The PE industry’s agility and resilience in adapting to the adverse market conditions of the last two years will serve it well as the market continues to recover. So far, the outlook for 2010 is positive, with leverage returning to some markets, the value of acquisitions increasing and exit opportunities on the rise.
We expect the following trends to emerge in 2010:
A more robust market with larger acquisitions and more exits.
Through March 2010, the disclosed value of global PE acquisitions rose 59% from $17 billion in 2009 to $27 billion, with the average deal size increasing from $70 million to $157 million. The pace of acquisitions should continue to climb through the remainder of the year as industry dynamics improve. With larger equity contributions, limited financing options and lower lending multiples expected to continue through 2010, acquisitions will be markedly smaller, compared to the prerecession peak of $706 million reached in the second quarter of 2007. The pace of acquisitions should continue to climb through the remainder of the year as industry dynamics improve.
That said, acquisition size should steadily increase as the global recovery gains strength. Dealogic data suggest the disparity between acquisition and divestiture size is greatest in weaker markets, when PE firms have opportunities to make smart acquisitions at bargain prices. Similar to 2001, in 2009, the price of the average acquisition was $100 million, while the average divestiture fetched $321 million. Comparable figures for 2006 were $424 million and $396 million, respectively. This suggests the gap between the average price PE firms pay for new acquisitions and the price they receive on divestitures will narrow as the economy improves.
Portfolio company bolt-on acquisitions exhibited some activity last year and appear to have picked up this year, as PE firms seize opportunities to purchase weaker competitors as well as non-core businesses that corporations look to sell. More corporate trade sales are expected in 2010 as the market fundamentals for buyouts continue to improve.
A key question lingers as to what banks – particularly government-owned banks – will do, now that they own a substantial number of non-core businesses. Following prior recessions, PE firms were often the preferred buyers of such companies, but so far, there is little evidence that history will repeat itself.
PE-backed exits are on the rise. Globally, there were 104 trade sales through 29 March 2010, including some high-profile secondary sales in Europe, compared with 78 for the full first quarter of 2009. While there was one IPO in the first quarter of 2009, 22 IPOs were listed in the first three months of 2010. Should this momentum continue, PE exit activity in 2010 will end the year significantly higher than in 2009.
Improved financing and liquidity.
Lending multiples are slowly increasing as banks return to financing buyouts and relax restrictions on leveraged loans. Standard & Poor’s reports that lending multiples for PE acquisitions averaged 4.1 through February 2010, up from 3.9 in the last quarter of 2009, with some banks recently lending up to five times EBITDA, a level last seen in 2006. While the lending pool is constrained in many parts of the world, in other areas, including the Nordic countries and the US, lending practices are returning to normal, with stapled financing and dividend recaps in the US, reminiscent of 2006. However, equity contributions are likely to remain closer to the historic high of over 50% than the historic average of 33%. Equity-only transactions continue to occur, but with the understanding that the acquired company will be refinanced within a year, creating a more typical buyout capital structure.
With the US Fed committed to keeping interest rates near zero for the rest of the year, investor demand for high-yield bonds should continue to be strong, making it likely that the wave of portfolio company refinancing started last year will extend through 2010.
Two factors could limit leverage for new acquisitions in 2010. Should the market for CLOs remain weak, it could effectively cap the amount of money available for acquisition financing, as banks would be required to keep the loans on their balance sheets rather than securitise them. Later this year, the Fed is expected to slow the amount of new money funneled to banks, further limiting the lending pool. Since leverage drives acquisition activity, its availability will determine the degree of deal momentum in 2010.
Stronger portfolio companies.
For the most part, PE portfolio companies have weathered the economic downturn through a combination of revenue protection, production efficiencies, cost cutting and careful working capital management. Lower commodity prices, sympathetic lenders and opportunities to refinance – thanks to a strong high-yield bond market – have helped ease financial pressures. PE firms have also taken a hands-on approach to protecting invested capital. Many have expanded their in-house operations teams and hired seasoned executives and consultants with deep industry expertise to assist portfolio companies strategically and operationally, in growing revenues, improving operating efficiencies and boosting profits.
Firms will continue to work on improving portfolio company performance this year as they look to right-size capital structures and increase revenue prior to exiting some of the businesses purchased at the height of the last cycle. To retain management talent at these companies, PE firms will focus on repairing incentives, especially in cases where existing compensation arrangements are under water.
Smaller funds as firms deploy capital.
With $500 billion of dry powder at the end of 2009, some PE firms will not need to raise new funds for several years. However, firms marketing funds in 2010 may find it easier, as the State Street Private Equity Index has posted positive quarter-to-quarter performance since June 2009, and most studies suggest that LPs will be maintaining or increasing their PE commitments in 2010. However, there will be a price. LPs are seeking better reporting, more rigorous risk management and more favourable fee arrangements from their GPs. Innovative GPs will see these developments as an opportunity to improve their fundraising processes. The time it takes to raise a fund will be significantly longer than it did prior to the recession.
Given these trends, funds closing this year are likely to be smaller than those closing at the top of the market. Although buyout funds will continue to constitute 40% to 50% of all funds raised, growth capital, industry-focused and regionally focused funds could gain share as institutional investors sharpen their investment outlook.
Emerging markets become more important.
Emerging markets led the worldwide economic recovery and have seen their share of PE transactions increase in the last decade. They could gain a larger share of deal activity if more firms conclude that the prospect of earning better returns outweighs risks arising from political, legal and structural market uncertainties. Some analysts have even contended that emerging market investments may carry less risk than those in developed markets because many of the destabilising factors that caused the “Great Recession” either did not exist or were not as prevalent in emerging economies.
Emerging markets primarily present minority investment opportunities for growth capital, with minority stakes comprising two-thirds of last year’s investments in Brazil, China and India. Deals are typically small by Western standards and oftentimes, more difficult to negotiate. However, opportunities for control acquisitions can vary sharply from year to year, country to country. Control investments are picking up in India, and they may become more common in China as foreign-based firms form local currency funds to attract local investors with the capital and influence needed to complete transactions typically not available to foreign PE firms. Competition for funds to invest in China should remain fierce as the number of funds domiciled in China increases and China’s SWFs become more active abroad.
Infrastructure opportunities abound.
Infrastructure funds should see better opportunities and increased deal activity in 2010 as the global economic recovery continues and the effects of infrastructure-focused stimuli in China and the US begin to take hold. PE’s core skills in managing portfolio investments should make infrastructure funds more attractive than direct investments in infrastructure assets. As LPs seek investments with stable cash flows and lower risk, PE-sponsored infrastructure funds could become the “utilities” of alternative investment portfolios, generating dependable, longer-term cash flows, while growth capital and buyout funds produce larger, shorter- to medium-term payoffs. From 2005 to 2009, infrastructure funds raised $115.3 billion globally.
Industry adapts as regulatory proposals proliferate.PE firms are coming to terms with more regulatory oversight. Certain proposals, such as registration and some increased reporting requirements, are not likely to have a major impact on larger funds. However, other proposals could fundamentally affect how the PE industry operates in various parts of the world.
The EU’s AIFM directive is of particular concern. If its more controversial provisions pass, the directive could isolate Europe and reduce the size of its PE industry. By raising compliance costs, imposing stiffer capital requirements, increasing governance and transparency requirements, and making it more difficult for managers based outside the EU to market their funds in the EU, the directive could effectively limit fundraising in EU countries.
The pace of reform in other parts of the world is slower as governments focus on curtailing risks that were responsible for the collapse of the global financial system. While some reforms are likely to pass in the US, whether perennial proposals such as taxing carried interest as ordinary income make it into final legislation remain to be seen. Tax pressures on the industry are likely to rise around the world as governments seek to increase tax revenue in order to reduce large deficits brought on by stimulus spending.
Ernst & Young’s perspective As we look backward to 2009 and forward to the future, the PE industry has weathered one of its toughest economic periods. The industry’s core value proposition – using engaged ownership and aligned incentives to maximise returns for the long-term investor – remains intact, as firms scour the globe for attractive opportunities. Firms that will thrive in the complex 21st-century world will be those nimble and creative enough to seize the opportunities a difficult and uncertain economy presents. Because the PE industry has many such firms, we believe it will remain an important asset class that draws significant investor interest in 2010 and beyond.