registered globally, the challenges to standout continue to grow.
So what’s next for Private Equity? How should GPs think about fundraising, investments, exits and more? What role will technology play – how can GPs be sure they’re not investing in the next industry to be disrupted? And what about LPs – what questions should they be asking as they look for new and better places to seek returns?
To find out, I spoke with Tim O’Connor, Partner in the Private Equity Group at Bain & Company about the industry and the firm’s Global Private Equity Report 2018.
Chris Riback: Tim, thanks for joining me. I appreciate your time.
Tim O’Connor: I look forward to talking to you today.
Chris Riback: I’ve read the Global Private Equity Report from Bain and clearly 2017 was crazy in the extreme for you and really the whole industry. Thank goodness we’re now in 2018 and everything is calm. Can I assume that you’ve been able to vacation straight through since January, nothing to do this year?
Tim O’Connor: I think it’s been even busier than last year, as my five kids can attest.
Chris Riback: I’m sure they can. How is that possible?
Tim O’Connor: I think there’s a confluence of reasons why that’s the case. I think there is a huge capital overhang in terms of money that’s been raised by funds that’s still looking for a home to put to work. You’ve got a continued good economy. You’ve got a nice set of financing sources ready and available to lend money to companies. And so that’s meant purchase prices are high, and so that means there’s a steady stream of assets coming for sale because they can earn good returns on those assets.
Chris Riback: How does that tension or that pressure play out? Money looking for homes, good economic business environment, homes then looking for money because of the factors that you just described, but then prices being high. How are you sensing the evaluation around valuations?
Tim O’Connor: I think the supply/demand imbalance means that prices are at an all-time high. End of last year the average company was selling for 11.2 times and that was the market clearing price. We work with 78% of equity capital globally and have co-invested alongside our best clients and so have understood market clearing prices, and the average clearing market IRR has gone from the mid 20s to about 18%. So returns have been competed down. I think a lot of people look at private equity as an asset class, but I think it needs to be looked at in the lens of just broader mergers and acquisitions.
Chris Riback: How do you mean?
Tim O’Connor: I think private equity deal count is about 10% or so of total acquisitions that occur in a given year, and corporate is making up the vast majority. And so you’re competing against public companies where the average revenue guidance for the average company is 2x its serve market, and bottom line target is 3x its serve market. The average company only grows at GDP, but might have street guidance to grow at 2 times GDP, or 5%. And so how do they make up the difference?
They have a public currency to help them make acquisitions. And so that’s 90% of the deals that are done, are done by corporates, and private equity funds are competing for the other 10% or so. And given that and the supply/demand imbalance, what you’ve seen is that purchase prices have gone up from 8, 9 times five years ago to an average of 11.2 times end of last year.
Chris Riback: When you talk about that 10%, when you say private equity firms are competing for that last 10%, is it that private equity funds are competing against each other and only for that slice, that 10% nub let’s call it, and/or are private equity funds competing with the corporates for some portion of that 90%? Or is that simply a function of the size of the private equity fund? When you get the really massive funds that can play with the corporates, then sure they might compete for that 90% but in large part, it’s private equity fund versus private equity fund for that last 10%. How do you divide all of that out?
Tim O’Connor: So the 10% is the final outcome in terms of what they’re successful at winning. So many of the larger deals there might be corporate interest in. Some of the small niche industry deals that a mid-market private equity fund [might pursue] might not have the same corporate interest, but we have seen in a number of different sectors corporate dipping down even in terms of deal size themselves.
If I’m a consumer products company and I have a bunch of legacy brands that are struggling to grow, we have seen them dipping down in terms of a lot of these healthy on-target brands that are growing, and growing nicely, and getting them at their nascent stage sooner than they used to. Similarly a number of tech companies are stretching down in terms of deal size and finding sort of emerging companies with interesting technologies that are pretty small as well.
So you can’t split it entirely by deal size in terms of who the competitive set is going to be, but at the end of a given year, there might be some assets that only private equity funds are competing for. There might be other assets that have a mix of corporate and private equity interests. But the nets results, you know 8, 10, 12% in a given year that the private equity funds will win.
Chris Riback: And I want to ask you in a bit about one of the points you were just kind of hinting at, that technology sector and the knowledge and expertise around technology that in the report you write about private equity funds really building that into their capabilities. But on this competition point or PE firms and corporate buyers, in the report one of the things that you advise is that PE firms need to beat corporate buyers “at their own game”. How can they do that?
Tim O’Connor: One of the reasons that corporate buyers are hard to sort of compete against is oftentimes they have synergies that they are able to bring to a given deal because they have a platform company, they have an existing company that … and they might have shared costs, shared customers that they are able to leverage and pay more than somebody who is buying this as a platform investment.
And what we’ve seen in the private equity industry is that private equity as an industry is following that same strategy, in that if you look at 10 years ago, add on deal count in terms of total deals was only about a quarter of the deals in private equity industry. In 2017 it was 50% of all deals that were done, that were add-on to a platform. And the reason that industries had to do that is, with industry pricing so high, one of the best ways to average down your multiple is to buy a small tuck-in company that’s going to trade at a much smaller multiple. There might be as much as five to eight times multiple difference in terms of what you pay for a platform versus what you might pay for an add-on.
And then you might also have synergies that cause that on a pro forma basis to be even less — so very much a sort of tried and true consolidation play that many of the corporates are playing. Industry by industry subsector, private equity funds are employing the same strategy.
Chris Riback: Let’s talk for a moment about debt. On the one hand you’ve talked about the excess capital, on the other hand you talk about the amount of financing available. In the report you wrote that significant supplies of inexpensive debt have led to higher leverage and in fact debt multiples in the third quarter of last year, of 2017, started to approach 2007 levels. What are you seeing around debt multiples so far this year? And what’s your concern level, or lack of concern level?
Tim O’Connor: I think debt levels remain elevated this year, and it’s very similar levels to last year. Now even a touch higher. I think the industry has proven quite adaptable. It’s sort of working through the wave of refinancings. There was a big cliff that the industry faced from those 2006, 2007 deals, that not unscathed, but did make it through it much better than others. I think the industry has proven to be pretty adept at cost cutting.
There are certain sectors though that there’s going to be some disruption. And I think the debt levels will not be a problem for the industry writ large. A lot of the debt is covenant light. A lot of the debt is at low levels of interest. But there are some industries that are undergoing dislocation where that debt burden will prove to be a problem.
Chris Riback: Do you mind revealing which industries, which sectors, you have your eye on in terms of the disruption?
Tim O’Connor: Well, I think they’re pretty obvious, right? So I think just retail, especially, there’s going to be and continues to be a rapid growth in terms of folks that are buying things over the internet, especially with Amazon. And if you look at the share of wallet progression of Amazon Prime customers over time, it’s pretty astounding. And so it’s not only consumer subsectors, but I think there’s also a number of distribution businesses where Amazon business is going after. It’s pretty hard to compete if you’re a private equity fund against a competitor that’s valued based on revenue growth and views your profit margins as their opportunity.
Chris Riback: No doubt. Not to mention a company that can raise the price of Prime by 20 dollars and I don’t imagine they’re going to lose many subscribers even based off of that. They’ve got a machine going, no doubt.
On the tactical side, and you mentioned it briefly earlier, I want to go a little deeper with you. One area that you highlight in the report is technology. And you note “The GPs are exploring how the pace of technological change is altering industry profit pools with an eye toward taking advantage of new opportunities before others see them and avoiding pitfalls prior to investment.” That’s quoted from the report. Are GPs good at that? When you look around are they staffed in way to really evaluate future tech impacts on specific companies or sectors?
Tim O’Connor: I think it’s mixed, right? And I think we’re of the belief that it’s hard to talk about the digital ecosystem. There’s so many different capabilities that one would like to have. It’s hard to insource those. And so when you talk about, are they staffed appropriately, our view is that the best firms don’t necessarily look to sort of insource a digital expert, but they build a digital ecosystem of folks that they work with repeatedly so that they’re able to bring the best of breed to any situation, whether that’s networks of IT providers or advanced analytic vendors or other digital partners.
There will be maybe a coordinating expert within the firm that will be the person that helps to build these relationships and understand what are the best of breed advisors that they can bring to a given situation. But there’s so many different elements, especially because most firms are making investments in a vast array of industries. And so the one expert that might be good to sort of understand what are the pricing opportunities in a chemical distribution business might not be the same for a firm that’s trying to develop an omni-channel strategy for a pet retailer.
Chris Riback: Perhaps from an LP point of view, is this an area that LPs are asking about? Are they asking sufficiently about it? Do you maybe expect that this could be an area of additional due diligence as LPs think about where to invest?
Tim O’Connor: I think understanding which industries are likely to be disrupted by digital, and which funds are taking advantage of those opportunities is a perfectly appropriate line of query for an LP when evaluating a given fund. I think one could learn from history here and there are sector specific funds that were doing well and then the internet came and disrupted a bunch of business models, and a lot of the traditional media subsectors that relied on choke points in terms of distribution — which allowed for very large profit pools — had that choke point in terms of distribution to content, went away. Audiences micro-fragmented and those investments went poorly. So I think it’s perfectly appropriate for LPs to think about different funds and what the sort of risks of digital dislocation is in the different funds they’re investing in.
Chris Riback: Let’s talk about exits. The report called 2017 a seller’s market. You’ve already kind of discussed how this year, I guess like last year because of the prices companies are seeing the opportunity to come to market for sales. Does it remain a seller’s market? Is that trend holding strong? Increasing or decreasing over last year?
Tim O’Connor: I think if anything it’s slightly increasing. Last year was great, but the economy remains good. There’s another year of growth and earnings that the companies have had largely since last year. The debt financing markets still remain good. The capital overhang for buyouts is now over $600 billion. And the supply/demand imbalance means that you still have a very attractive market for exits.
Chris Riback: Let’s talk then just quickly about the guidance for LPs. There’s a list of very engaging terms that you use – looking over the hedge, walking among the zombies, picking up the pieces. In a general sense, what guidance are you giving GPs, or would you be giving GPs? Maybe talk to me about looking over the hedge or walking among the zombies. What are you kind of telling GPs they might want to be thinking about? Suggesting to GPs they might want to be thinking about?
Tim O’Connor: I think the specific portion of the report that you’re referencing just talks about deal sourcing. And so looking over the hedge, what we have increasingly seen among our private equity clients is the hedge is, think of it as the neighbor’s back yard. And we see a lot of sponsor-to-sponsor transactions where you’re looking into another sponsor’s portfolio at assets that they’ve held for 3+ years, as assets that are likely to come to market, and getting smart on those assets in advance. And depending upon the deal intermediary I talk to, as many a sixth to a third of all processes get preempted as you see different funds doing a lot of work in advance of a process so that they’re able to put forth a fully informed, fully valued bid with no outs possible that causes another sponsor to part with the asset at a very attractive price. In terms of walking among the zombies …
Chris Riback: That’s a show on A&E isn’t it?
Tim O’Connor: Yes. It seems like there’s lots of shows like that these days for some reason. But we’re identified 19 zombie funds that – zombies being notoriously hard to kill – private equity funds are notoriously hard to kill. And there’s a number of funds out there that are not going to re-raise but they actually still do have some portfolio assets. And approaching them about specific companies that you might be able to buy.
And then I think picking up the pieces, one of the single highest returning sources of private equity deals have been corporate carve outs. And there they have higher IRR than many of the other sources that we’ve looked at as we’ve done our analysis of returns by deal source. And it’s not surprising, right? So in any given corporate they’re de-prioritized for investment resources. They’re de-prioritized for management resources.
If you as a private equity fund buy them and you’re able to provide them all of the love that they did not get as a corporate, and provide them all the investment resources to go after the opportunities that they have available to them that might not have been as good as the one available to their corporate division, that might have been in a slightly higher growth market, and you’re able to upgrade their management talent by bringing in somebody who’s going to be motivated with a private equity package, we’ve seen that be incredibly effective source of deals for private equity funds that have earned above average returns.
Chris Riback: And public to private activity, also related on the corporate side. Is that something that you’re still seeing a lot of interest in?
Tim O’Connor: Yes. I think public-to-private conversions are on the upswing. Public companies tend to be bigger companies, and taking them private presents an opportunity for especially for the megafunds. And so we have seen the total value of the buyouts surge to about $180 billion in 2017. It was about twice the level of the year before. Those tend to be lumpy, and they tend to be tied with large specific deals. So if you actually look at and take out the big public-to-privates in a given year, the remainder of the deal value is pretty constant within a range — absent the financing markets going off the rails in a given year.
Chris Riback: Tim, the report states that fund raising over the past five years has been historically strong and 2017 was the best year on record for buyout funds. How long can that continue?
Tim O’Connor: I think it’s going to continue as long as returns remain attractive. And I’m a believer in the asset class and if you actually look at buyout fund performance relative public markets in all major regions over the long term, the buyout funds have out-performed. And this is even more so for top performing buyout funds. The private equity industry is not a random walk down Wall Street. We work with funds that repeatedly out-perform their peers and they have developed strategies over time and capabilities over time that allow them to earn reliably above average returns.
As we talk to LPs, LPs remain committed to the asset class and are increasing target allocations. And part of this is just simply in a low interest rate environment, they need to generate returns to satisfy either their pension holders or the endowment that they’re serving. And LPs have been cash flow positive on the private equity investments for seven years running, and have returned two dollars for every one that they’ve had to put into the industry. And so that’s just been a great fund raising environment for the private equity industry. 85% of buyouts last year exceeded their fund raising targets. More than 2/3 of them raised their fund in less than a year. And so it made for just a great environment. But that was based on historic great performance.
Chris Riback: And that opportunity is there not just for the megafunds but there’s still plenty of room for smaller players as well?
Tim O’Connor: Yes. And we’ve seen an increasing number of first time funds. First-time funds actually raising a billion dollars. Yes, they have a track record at their prior fund in order to do so, but as we talked to LPs what we find is that they are most interested in the middle market because they view the returns there as potentially even better than with the megafunds.
Chris Riback: Tim, thank you for your time and for your insights on the report and on the sector.
Tim O’Connor: Thank you, Chris. Enjoyed the conversation.