After a sharp drop in buyout deals following the global financial crisis, PE firms quickly landed a steady stream of new deals, with only minor year-to-year ups and downs.
In 2016, global buyout activity lagged 2015 levels: The number of deals declined 18 per cent, and value dropped by 14 per cent.
Volatility in equity markets early in the year, caused by factors ranging from China’s stock bubble burst to a drop in oil prices to uncertainty in Europe regarding Brexit, dampened buyouts. And persistently high asset prices throughout the year inhibited deal making, as noted in consulting firm Bain & Company’s newly released Global Private Equity Report 2017.
Simmering just under the market’s surface, general partners (GPs) grew even more frustrated with not finding and closing enough good deals. A recent Preqin survey of buyout GPs in late 2016 reported that 90 per cent of respondents expect to deploy the same or more capital in PE investments in the coming year, yet almost 40 per cent expect it will be more difficult to find attractive opportunities.
Supply of assets is not the problem. A healthy number of assets – large and small – have been coming on line in a variety of flavours, such as public companies being taken private, carve-outs of assets from large corporations or PE firms regularly scanning other firms’ portfolio companies for potential buyouts.
Demand is strong as well, driven by large stores of dry powder and cheap debt. Committed but undeployed capital rose to a record level of $1.47 trillion in 2016. Of that amount, $534 billion was earmarked for buyouts – a 13 per cent increase for the year and a ten per cent CAGR since 2012. By year-end, PE firms in every region had refilled buyout coffers faster than they could put capital to work.
Investors also found plenty of debt available to ride in tandem with their equity stakes. Particularly strong was the market for speculative debt, including leveraged buyouts, motivated by the search for higher yield.
With ample dry powder in the wings and debt readily available to ignite the powder, what makes crafting the deal so difficult?
The crux of the problem lies in high and rising prices, combined with intense competition for assets – all at a time when the threat of recession looms larger and throws those prices into doubt.
Resilient PE markets have provided a floor on sellers’ price expectations. Acquisition multiples reached record or near-record highs across the US and Europe, at more than 10 times EBITDA in both regions at the start of 2016.
In a recent Preqin survey, buyout GPs overwhelmingly cited deal pricing as the biggest challenge facing the industry.
Recession on the way?
The new wrinkle is that every month brings us closer to what many consider an inevitable next recession. Assumptions that GPs now build into any deal model for market beta – future multiple expansion, GDP expansion, leverage – have turned more bearish. GPs find it increasingly difficult to pencil out how assets bought at high prices today will achieve targeted returns.
GPs also face stiff competition from deep-pocketed strategic acquirers leading an M&A boom and limited partners (LPs) doing direct investments, with each group amplifying demand that keeps prices high. Corporate buyers have a different intent than GPs.
At a time when organic growth is hard to come by, they are willing to pay higher multiples for assets they view as strategic or that will lead to synergies and help fuel growth.
For example, Canon outbid KKR and Permira to buy Toshiba Medical Systems in 2016, paying close to $6 billion for a company generating operating profit of $160 million.
Although the ranks of LPs investing directly on their own remain small, their lower cost of capital and subsequent ability to pay a higher price make it difficult for PE firms to compete with them at auction.
Persistently high asset valuations and stiff competition from corporate buyers and direct investors will continue to make deal making challenging for the foreseeable future.