Bain & Co., a consultancy to the private equity industry, has issued its Global Private Equity Report 2017.
One central theme of the report is that prices of desired assets aren’t merely high, they are “structurally high,” and thus likely to remain so. They are high because there is a lot of demand for them, in the form of “dry powder” looking for use. Further, “while caution about interest rates remains, there is a general expectation that debt will remain affordable,” so leveraged deals remain doable.
The high prices eliminate any margin for error. Investors have to pick winners, they have to develop their investment theses and they have to underwrite the associated risks.
In the words of Hugh H. MacArthur, Bain’s head of global private equity, in a preface to the report, the future for this industry “:is coming into higher definition, and it will favor those investors who understand acutely what they do best and how to capitalize aggressively on their strengths amid macro uncertainty and fierce competition.”
In 2016, the number and value of buy-out backed exits declined against 2015, and that was itself a decline as against 2014. But these are declines from an unusual high (caused by the passing of an elephant through a snake, the unwinding of pre-global-financial-crisis deals long on hold). Once the snake did process the elephant successfully, decline was to be expected. Seen in that context, the numbers from 2016, assets sales of $328 billion in disclosed value from 984 deals, adds up to “an extremely strong run – indeed, by value, the industry experienced its fourth-best year ever.”
In North America along the number of exits was 437, with disclosed value of $182 billion.
Public Versus Private
In Europe, on the other hand, “many deal processes stalled” in 2016 due to Brexit, issues concerning migrants, and the rise in the amount of sovereign debt and all the uncertainty generated by such matters.
It is good that private investment markets are as strong as they are, because firms that want to get access to the public markets via an IPO will find the situation “challenging.” The biggest IPO in 2016 was that of a Chinese concern, ZTO Express, backed by Warburg Express. Since there exists a large backlog of companies looking to go public on China’s exchanges, ZTO went public on the NYSE.
As a whole, though, IPOs dropped 40% by count and 48% by value from 2015 to 2016.
Some exits come about because of follow-up sales of shares of companies that had been brought public in earlier years. For example, the Carlyle Group acquired a paint company, Axalta Coating Systems, in 2013. It took Axalta public in 2014. Last year it sold its remaining stake in Axalta in two placements.
Follow-on sales value was more than twice the IPO value for buy-out backed companies in 2016.
But let us return to the issue of all that “dry powder” mentioned above. As Bain’s paper observes, committed but undeployed PE capital reached a record level of $1.47 trillion in 2016: $534 million of that was earmarked for buyouts. “By year-end, PE firms in every region had refilled buyout coffers faster than they could put capital to work.”
The powder will find employment over time. More than three quarters of that undeployed capital (78%) was less than three years old at the end of 2016. An impressive 92% of it was five years old or less. So … money just doesn’t sit around. That fact itself indicates that demand for the assets this money is expected to buy is and remains high, hence the structurally high prices.
Macro Concerns and High Tech Valuations
Closing deals is complicated by a macroeconomic fact. The world seems to be in the late stages of a boom, so each month that passes “brings us closer to what many consider an inevitable next recessions.” Buyers have to factor this into their models in trying to figure out “how assets bought at prices today will achieve targeted returns.”
A final point: under the circumstances there might be some reason to worry about a bubble, especially in the somewhat opaque world of high-tech, where the big money is to be made by the next stroke of inventing genius. And, indeed, the paper acknowledges that tech deals are now trading at a premium. But it is not a bubble, we’re assured. “There is convincing evidence that the current levels of deal activity and prices are supported by underlying business fundamentals” rather than “fluff.”