Private equity investment in Europe

February 2013 | COVER STORY | PRIVATE EQUITY

Financier Worldwide Magazine

As the European crisis continues with few signs of recovery on the horizon, private equity (PE) buyout activity has dropped. European investments, however, can still provide significant returns and a number of firms are taking advantage of the economic climate. With many European companies struggling to refinance debt as banks pull back and the continent’s capital markets remaining largely closed, PE firms can fill the gap, raising debt funds to deploy in a cash-starved market. Those firms bold enough to enter the European market must, however, be prepared for challenges along the way.

Trends

PE investment and fundraising has unquestionably suffered since the global financial crisis, more so in the years since the onset of the sovereign debt crisis. Since 2009, a number of patterns have emerged in the PE space. “The biggest trend is that there is simply less of everything,” says Karsten Langer, a partner at The Riverside Company and a past chairman of the EVCA. “De-leveraging, regulation and investor cautiousness have reduced the availability of capital, and slow growth in Europe has driven more capital to other global regions. The sovereign debt crisis and the threat of a collapsing euro made a challenging situation even worse. Additionally, both LPs and GPs have become much more selective. GPs are being even more cautious as buyers while LPs have become much more careful and demanding investors.”

2012 saw PE buyout activity in the region slump to its lowest level since 2009. According to Dealogic figures, the total value and volume of European buyouts for the year came in at just 705 deals worth a combined $53.6bn – down from the 772 deals of 2011 which were valued at $65.7bn. The year, however, was also one of contrasting themes. While overall deal value and volume fell, a shift toward larger deals emerged. By October, 10 buyouts totalling €1bn or more had been completed, the largest of which was the €1.8bn buyout of BSN Medical. This trend was countered, however, by a slowdown in deals in the lower to mid-market.

PE exits have also suffered. IPOs have had a hard time in Europe since the financial crisis, and flotations of PE backed businesses even more so. In addition, the European environment has hindered the sale of companies between PE firms, which can account for up to half of PE exits annually. That said, some large disposals did take place in 2012, notably KKR’s sale of a 45 percent stake of pharmacy group Alliance Boots to the company’s US rival Walgreen.

On the fundraising front, funds raised more capital during the first three quarters of 2012 compared with the same period in 2011. According to Dow Jones, PE firms raised $47.8bn across 118 funds – a 20 percent increase in capital raised. Yet many funds failed to meet expectations – something of a running theme as the eurocrisis has progressed. “As capital has become scarcer, fundraising has become even more competitive, with many funds failing to close or closing below their target size,” explains Hugh Naylor, Head of Private Equity at Trinity International LLP. “That said, top performing funds, certain specialists and those that have generated a loyal LP base continue to raise funds successfully. The time taken to raise a fund has increased and LPs have gained traction in negotiating the more egregious fund terms with particular pressure on management fees. Sponsors need to be more creative – whether in offering incentives to key, early investors or defining their funds – and developing and maintaining ongoing contact with LPs has become even more paramount.” However, with PE activity stymied, firms that fail to put their money to work may be forced to release clients from their commitments after a given time, resulting in lost fees and making future fundraising more difficult.

New opportunities

Despite the challenges there are opportunities for PE investors, and multiple openings exist to generate solid returns in the coming years. Europe is the largest single market in the world and a leading region in terms of innovation, education, and other measures. For those willing to accept some risk, the continent’s economic turmoil has revealed new avenues for investment. Entrepreneurs and businesses still need funding for growth, and PE can provide much-needed capital and expertise, either through traditional equity investments, or by raising dedicated debt funds. With the role of banks more subdued than in the past, and the reliance on capital markets and alternative lenders increasing, today’s economic landscape presents investors with a unique opportunity, explains Mr Langer. “This reshaping of banks’ lending portfolios creates an opportunity to buy whole portfolios of loans to good mid-market companies, which benefits all parties: banks achieve lower leverage ratios to meet stricter regulatory requirements, companies get a new lender with an interest in helping to fund the company’s growth, and the new lenders get an opportunity to invest in good companies on attractive terms. Many of the world’s largest companies were created during times of economic difficulty. PE investors find those that are able to thrive in these times and help them be even more successful.”

Unsurprisingly, perhaps, investors have tended to gravitate towards businesses with a stable demand in the healthier economies of northern Europe, including Germany and France, though regulatory uncertainty and the demonisation of PE in the media has dampened enthusiasm. Many buyout groups are channelling money into previously less popular regions like Scandinavia, which are now viewed as relatively healthy, but wherever there exists strong, cash-generative businesses, the competition is intense.

In Central Europe, PE firms have remained confident and dealmaking has continued. October saw Advent International win a bidding battle for Polish retailer EKO, taking a 97.98 stake in a public-to-private deal. The same month saw Mid Europa Partners announce the acquisition of laboratory diagnostics company Alpha Medical, before buying vitamins, minerals and dietary supplements manufacturer Walmark in December. In addition, Abris Capital Partners was active in Poland and Romania, closing deals in the financial services industry.

Investors have naturally been more cautious about southern Europe, due to concerns over the macroeconomic climate and low growth expectations. For those willing to take the risk, however, southern Europe can prove an attractive buying opportunity – though not one for the faint-hearted – and there are signs that investors may be returning to southern shores. Bain Capital recently paid €1bn for the Spanish call-centre business Telefónica and, in December, Clessidra made an offer for the Italian commercial broadcaster Telecom Italia. Acquisitions in the region have proved successful. At the end of 2011, for instance, Portugal’s NewVision was acquired by the Riverside portfolio company Tensator. Since that time, the firm’s sales have doubled.

Despite depressing general interest in the region, the European crisis has clearly uncovered opportunities for PE firms willing to take the risk, but while one may expect that firms in distress would prove a major haul for investors, the reality is that such assets have not provided the easy investments that many expected. This is due in part to political intervention. Europe’s politicians have provided financial institutions with billions of euros of support, relieving some of the pressure of increasing loan defaults. Given the funds they have plunged into European business, banks continue to dictate the terms of asset disposal and tend to begin with those of the highest quality, working their way through the books to lower quality assets which can be bought ‘at value’. Banks have also asked for offers on assets, based on financial information, without revealing the names of some firms, and have required investors to take some ‘rotten’ assets with others where they see value. “While there have been a number of distressed opportunities, the anticipated flood of ‘good businesses with bad balances sheets’ has not materialised,” says Mr Naylor. “Banks have tended to avoid painful write downs by extending sub-performing loans and retaining recapitalised businesses on their balance sheets. Impending changes in capital adequacy requirements should provide a strong incentive for the banks to dispose of such assets but the Basel Committee’s recent decision to soften the impending Basel III capital adequacy rules may further delay this.” Distressed sellers may well be holding out in the hopes that the economy will improve, and are reluctant to sell to private equity firms unless it becomes absolutely necessary.

Risks and strategies

For those eager to take the plunge, the nature of the European economic crisis undoubtedly means that acquisitions in the region come with a significant element of risk. PE firms would be well advised to tread cautiously and must take the time to understand the market they are entering – a fact which may have been forgotten in the once relatively safe markets of Europe. While regulatory fears are a major factor, the overriding issue remains the euro, though the creation of the European Stability Mechanism has provided a degree of short-term comfort. “Some longstanding macro certainties are changing,” explains Mr Langer. “The need to address the deficit and public debt issues is causing some traditional markets, like those for government-sponsored services, to change. Financial liquidity is reduced among traditional financial intermediaries like banks, but new lenders have emerged and some ultimate investors such as family offices are playing a more active role. Europe as a whole is expected to continue to be a low-growth environment for the coming years. But there are individual regions and sectors, or businesses within sectors, that will continue to perform very well due to innovation or counter-cyclical characteristics. Being able to identify these is crucial.” In addition, says Mr Langer, a major change has been the way in which deals are financed, although this is more noticeable in larger deals where significantly more equity is now required. For deals below €100m in equity value, the impact of leverage decline has been less marked, but leverage multiples have dropped from around four times to three times EBITDA.

In light of the difficult conditions, PE firms have employed new approaches to getting deals done. Acquisitions now require a much more cautious approach, and a characteristic of the transactions completed in the past few years has been the time put aside for their completion. Deals in the current climate take longer because they require more thorough due diligence. However, this leaves greater scope for arguments over price, and sponsors are increasingly weighing the need for the seller to sell as part of their diligence, notes Mr Naylor. “Creative techniques are being used to bridge valuation and financing gaps such as vendor financing, earn outs and deferred payments, as well as partial sales, enabling the seller to retain an equity stake. Sellers, while still using auction processes, are often pre-marketing businesses to gauge buyer appetite and price ranges, with the disposal remaining confidential. The twin-track process, where a trade sale and an IPO are run in tandem, remains popular, notwithstanding the fickle nature of most European stock exchanges, though the costs means that this is only really appropriate for the higher end of the market.”

The future

What then is the future of PE activity in the region? At the opening of 2013, what can we expect for the year ahead? Mr Naylor’s prediction is mixed. “As long as uncertainties remain about the euro, M&A activity will remain slow, with LPs and international sponsors focusing on opportunities elsewhere, particularly in developing countries and the US,” he says. “For domestic funds not exposed to currency risk, opportunities remain but over-performance needs to be generated by management improvements rather than leverage or multiple arbitrage. There remains massive overcapacity in European private equity and to date, with limited exceptions, there has been little in the way of consolidation. Given the long term nature of private equity funds, many sponsors will simply wind down their fundraising activities and go into long term run off, living off the annuity created by ongoing management fees. Unless political and economic risk begins to bottom out, it seems PE activity could continue to suffer.”

But despite any major shift in the European economic landscape looking unlikely, Mr Langer retains some optimism for the role of PE in the immediate future. “The macroeconomic environment will continue to be relatively unfavourable, and deal selection will continue to be very important, but PE will remain an important form of ownership for private companies, so activity will increase slowly as the market gains confidence. PE has demonstrated its ability to be a better owner of businesses, helping them survive and grow, and many business managers will want to access this source of capital and expertise. PE funds and related debt funds will provide an increasing share of debt to mid-market private companies.”

Conclusion

Though PE investment in Europe has stalled in recent years, given the political and economic atmosphere of the region, it has proved relatively resilient. And, given the success of fundraising, there are clearly many who see opportunities in the market. It is an uncertain time, but perhaps it is the right time to act. As William Conway, co-founder and chief executive of the Carlyle Group, told Bloomberg, “it is precisely in times like this, when economic data and markets are sending confusing signals, that the best investments can be made.” While most continue to steer clear of Europe, there is evidently the potential for huge profits for investors who step where others fear to tread, and, even if only for the sake of maintaining a diverse portfolio, European private equity should continue to play a meaningful role.

Matt Atkins