The private equity (PE) landscape over the past 12 to 18 months can best be described as resilient, with old trends continuing to play out. Increased specialisation by size, industry and strategy, as well as consolidation among large-cap PE investors and middle market advisory firms, has contributed to a positive mood throughout the sector. Additionally, with successful exits having boosted overall returns, PE firms have been keen to launch new fundraising rounds. Going forward, the market remains vital, dynamic and lucrative for participants, with PE dry powder now at record levels.
FW: Reflecting on the last 12-18 months in the private equity market, how would you characterise recent activity and general developments?
Abelow: Old trends continue to play out: increased specialisation by size, industry and strategy, consolidation among both large-cap PE investors and middle market advisory firms, redoubled attention to improving businesses during ownership periods, and a scramble to identify how to best access alternative sources of financing to fill the void left by the withdrawal of traditional lending institutions. All of these changes are occurring within a market that remains vital, dynamic and lucrative for market participants.
Casali: In Australia, the first six months of 2015 showed high levels of deal flow, particularly for mid-market PE deals. This high level of deal activity was accompanied by an increase in competitive sale processes necessitating ‘clean bids’ with minimal conditionality. Increased deal activity continued during the third quarter, but tailed off towards the end of the financial year, with sponsors pointing to a lack of quality, appropriately priced, investment opportunities. The ongoing weakening of the Australian dollar – and US recovery – has contributed to increased interest from overseas investors, and we expect this trend to continue into 2016 with greater competition for domestic sponsors.
Taylor: The main theme of the last 12-18 months in the UK has been the continued resilience of PE exits. The period started with a strong IPO market in the UK, with PE listings including Aldermore Bank and Auto Trader. Despite few IPOs coming to market in the second half of 2015, the exit market has continued to be buoyant, with prices on trade sales and secondary buyouts remaining relatively high. One feature of the UK market has been the particular level of activity in real estate, as specialist PE real estate funds have been joined by sovereign wealth funds and pension funds. Examples include Blackstone’s £415m acquisition of Broadgate Quarter, in the City of London, Norges Bank’s acquisition of the BAML Financial Centre from the GIC, the investment by Oxford Properties, the property investment arm of Ontario Municipal Employees Retirement System, in a development in London’s West End and CPPIB’s investment in Paradise Circus, Birmingham. With successful exits boosting overall returns, PE firms have been keen to launch new fundraising rounds.
Evans: Activity in early 2016 feels slow, but this comes on the heels of pretty robust activity in 2014 and 2015. It will be interesting when we see Q1 data how active the private equity market actually was on an absolute basis. January and February are often seasonally slow, although that wasn’t true in 2015. Concerns about China and energy prices, combined with liquidity issues in the financing markets, have combined to slow deal activity, but the first two appear to have abated. The liquidity issues in the financing markets will resolve themselves, probably sooner than most people think.
Armstrong-Cerfontaine: Luxembourg is the leading PE jurisdiction in Europe and the hub for PE investments into Europe. Many structures to optimise private equity investments go through Luxembourg, placing it at the forefront of private equity activity. 2015 was generally a strong year for European PE deal activity. According to Preqin’s 2016 Global Private Equity and Venture Capital Report 3556 deals took place in 2015, in line with the average number of deals since 2011 – on average, 3660 per year. Whilst deal value increased to US$411bn, PE investments are yet to match the big tickets of 2007, US$694bn. The year witnessed corporates dominating exits, with a slight reduction of IPOs and secondary buyouts. A strong interest of Chinese investors, including state-owned investors, marked 2015. HNA Group Co.’s interest in Swissport, the sale of Vistra and Orangefield to Baring, and the acquisition by Jianguang Asset Management of NXP’s radio frequency arm, are examples of the increasingly robust presence of Chinese investors in the European market.
Scrivano: The past 12-18 months have seen most M&A activity by strategic acquirers, which were using cash on hand, debt financing or their own stock as currency in acquisitions. In some cases, due to high valuations, strategic acquirers using their own stock as currency could afford to ‘overpay’. This resulted in PE funds still doing deals, but at a lower activity level than strategic acquirers. Over the last 12 to 18 months, PE funds have tended to be sellers of portfolio companies and other assets. Given how 2016 is unfolding, and the dislocation in the equity markets, we expect to see private equity sponsors that have access to financing doing more deals and serving as an increasing counterweight to strategic acquirers. In addition, with the IPO markets being challenging, we expect that will also lead to buying opportunities for PE funds.
“Concerns about China and energy prices, combined with liquidity issues in the financing markets, have combined to slow deal activity, but the first two appear to have abated.”
FW: To what extent have private equity firms exercised restraint in the deployment of capital amid high asset valuations in recent months? How does this align with the typical annual pace of capital deployment?
Taylor: UK PE firms do seem to have taken on board the harsh lesson of overpaying in the lead-up to the global financial crisis (GFC). There is no shortage of potential targets, but buyers are often deterred by sellers’ pricing expectations. With stock markets riding high at the start of 2015, listed companies were able to take advantage of their lower cost of capital to make acquisitions. As stock prices recede, and given PE funds’ significant levels of dry powder, we may see the trend tipping in favour of PE funds, provided that they can access acquisition debt on attractive terms. If prices do not fall, it will be interesting to see whether this restraint will continue when PE firms are faced with either doing deals at high prices or potentially not using their dry powder. Levels of capital deployment depend on underlying economic factors, so there is no typical annual pace or trend rate. Nonetheless, given general optimism around the UK economy, and tentative growth within the eurozone, we could have expected more capital deployment in the last 12 months than has actually happened.
Armstrong-Cerfontaine: There is an unprecedented amount of dry powder for investments by private equity firms, with high competition for overpriced assets in Europe, where the economic and regulatory landscape is challenging. The overall value of money raised in 2014 and 2015 was strong but sponsors struggled to invest for a number of reasons. Firstly, they were reluctant to match the high prices asked for assets. Secondly, there is much competition for deals between well-known houses, with new players sometimes ready to pay more and corporates, all with plenty of cash to spend. And overall, fewer deals were executed. Therefore, many sponsors have been active in continuing to increase the exit value of their portfolio with add-on acquisitions of portfolio companies funded by equity, quasi equity and in some cases, partly by external financing, and some broadened their investment strategy to increase co-investments in targeted sectors. The global amount of dry powder exceeds $1.14 trillion, according to Preqin. This is not good news, either for sponsors or their investors. If sponsors keep too much money in the bank, they do not generate income from management fees and the profits of their targeted investments. This could trigger cancellation of commitments for under-active sponsors and delay future fundraisings.
Scrivano: PE funds have certainly shown restraint by not overpaying relative to the value of the asset in question. PE funds tend to be disciplined acquirers, and in many of the auctions we have seen over the past few months, strategic acquirers have been willing to stretch on price and even pay more than the typical PE fund might view the asset as being worth on many occasions. This has resulted in PE funds having a significant amount of dry powder for acquisitions going into 2016.
Abelow: A number of our clients tell us that their view on the macro economy has turned more negative, but private equity firms don’t invest in the macro economy, they invest in micro economies. As a result, the practical – and possibly perverse – effect of their increased pessimism is a flight to quality. This has pushed up the prices for the really attractive assets in the market. Businesses seen as being a-cyclical, countercyclical, or tied into cycles other than the broader economic one have been commanding outsize attention, as have, in general, more attractive businesses. During 2016 we have seen broadly distributed auctions – not narrowly shopped deals where you might expect to see this – produce bid yields off of CIMS of up to 50 percent. That is, in my experience, simply unheard of.
Casali: Our experience is that private equity sponsors, despite their funds generally being 10 year closed end funds, deploy their capital patiently. Our assessment of recent acquisitions is that they remain cautious in deploying capital in a low growth environment.
Evans: Purchase price multiples remained near record levels in 2015, suggesting that not much restraint has been exercised. However, the long-term trend of increased competition for quality companies continues to push private equity companies to be ever more resourceful in how they can find and create value. So, high multiples may be a function of greater resourcefulness rather than reduced restraint. Anecdotally, firms range from being on pace to somewhat behind typical fund investment pace.
“Our experience is that private equity sponsors, despite their funds generally being 10 year closed end funds, deploy their capital patiently.”
FW: What techniques are deal-making professionals deploying to ensure maximum value creation and the delivery of top-tier returns from portfolio companies?
Armstrong-Cerfontaine: Value-creation techniques depend on the size of the fund, its investment strategy to select the best deals in a targeted sector and region, and the selection and execution of the exit strategy to deliver superior returns to investors. What is certainly clear is that adaptability is in the DNA of private equity firms and there is an increasing understanding of the potential pitfalls of regulatory, environmental, tax, social and governance issues and that this impacts on the way the deals of tomorrow will be executed. Sustainability is increasingly presented as core to the framework of making better investment decisions, and sponsors often explain that the culture of a private equity firm is imperative to the success of the franchise. A sponsor’s due diligence includes an assessment of the portfolio company’s lifecycle and the identification of its key strategic needs. The due diligence is usually extensive and includes financial, operational, tax and market research. This exercise is key to maximising the outcome of the investment. Shortly after completion of the acquisition, it seems that the ‘real’ work begins with an incentivised management to enhance growth, margins and cash flow. This implies quite often that the portfolio company invests in growth opportunities to deliver business performance. I have not seen any magic formula applied across the board.
Scrivano: Dealmaking professionals are employing a number of tactics to maximise value creation. We have seen several deals where PE funds used an existing portfolio company as the acquiring vehicle of another public company, thereby potentially generating significant cost savings which will enhance value creation. We have also been seeing PE funds agree to increased ‘equity checks’ in recent deals, with the concurrent amount of required debt financing being correspondingly reduced. We have also seen PE funds partner with co-investors who may not be PE funds themselves – such as wealthy families or even strategic investors – as a means to decrease reliance on debt in deals. Given the current instability in the debt markets, it will probably be a while before we start seeing dividend recapitalisations again.
Casali: Alignment of interest remains the key feature of private equity transactions, and in addition to management incentives, vendor reinvestment continues to be a common feature of transactions in the Australian market. We have also seen an increase in earnout and deferred consideration provisions in transactions – reflecting the fact that PE sponsors are prepared to only pay for earnings that are proven and to be more cautious about paying upfront for forecast earnings that may not materialise. Escrow arrangements are also reasonably common, although their use in the Australian market is far less common than in Europe and the US.
Evans: PE firms continue to seek to work on a proprietary basis with experienced managers to find and create value. While the concept is not new, increasing numbers of firms are formalising their relationships with a network of ‘operating partners’. When not deployed as a CEO of a portfolio company, these relationships range from consulting or retainer agreements to full-time employment as members of the firm. The operating partners help source opportunities both through their networks and sometimes by helping develop ‘white papers’ on particular sectors that allow the PE firm to react aggressively and with confidence when an opportunity is presented.
Abelow: Some dealmakers have redoubled their efforts to acquire add-ons for their existing portfolio companies. Many of these acquisitions are intended to accumulate scale and scope, but a handful of the best are intended to be truly transformative for the companies themselves or even for the industries in which they operate. The advantages to this strategy in a market like this are clear – in a market that is still, on balance, a seller’s market, acquiring through an existing portfolio company allows the realisation of cost and revenue synergies, size arbitrage, and so on, and therefore produces, all else equal, a superior ROI to tabula rasa platform investments. Second, private equity firms that might swallow hard and pay more than they would like for an asset now have added pressure to improve it before sale, and pushing operating improvement has become a bigger part of business as usual for many funds.
Taylor: Value creation begins months or even years before the investment starts. Dealmakers conduct due diligence from public sources, speak to sellers, work up strategies and run models long before any auction process starts. This pre-planning has become more important in recent years, a trend we expect to continue going forward. The last few years have seen more of a return to the traditional model of PE funds actively managing assets during the investment period, in contrast to the practice that developed for some PE funds in the immediate lead up to the GFC of looking to sell relatively soon after buying. This more activist attitude includes close involvement in hiring, retaining and removing directors; greater attention to monitoring investments and providing specialist management services to portfolio companies, either as, for example, turnaround specialists or simply as a result of sector experience built up through previous investments. This has been coupled with a sharp increase in asset holding periods since 2008. Even where PE firms play a less activist role, their board appointees often bring a breadth of experience and understanding of the financial context of the investment that few management teams are able to provide on their own. Finally, leverage does retain a significant role in driving returns on most successful large investments.
FW: What trends are you seeing in terms of bank financing for leveraged PE deals?
Scrivano: Presently, the debt markets remain under pressure. The leveraged loan market is choppy. The high yield market is continuing to suffer dislocation, although bond deals are still being done. Some PE funds have explored and have used hedge funds as a source of deal financing; it remains to be seen whether that will be a viable alternative means of financing deals, as compared to traditional debt financing. And much of this has led to larger ‘equity checks’ in PE deals, as well as PE funds being more willing to take on co-investors.
Evans: In early March 2015 the bank financing market was weak, principally because banks are unable to hold significant loans on their balance sheet and liquidity issues in the market have made syndication so difficult. The real trend is the increasing use of non-bank sources of financing, principally direct lending funds. These funds have capital, and are eager to deploy it.
Casali: The trend to non-bank lenders in Australia is still in its infancy – estimated at only 5 percent in 2015 – but is set to grow as a result of the retreat of European banks and more onerous capital requirements for banks under Basel III. With the steady rise of the superannuation/pension industry, many non-bank lenders are superannuation/pension funds, and it is perhaps inevitable that they will make more direct senior loans to fund private equity transactions. But they are not alone, with several speciality senior loan funds currently active or planning to enter the market, including QIC Global Infrastructure, Metrics Credit Partners and Intermediate Capital Group. Borrowers will welcome this trend as it increases competition for debt, while banks gain a new category of debt providers to sell loans to without threatening important ancillary business lines. And following the exit of sizeable lenders such as GE, HBOS and RBS from Australia, it is pleasing to see French bank Natixis establish a local presence.
Taylor: Recent trends in the UK and beyond reflect the influence of the bond markets and the rise of alternative lenders, which has resulted in a convergence between leveraged loan terms offered by banks and those available in the bond markets. We have seen grower baskets providing borrowers with the flexibility to make acquisitions and disposals and incur additional financial indebtedness, including under accordion facilities, up to the greater of a hard cap and a soft cap which expands and contracts in line with EBITDA. We are also seeing covenant loose or lite terms, with financial covenants limited to one or two covenants or springing covenants applicable to RCF. Headroom is up to 35 percent, against 25 percent historically. Further, we are seeing EBITDA equity cures, as well as portability, carve-out from change of control prepayment provisions applicable to disposals to white-list investors was a developing trend in 2014 but one which declined in 2015.
Abelow: The large banks are under so much pressure from their friends in government that they have effectively ceded huge chunks of the market to alternative capital providers – direct lending funds, such business development companies as are still standing, insurance companies, even mutual fund companies. The direct lenders are upturning a lot of old assumptions about the lending market.
Armstrong-Cerfontaine: There is a clear shift toward debt funds as senior finance providers, including for larger transactions. Senior debt was, and continues to be, made available by banks, though debt funds were financed and continue to fund small to mid-size loans, up to €200m, on a standalone basis. Furthermore, debt funds also fund larger financings as they now form syndicates capable of financing large cap transactions of €500m-plus. They will be increasingly present in the leveraged finance market, given that they are less exposed to market and regulatory pressures and they can offer more attractive terms than banks. The pace of their progress will, in part, depend on the liquidity in the high yield market. Covenant loose or covenant lite terms, more common for high yield financings, are common for loans granted by debt funds. Debt funds’ financings do not include market flex and provide for a large headroom for financial covenants, generous rights to cure and little or no mandatory amortisation, and their financings are becoming ever more competitive with other sources of debt finance. Their presence on the leveraged finance market will increase, and the pace of their progress will, in part, depend on the liquidity in the high yield market.
“Recent trends in the UK and beyond reflect the influence of the bond markets and the rise of alternative lenders, which has resulted in a convergence between leveraged loan terms offered by banks and those available in the bond markets.”
FW: Although private equity deal-making activity was relatively subdued in 2015, were there any particular investments that caught your eye? What does this tell us about the underlying health, or otherwise of the market?
Abelow: While I have certainly seen published data suggesting that the middle market was not as robust this year as in years past, this is simply not consistent with our experience. We saw a remarkably active year in which both strategics and financials were active business buyers. In fact, as large cap sponsors seemed to have had difficulty deploying capital, we saw a number of very large funds appear as aggressive buyers in the middle market, further crowding that field. This is one of the reasons why in the fourth quarter, even as activity levels did seem to dip somewhat, overall valuations actually increased.
Casali: Our view is that private equity activity has not been subdued – activity levels are buoyant, particularly in the mid-market, although they are not at record highs. That said, private equity sponsors have been active in the health and medical, education and transport sectors. The diversity of sectors which have attracted private equity attention points to the fact that the market is generally healthy with opportunities across sectors and activity is not being driven by legislative reforms.
Evans: Rather than one specific deal, what catches my eye is the continued relative dearth of large private equity deals, those approaching $5bn or more. The large deals require partnering with a strategic, for example Kraft and Safeway, a significant co-investor syndicate such as in PetSmart, or the traditional club. Given the competitive environment, we should see more of these structures leading to deal sizes moving up.
Scrivano: While there were several significant PE deals in 2015, although less in number than we all would have liked to have seen, some of the deals were notable for the size of the deal – they were in the billions of dollars – as opposed to creating a new ‘deal technology’. As to the underlying health of PE, it is still very robust. PE funds have been biding their time, and will likely do deals in 2016 when strategic acquirers may be nursing hangovers for the deals they have done in the past few years where many overpaid. Some PE funds may even be purchasing portions of companies that strategic acquirers bought, as the strategic acquirers sell assets to pay down debt.
Armstrong-Cerfontaine: Rosnef’s investments through Luxembourg based LT Investments Luxembourg into Pirelli alongside China’s state-owned ChemChina for €7.1bn, the €1.2bn acquisition of Groupe Louvre by Sailing Investment Co, S.à r.l, wholly-owned by Shanghai Jinjiang International Hotels Development Company Limited, the Shanghai-listed Chinese company which is a subsidiary of Chinese state-owned Jin Jiang International Holdings Co., Limited or PAI’s discussions with HNA for the sale of Swissport continue, of course, to evidence China’s strong appetite for European brands. These deals are also a clear signal that Chinese investors, including state-owned investors, are ready to play a leading role in enhancing the market share of European companies in Asia while benefitting from a weak euro. It is also worth noting that in Luxembourg, 2015 was the year of big deals, with a widespread geographical cover. Private equity backed exits in 2015 surpassed the excellent records of 2014 for European buyout exits, with trade sales being at the core of the largest exits. This follows the trend seen in Europe as a whole.
Taylor: It is something of a generalisation to characterise 2015 dealmaking activity as subdued. Some sectors were very active, with UK infrastructure a prime example. Antin Infrastructure Partners recently acquired 99 percent, and operational control, of the CATS North Sea gas pipeline from BG and BP for a total in excess of $1bn, over two separate transactions in 2014 and 2015. This was one of the first financial investments in North Sea midstream infrastructure. It is in line with the UK government’s strategy of encouraging new value-added investment into midstream infrastructure, with a view to maximising the continuing viability of oil and gas production in the North Sea. At the customer-facing end of the infrastructure sector, USS, a UK pension fund, acquired Moto, the UK’s leading motorway service station company, from a consortium of infrastructure investors including Macquarie and EPIC. USS subsequently sold 40 percent of Moto to PE fund CVC’s strategic opportunities fund.
“It is likely that one of the more interesting trends we see this year won’t involve sector or regional preferences at all, at least not directly, but will involve the response to increased corporate distress.”
FW: Which industries do you expect to see attracting significant investment this year? Where are PE firms focusing their efforts, and are any regions tipped to be hotspots?
Evans: In a continuing very competitive deal environment, PE firms will focus on industries where they have experience. Healthcare and life sciences will continue to be key areas for many firms – the underlying macro forces are very strong, innovation is occurring rapidly, and changes in the health insurance market present opportunities. Consumer products will present opportunities and be active for firms that are comfortable in that space. China will continue to be a focus despite the currently slowing growth there, and Africa and India are increasingly being targeted for their very significant opportunities for growth.
Armstrong-Cerfontaine: Two months ago I would have suggested that in Europe the UK would remain on top of the list. But the goalposts have moved recently, as some investors have put deals on hold, waiting for the UK’s vote on ‘Brexit’. This is a huge roadblock that creates much uncertainty around potential new deals in the UK, which in turns impacts on deal flow in Luxembourg. I would expect 2016 to look quite similar to 2015, with investments in the US and Asia dominating the scene, as growth in these regions is stronger than in Europe and with investment diversified across many sectors. If competition remains as fierce as last year and there is no improvement on the pricing of the assets, corporates should continue to dominate the landscape for exits.
Taylor: Infrastructure is likely to continue attracting PE investment, given its stable pricing structure and relative immunity to short-term economic fluctuations. PE buyers are likely to stay interested in energy assets, with low oil prices creating opportunities as multinational companies react and look to divest, particularly in more mature areas of production, such as the UK North Sea, which is viewed as having relatively high production costs when compared to its competitors. We would also expect continued activity in alternative financial investments, filling some of the spaces that the larger banks exited following the GFC. Geographically, we would expect to see continued growth in African PE – and emerging markets PE in general, most notably in the TMT sectors, as PE firms look to take advantage of the growing African middle class and some of the most benign economic and political conditions ever experienced on the African continent.
Scrivano: We expect PE funds to continue to invest in industries with steady, somewhat predictable, cash flows. Manufacturing, consumer products, medical devices, software and industrials are but a few examples. The US will continue to be a hotspot. The picture in Europe is a bit less clear, although we expect continued activity in Europe. Asia appears to be in more of a buying mode than a selling mode. South America has seen some activity, although that has slowed to some extent due to downward pressure resulting from economic and geopolitical issues.
Abelow: It is likely that one of the more interesting trends we see this year won’t involve sector or regional preferences at all, at least not directly, but will involve the response to increased corporate distress. The last deep distressed cycle was only half a dozen or so years ago, which even in the financial sector is well within living memory. Too many financial sponsors are keenly aware that they failed to seize the moment then and left great riches on the table – many are resolved not to make the same mistake again. As a result, a number of firms will be making distressed-for-control investments or deploying similar strategies. Many of those that are unable to do so will nevertheless be inclined to make bolder bets on deep value than they did previously. Today, this means chasing energy and those close derivatives like shipping or mining where distress is currently over indexed, but other sectors like retail, restaurant and even some, like software, that really weren’t too leveraged historically, are beginning to make an appearance.
Casali: Private equity sponsors have been particularly interested in pursuing opportunities in the health and medical, education and transport sectors. We expect that sectors like financial services, food and, to a lesser extent, retail – given the challenging Australian retail environment – will receive renewed attention in the year ahead. Non-core business units of larger corporates will also continue to be attractive at the right price. An important and emerging theme is that private equity funds are increasingly looking at businesses with a strong digital presence as a key driver of growth.
FW: What legal and regulatory issues are shaping the PE industry at present? How can the related risks and challenges be mitigated at the fund level?
Casali: Regulation of private equity in Australia has been relatively stagnant, save for two areas creating headaches for investors in private equity and GPs. The first area relates to fee pressure – there has been substantial government pressure to reduce fees borne by superannuation investors. One of the tools to increase this pressure is compulsory greater fee disclosure. The disclosure regime applies standard reporting across all asset sectors which has the effect of making private equity look incredibly expensive. This is because fees are measured against invested capital and not committed capital, which can produce fee loading disclosure of 20 percent per annum for a fund that charges 2 percent management fee and has only called 10 percent of committed capital. This is driving fee downward pressure and alternative fee structures. The second area relates to portfolio holding disclosure – superannuation funds are required to disclose their portfolio holdings. This has the effect of such funds requiring GPs to agree to provide data even at a portfolio company level. The government has recently circulated draft legislation which we are hopeful that if passed would limit the extent of disclosure in this regard.
Abelow: The regulators initially didn’t seem to know much about the PE industry, but they have gotten smart quickly. As they have done so, they have and will continue to shift their attention from their early preoccupation with topics like the appropriate process and disclosure for allocating fees and expenses between funds or between funds and portfolio companies towards arguably more substantive issues like valuation methodologies and appropriateness of co-invest relationships. The inspectors will, effectively, work their way from the plumbing and electrical wires into the front parlour.
Evans: Active antitrust review continues to impact exit opportunities and the ability to do transformative acquisitions. But it also presents opportunities, potentially levelling the playing field against strategic competitors in some sale processes, and triggering divestitures. In terms of risk to firms and funds, the US Foreign Corrupt Practices Act and the UK Bribery Act are areas of heavy enforcement attention, and potentially increased attention on PE firms as a way to drive compliance across many operating companies. The largest private equity firms are giving significant attention to these compliance risks both in diligence and in the operations of portfolio companies. This heightened attention will migrate down to mid-size and smaller firms as they begin to appreciate the risks.
Taylor: The main legal issue facing the UK PE industry over the next few years is likely to be tax related. The UK government plans to introduce changes in April 2016 that would make some investment managers’ carried interest subject to income tax, rather than the generally lower capital gains tax. This change seems to be aimed at profits arising from shorter-term activities, characterised as ‘trading’, rather than the kind of medium term investments that PE firms favour. It is not yet fully clear what will constitute trading, but managers in PE funds with holding periods of less than four years may find part or all of their carried interest subject to income tax treatment. A larger change may come if the UK government – and governments generally – seek to limit the extent to which interest payments can be deducted from taxable profits. This could lead to significant reductions in returns on some investments, especially if they are highly leveraged. Any such moves are likely to be reflective of a wider international tax reform effort, as evidenced by the OECD’s widely publicised base erosion and profit shifting initiative.
Scrivano: There are a number of legal and regulatory issues that are currently pending that have the potential to affect the PE industry. A number of rules under the Dodd-Frank Act that could affect PE have yet to be finalised. We are also seeing increased US Securities and Exchange Commission (SEC) focus on monitoring fees. There are also continued discussions on changing the tax treatment of the carried interest that most PE funds use to compensate their professionals. There is also continued discussion of rulemaking at the SEC Division of Investment Management that would impact PE funds.
Armstrong-Cerfontaine: The tax, legal and regulatory landscapes shifted significantly for European private equity fund managers and investors in 2015. Some positive initiatives were welcome, such as the European Commission’s plans for a Capital Markets Union (CMU) across Europe, with the highlight on the important role that private equity and venture capital play in creating a single market for capital; the review of EuVECA; the ‘AIFMD light’ regime for smaller managers; and the review of the prospectus regime. However, the regulatory skies were generally very cloudy. Many member state regulators demand fees and forms before a fund can be marketed using the AIFMD passport, and this undermines the single market. There is still much uncertainty on the plans for a ‘third country’ passport, designed to allow non-EU managers to opt in to AIFMD and market freely throughout the EU. Remuneration under AIFMD, which was thought to be settled, reappeared during the summer, as a consultation was launched on remuneration under UCITS V and AIFMD, and this may cause headaches to management teams. But the biggest changes in 2015 which may create havoc for sponsors are tax related. The OECD has continued with its wide ranging BEPS initiative, and the private equity and venture capital industry will be particularly interested in the proposals on treaty abuse and interest deductions.
“Private equity backed exits in 2015 surpassed the excellent records of 2014 for European buyout exits, with trade sales being at the core of the largest exits.”
FW: Are PE firms achieving expected returns from available exit routes? How would you describe the outlook for trade sales, secondary buyouts and IPOs in 2016?
Scrivano: While it depends on the PE fund and the asset in question, as a general matter the last several years have seen PE funds return significant capital back to their investors. Most of those PE funds have achieved, and in many cases exceeded, the returns they expected. As to 2016, the market for IPOs has chilled somewhat as of late, which would suggest that 2016 is likely to see more trade sales and secondary buyouts for PE funds that are sellers. However, PE funds are also likely to be buyers in 2016, and may be on the other side of many of those transactions.
Taylor: High stock prices in the UK and globally allowed listed corporates to compete effectively with PE funds in auction sales. Corporates have also become more adept at using acquisition debt, with corporate groups expressly looking to make leveraged acquisitions. The architecture is therefore in place for trade sales to flourish as an exit route. Whether or not they actually will thrive is likely to depend on wider economic circumstances. The outlook for secondary buyouts in the UK is good. PE firms have large war chests that they will need to spend or hand back to investors. Debt is likely to be available from banks, debt funds and potentially also the capital markets. Conversely, while the stock market remains off its peak, fewer PE sellers are likely to consider IPOs than would have been the case 12-18 months ago. Given the planning time involved, IPOs are not likely to be a common exit route in the first half of 2016. However, if market sentiment takes a turn for the better in the next few months – and assuming the UK votes to remain in the European Union in June – we could see a revival of the market in the second half of 2016.
Armstrong-Cerfontaine: Fierce competition resulted in a big run-up in asset valuations, which were very high in 2015, leading to the assumption that sponsors achieved expected returns last year. Macroeconomic factors impact on the strategy and the execution of any exit, which is carefully thought-through by sponsors. There is much uncertainty given the current market volatility and it is therefore difficult to predict outcomes for this year. So long as the IPO market remains weak, there will be fewer exit options for sponsors. Certain industry experts believe that the high exit volumes and values in recent times have been fuelled, in part, by the easy availability of credit. One industry expert believes that so long as the lending window stays open, trade sales will continue to be high. Secondary buyouts will also depend on the pricing of assets, and it is expected that corporates will continue to fight for assets to make strategic acquisitions.
Evans: Broadly viewed, opportunities for exits are strong. Trade sales have been and will continue to be a reliable source of buyers. Corporate balance sheets are generally strong and CEOs are looking for opportunities to grow. Chinese companies are increasingly active in the US and Europe and this trend will continue. Secondary buyouts are currently challenged due to the financing markets, but there are near record levels of dry powder and a limited number of companies of a size that PE firms can swallow, so secondary buyouts will return quickly. The IPO market is of course cyclical, but continues to be viewed as a likely exit strategy for consumer, technology and other business that offer the growth opportunity desired by the public markets.
Casali: 2015 was the comeback year for the competitive dual track IPO and trade sale process, albeit with mixed results. Competition from the IPO market remains – albeit at a slightly tempered level when compared to 2015 – with an increased focus on the trade sale track of the process as private equity and trade buyers, particularly foreign corporates, have shown their willingness to pursue synergistic acquisitions. However, a number of sponsors have aborted sale processes in troubled sectors, particularly those exposed to the resources and construction sectors. IPO activity by PE sponsors may have peaked in mid-to-late 2014, but 2015 has so far seen a steady run of sponsors taking or seeking to take exit opportunities by way of IPO. More recently it appears that increased scrutiny from institutional IPO investors, more competitive pricing and volatility have led to the withdrawal of several high profile IPOs, but investors will continue to have an appetite for appropriately priced quality assets for the rest of 2016. To the extent that accessing the IPO market for exits becomes more difficult, this may be balanced via increased buy-side opportunities for larger PE funds.
Abelow: The proportion of sponsor ‘exits’ that are accomplished through IPOs varies widely year-to-year. Sometimes, as in 2008 for example, it is close to zero; other times it can rise to north of 15 percent. But even then, IPOs are highly concentrated in certain industry sectors and in larger transactions. More importantly, an IPO is seldom a true exit. With over 80 percent of last year’s IPOs trading below their initial offering price, it’s often a dead end road for a sponsored company. As for trade vs. secondary sales, both can be viable routes, and increased globalisation has certainly expanded the list of likely strategic buyers in a number of sectors. A recent study, however, came to an interesting conclusion that I think gave the lie to an important misconception. It seems that sponsors do just as well buying from other sponsors as they do buying from trade or family/entrepreneur sellers. This makes sense, as the sponsor community begins to mature and sponsors become more differentiated among themselves in terms of capabilities and skill sets.
FW: How has private equity fundraising fared in the last 12 months? Under current market conditions, what are LPs looking for in terms of private equity investments?
Abelow: LPs seem increasingly focused on the extent to which private equity firms have matured into true institutions. They want to see repeatable processes at work, both during deal selection and underwriting and during the ownership period. They want to see internal career development plans and succession strategies for founders. And they want to see a professional, sensible and defensible approach to valuing investments within the portfolio.
Scrivano: While PE fundraising fared very well in the past 12 months, it did end up lower than in prior years on a year over year percentage basis. Based on the reports from certain market intelligence services, the amount of fundraising globally in 2015 was approximately 15 percent lower than in 2014, and slightly lower than in 2013. However, the amounts raised still compare very favourably with PE fundraising that occurred in 2009-2012.
Evans: Fundraising remains very strong in the aggregate. Preqin data shows that 2015 fundraising was roughly on par with 2013 and 2014, and eclipsed only by 2007 and 2008. Capital distributed has greatly exceeded capital called for the last three years, so LPs continue to need to make commitments to deploy capital in private equity. And LPs generally are increasing, not decreasing, their allocations to private equity. LPs are looking for firms with a defined strategy and a stable team with a track record of sticking with that strategy. And most LPs are looking for co-invest opportunities.
Casali: 2015 proved to be a good fundraising year for some but a better one for others, with one end of the spectrum seeing a number of sponsors raise funds quickly and with ease – several first and final closes. At the other end, deal issues or depleted investor bases have prevented other funds from raising capital. There are a number of top quality Australian general partners coming to market in 2016 in what will be a strong year of fundraising, despite increased competition for capital from Asian managers who can allocate opportunistically across Asia, and Australia and New Zealand. For example, CHAMP Private Equity recently had a very strong first close of its fourth fund. We have seen increasing fee pressure on GPs from LPs, as well as a strong desire by LPs for co-investment deal flows.
Armstrong-Cerfontaine: 2015 was a successful year for fundraising, with a few new players on the market set-up by initiators spinning out of well-known houses to set their fund. There is a vast array of choices for limited partners to invest in new funds, though the number of funds closed last year was slightly less than in 2014, according to Preqin.
Taylor: Fundraising activity has been robust, although we have seen a continuation of the trend for investors to prefer established managers over first-time funds. Competition for allocations is intense and LPs have increasingly focused on their existing GP relationships and managers that have a demonstrable track record. Successful first-time funds have tended to be funds that have differentiated from the market – for example, on the basis of a more focused strategy than the traditional buyout funds. In response to LP demand, we have also seen a degree of innovation on structure, particularly for emerging markets funds, where some GPs have moved away from the traditional closed ended fund investment model to adopt more flexible holding structures, which allow for longer holding periods and more flexibility around the timing of drawdowns and distributions throughout the life of the vehicle.
“We have seen several deals where PE funds used an existing portfolio company as the acquiring vehicle of another public company, thereby potentially generating significant cost savings which will enhance value creation.”
FW: Are you still seeing increased scrutiny of fund managers, with LPs demanding more information, disclosure and transparency? Are PE funds improving their backroom capabilities to meet investors’ needs?
Taylor: Transparency on fees has been a theme and we expect the recently announced ILPA fee reporting template to drive further convergence in that area. GPs have also had to deal with the first full cycles of reporting under AIFMD, although many GPs have outsourced a significant part of the reporting burden to fund administrators rather than resourcing it themselves. On top of those requirements, we continue to see requests for more bespoke reporting of portfolio-level information, as well as a focus on ESG reporting from a broader range of investors than we would have expected to require that previously. All in all, the trend is definitely toward more disclosure and smaller GPs are more stretched as a result. We have seen a general strengthening of PE funds’ backroom capabilities over the last few years, in particular with increases in their in-house legal teams.
Abelow: Private equity funds and hedge funds are increasingly calling upon portfolio valuation services, and there is active and dynamic pressure to establish market norms for periodicity and appropriate standards of review. Many PE firms are building substantial ‘back office’ capabilities to accommodate this, as well as hiring more third-party advisers.
Evans: Pressure from regulators and LPs continues the push for transparency, and the new frontier appears to be desire from some LPs for standardised reporting practices. The SEC’s presence exams across the industry, leading to enforcement actions against many of the largest firms, have changed some practices and significantly increased disclosure. Issues long understood generally by LPs are now the subject of very specific disclosure. The back offices of most PE firms are now pretty robust, but it appears that is not true for many LPs, even some of the largest. With thin staffs and many managers in their portfolio, LPs will increasingly push firms to comply with standardised reporting packages, and GPs will gradually adapt.
Armstrong-Cerfontaine: In 2016, transparency will be high on the agenda for both investors and managers but standardised reporting may be difficult to implement across the whole industry, with the guidelines of the EVCA – now named Invest Europe – providing for a little more flexibility. Also included in the Invest Europe Handbook will be the newly updated IPEV valuation guidelines, when finalised. The proposed changes to the guidelines are not major but they have been restructured and contain helpful clarifications. Key themes that the panel of investors discussed at the Super Return conference in Berlin in February this year as being paramount when investing into funds included true alignment of interest, transparency, discipline, and counterparty risk. The desire for continued standardisation of key documents, including fee-reporting templates, through ILPA and Invest Europe, is welcome to the LP community. Environmental, social and governance issues are also high on the agenda in fundraisings, whether it be investor queries over a general partner’s own policy, or requests for a general partner to confirm, typically by way of side letter, that it will consider and adhere to an investor’s particular policy.
Casali: With the growing trend of offshore investors forming a large part of the investor base for recent PE fundraising in Australia, side letter terms are becoming more and more complex and lengthy as they deal with the foreign regulatory and tax reporting requirements of investors. Increasingly, PE fund managers are needing to expand the role of their finance and compliance teams to support these additional reporting requirements and compliance measures.
Scrivano: We are seeing a continued focus on disclosure and transparency. LPs are asking for more information, particularly on PE fund fees and expenses, and even in some cases how valuations were arrived at. We have also seen FOIA requests made to LPs in PE funds, as another means to obtain increased transparency. PE funds are rising to this challenge though, and are taking meaningful steps at increasing disclosure and transparency.
FW: What trends do you expect to see in the coming months? How do you envisage deal flow developing in 2016 compared to 2015 levels?
Armstrong-Cerfontaine: Despite challenging macroeconomic metrics, low short-term growth and a high risk of recession, opportunities will continue to arise for those with the right outlook, strategy, processes and policies in place. Overall, levels of dry powder are expected to remain high as the European economic landscape remains challenging, prices are high for European assets and the European regulatory landscape remains uncertain. Many measures to kick-start the European economy are still in an embryonic stage. 2016 will be as challenging, if not more, than 2015.
Abelow: I don’t disagree that there are some clouds on the horizon, but I remain optimistic about the state of the middle market. The underlying dynamics driving growth in transaction volumes here, which for many years have arguably been technical rather than fundamental in nature, haven’t changed. In fact, many of them are becoming even more pronounced. For example, private equity dry powder, complete with attached shot-clock, is now at a record high. I’m not booking any long vacations any time soon.
Scrivano: It looks quite likely that 2016 will be a year of opportunity for PE funds. That will certainly be the case for PE funds that are able to price, negotiate and execute deals in a turbulent market, particularly when strategic acquirers who would have used their stock as currency in deals may be sitting on the sidelines. After several years focused on selling, expect PE funds to return in force to the market as buyers.
Evans: We will continue to see firms use imagination as they seek to deploy capital in a crowded market with difficult financing conditions. Some firms will – and should – take advantage of limited financing to transact now at more attractive multiples and refinance in a better environment. As PE firms look for take private opportunities, we should see both instances of cooperation between activist shareholders and PE firms, as well as increased use of activist techniques – particularly acquiring toehold stakes – by PE firms. Absent a significant external shock, we should see deal activity rebound in the second quarter and be robust for the balance of 2016.
Casali: Venture capital is making a comeback after many years in the doldrums. Both federal and state governments in Australia are investing heavily into innovation in terms of both policy focus and active measures as both streams of government share a strong belief in Australia being a global leader in innovation and are harnessing government support to aid this. The Atlassian IPO has raised a lot of awareness for VC and the introduction of significant investor visas and the requirement to make a minimum AU$500,000 investment in VC in order to obtain permanent residency in Australia is resulting in increased VC funds being established in Australia in response – however, interest in the visa programme has waned since the new investment requirement into VC and little capital has been raised to date by these funds. Equity crowd funding is topical, and is gaining momentum while creating awareness and an appetite among private investors to access VC assets. Given the recent volatility of equity markets, PE funds are seeing value in listed equity and we expect to see an increased level of take-privates in the year ahead.
Taylor: Given various global uncertainties, such as the slowdown in Chinese economic growth and the current ‘Brexit’ debate, we would expect a slow first half of 2016 for UK private equity. Overall, we would express cautious optimism for the remainder of 2016, with sectors favoured by investors, such as infrastructure, continuing to outperform the rest of the industry.
John Taylor is a corporate senior associate specialising in private equity. He has worked for investors, corporates and management teams on a broad range of significant transactions, including UK and international buyouts, mergers, acquisitions, disposals, takeovers, joint ventures and equity financing.
Justin Abelow is a managing director in Houlihan Lokey’s financial sponsors group and co-head of the firm’s private equity practice, focusing on private equity coverage in the US and Europe. He is also a member of Houlihan Lokey’s management committee. Over the course of his career, Mr Abelow has worked on more than 300 closed transactions involving more than 40 discrete private equity firms.
Alexandrine Armstrong-Cerfontaine’s practice focuses on advising private equity sponsors on their investments, corporate finance, syndicated financings and fund formation, including leveraged financing and restructurings. She acts for a wide range of investment houses in the private equity, real estate and leveraged finance sectors. She is recommended in Legal 500 (Luxembourg) which states that she is “a standout lawyer with an exceptional ability to grasp complex projects and respond to clients’ requirements and needs”.
Riccardo (Ricky) Casali is an experienced corporate lawyer and strategic adviser. He specialises in M&A, capital raisings and general corporate and securities matters with a main focus on advising a number of leading domestic and international private equity houses on buyout, expansion capital and exit transactions as well as portfolio company bolt-ons, roll-ups and co-investments. He advises regularly on general corporate and securities laws. He is a ranked by Chambers (Asia-Pacific) as a leading individual in private equity.
Paul S. Scrivano is head of the Global Mergers & Acquisitions and Private Equity Practice at O’Melveny & Myers LLP. He has extensive experience across a broad range of US and cross-border M&A transactions, including mergers, tender and exchange offers, stock and asset acquisitions, divestitures and joint ventures. He has also received numerous awards over the years, including being named an Americas Top 50 Lawyer in the M&A Atlas Awards (2014).
Daniel S. Evans’s broad M&A and corporate practice includes acquisitions and dispositions for private equity and strategic buyers and sellers, private fund and general partner organisation, public offering and other financing transactions, and general corporate representation. Mr Evans also has significant experience with joint ventures, independent committees of directors, proxy contests and executive employment agreements. Additionally, he has led more than 50 M&A transactions ranging in size from less than $100m to $2bn, including several going-private transactions.
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