Simon Henderson
Private equity (PE) exits surged in 2014 with buyout-backed exits hitting record highs worldwide for both count – up 15 percent – and value – up a staggering 67 percent – from 2013 levels.
According to the sixth annual bellwether Global Private Equity Report released by Bain & Company, the world’s leading advisor to PE investors, exit value was amplified by sales of a handful of very large assets to strategic acquirers, as well as an IPO market firing on all cylinders in the first half of the year. The IPO exit channel was particularly strong in Europe, which experienced a doubling of buyout-backed IPOs by count and value, turning in the best year on record. In Asia Pacific, PE-backed IPO value almost quintupled to $63 billion.
According to Bain, superabundant capital in the hands of PE funds and investors of all types globally, combined with plentiful, cheap debt, made 2014 a great time for PE funds to sell. However, buyers did not fare as well, facing strong public market valuations that stirred intense competition and inflated asset prices. Global buyout investment activity barely budged last year – up just 2 percent by count and down the same percentage in value versus 2013 activity levels.
“Last year was undoubtedly the year of the exit, which raised the caution flag for many buyers,” said Simon Henderson, head of Bain & Company’s Australian Private Equity Practice. “The surge in global liquidity and near zero-interest rates has inflated asset valuations and boosted acquisition multiples on private PE targets, which will make it more challenging to earn the same high levels of return going forward.”
The net result of wide-open exit channels, combined with a challenging deal environment, is that limited partners (LPs) have been cash flow positive for four consecutive years, marking the first time in the history of the PE industry that a cash flow imbalance has been in place for such an extended period of time and at such an extreme degree. Institutional investors continued to recycle capital back into their best performing asset class. With so much money in the hands of LPs looking to reinvest in PE, the improved fund-raising results that top-performing firms enjoy is spilling over to other general partners (GPs) more broadly.
The past 25 years have seen a vast global expansion of financial assets on investors’ balance sheets, totaling some $600 trillion in 2010. Financial assets will increase by another 50 percent to $900 trillion by the end of the decade, according to Bain’s Macro Trends Group. With undeployed capital – or dry powder – at a record high and a limited supply of attractive investment opportunities, fierce competition for assets and very high prices show no signs of letting up anytime soon.
Other key findings from the Bain PE report:
- PE limited partners are increasingly experimenting with shadow capital, the vast sums of money that institutional investors are putting to work through co-investments, separately managed accounts and direct investments. The biggest risk of shadow capital is not the threat of LPs competing directly with GPs, which remains small; it is whether it will change the economics of the industry as GPs trade increases in assets under management for a discount in their services.
- Investors are renewing their focus on the U.S. Bain’s Macro Trends Group sees several secular trends that could power the U.S. economic expansion through the rest of this decade and potentially beyond. While the U.S. market has a deep pool of companies to buy, it is also PE’s most mature and intensely competitive market. Among middle-market businesses with an enterprise value of between $100 million and $500 million, for example, Bain found that PE ownership increased from 8 percent of companies in 2000 to 23 percent in 2013—nearly one company out of four.
- Returns for the PE industry are compressing, as the spread between the top- and bottom-performing funds has narrowed for recent fund vintages. Swings in just one or two deals can push a fund out of one quartile and into another. Bain analysis found that it is only after around the seventh year in a fund’s life that investors can have confidence in knowing where a fund will ultimately end up
Looking ahead to the rest of 2015 and beyond, Bain predicts that superabundant capital is here to stay – and could continue to challenge PE investors going forward. Plentiful, low-cost debt in the hands of yield-hungry creditors adds upward pressure on prices and ensures they will stay high. At the same time, longer holding periods will be more the norm to prepare fully priced assets for exits that deliver attractive returns.
“We’ve entered a different world where plenty of money in the hands of many has had a democratizing effect on PE returns, making it harder to spot the winners,” said Henderson. “Past performance is not always a reliable indicator of future returns and, as a result, PE firms are going back to basics to generate market-beating returns.”
In response, Bain anticipates an uptick in the number of leading PE firms seeking creative ways to identify new investment themes before the market fully prices them. Specifically, GPs are developing repeatable sourcing models to separate themselves from the pack of rivals showing up at auctions ready to pay full price.
Bain also cautions that in the age of consistently high asset values, GPs can no longer count on market beta to help boost their returns. GPs that aspire to consistent top-quartile performance will need to be thoughtful about which investment thesis to pursue, follow up with great due diligence on the assets they pursue, and apply a disciplined, repeatable value-creation process to every company in their portfolio.