Hugh MacArthur

The global private equity (PE) industry posted another solid year in 2017, as buyout value and exits both showed healthy gains. Firms closed out the strongest five-year stretch for fund-raising in the industry’s history as limited partners (LPs) continued to respond to PE’s outperformance vs. other asset classes by flooding the market with new capital. Growing investor enthusiasm produced the largest buyout funds ever raised in the U.S., Europe and Asia, and served as a ringing endorsement of the industry’s prospects in the years ahead. But it also intensified the pressure on general partners (GPs) to keep the good times rolling amid recent market volatility.

These are the key conclusions from Bain & Company, the world’s leading advisor to PE investors, in its ninth annual Global Private Equity report, released today at the 15th annual AVCJ Forum.

“Investor enthusiasm for private equity endures, leaving the industry awash with cash. This is both a blessing and a curse,” said Hugh MacArthur, global head of Bain & Company’s Private Equity practice.  “Funds have ample money to spend, but the competition for deals is fierce. With deals being done at record-high multiples, the right sort of diligence is more essential now than ever before.”

Bain & Company found that large sums of cash continued to flow in to the asset class throughout 2017. The $701 billion of PE capital raised globally nearly matched the high-water mark set the previous year. Buyout funds led the pack, capturing $301 billion, a staggering 27 percent increase over 2016 – a signal that investor enthusiasm is increasing.  This total benefited from the record number of mega-buyout funds (those larger than $5 billion) that closed during the year. As one measure of the extraordinary investor enthusiasm in 2017, all 10 of the largest funds closed during the year raised more than their targets, and they easily could have raised even greater amounts.

At the same time, the industry’s inability to put money to work as fast as it’s coming in is generating annual records in a more problematic metric—dry powder. At the end of 2017, buyout funds were sitting on an all-time high of $633 billion in uncalled capital ($286 billion of which was in megabuyout funds), with totals rising at a rate of 12 percent compounded annually for the past five years.

Trimming back the massive overhang of uncalled capital will require doing more and larger deals. There is no shortage of assets in play. In 2017, over 38,000 companies were bought and sold around the world, at an estimated value of $3.3 trillion. The problem is that private equity’s share of this robust market last year was just 13 percent by value and 8 percent by deal count. The clearest opportunity for private equity to put large amounts of capital to work is to claim a bigger share of the massive M&A market by doing more large-scale, M&A-based deals.

“This structural imbalance is, without doubt, the industry’s biggest challenge, stemming from heavy competition for deals, which puts persistent upward pressure on asset prices,” said MacArthur.  “In the coming years, this, along with heavy competition and the looming threat of an eventual economic downturn will require PE funds to create portfolio company value from the inside out – through better leadership and execution – or accept middling returns.  We could also see more M&A-based deals, including buy-and-build transactions that continue to be a staple of deal making as well as more, bold, large-scale M&A.”

In the search for ways to put money to work, GPs were hampered by several factors—high valuation multiples, stiff competition and an uncertain macroeconomic outlook that complicates future value calculations. New research from Cambridge Associates reveals that half of all buyouts today are transacting at more than 11 times EBITDA. These factors pushed funds to be selective, and in some cases prompted them to stay on the sidelines.  Yet as dry powder continues to accumulate, the pressure to do deals is only building, testing the industry’s ability to maintain discipline.

The same forces that complicated deal making in 2017 made for a great time to exit. Buyout backed exit value came in at $366 billion, the third-best year ever, while exit count rose 3 percent. All main exit channels—sales to strategic buyers, sponsor-to-sponsor transactions and IPOs— produced increases in both count and value globally.

As strong as the exit environment was last year, the data also suggests that PE firms are working harder and longer to create value. Bain & Company’s 2017 report noted that holding periods for companies in PE-fund portfolios were settling into a new normal of around five years. The five-year median in 2017 only strengthened that conclusion. During the industry’s pre-crisis heyday, the median holding period for portfolio companies was less than four years, and PE firms were exiting around 40 percent of all buyout-backed deals in less than three years. More recently, those “quick flips” retreated by half, to around 20 percent, and are likely to stay low.

Bain & Company has identified three areas in which top performers are building new capabilities to thrive in an increasingly difficult environment:

• First, they are honing their leadership assessment skills, learning to identify the right team early and fill roles with fit-for-purpose talent, from the C-suite to the front line.
• Second, they are recognizing the importance of generating top-line growth by helping companies build world-class commercial capabilities. A smart blend of initiatives to better segment customers, increase sales effectiveness and sharpen pricing can lift EBITDA by up to 15 percent.
• Finally, they are learning to fight through the hype surrounding digital to sort out how new technology can transform the due diligence process and how companies can create value during the holding period. The firms that can master these skills are those most likely to outperform the averages, as producing top-tier returns becomes harder each year.

The Global Private Equity Market in 2017:  By the Numbers

• Deal value increased 19 percent, to $440 billion in 2017, reflecting the growing size of the average deal and a stream of large public-to-private deals.
• Global buyout deal count was essentially flat in 2017, up just 2 percent to 3,077 deals – off 19 percent from 2014, the high-water mark for deal activity in the current economic cycle.  For the first time, Bain & Company included add-on transactions in its investment comparisons, as they now represent half of the buyout deal market by count.
• GPs sat on record levels of dry powder—$516 billion earmarked for buyouts at the start of 2017. Soaring valuations amid stiff competition for assets, especially from corporate buyers, made it very difficult for PE firms to find and win deals.
• Buyout-backed exit value came in at $366 billion, the third-best year ever, while exit count rose 3 percent. All main exit channels—sales to strategic buyers, sponsor-to-sponsor transactions and IPOs—produced increases in both count and value globally.
• The median holding period for buyouts remained steady at five years. Thanks to the robust debt markets, dividend recaps continued to be a favored strategy for taking some money off the table sooner rather than later.
• Buyout funds captured $301 billion, a staggering 27 percent increase in fund-raising over 2016.

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James Vile

According to Bain & Company’s eighth annual private equity report, firms have to get smarter about how to differentiate themselves in a challenging fund-raising environment.

Global markets experienced a roller-coaster 2016 as the outcomes of the U.K.’s Brexit referendum and the U.S. presidential election rocked investors.

Yet, the global private equity (PE) industry proved its resilience, turning in healthy results for the year.  Exit activity was strong, but overall totals for 2016 declined as deals that had been on hold during the global financial crisis were finally digested. With investors on the hunt for yield, PE remains a favored asset for institutional investors. Fundraising surged as limited partners (LPs) continued to recycle distributions into new capital commitments.

Returns also had another strong showing, continuing to outperform public markets by a sizable gap over both short-term and long-term time horizons.

Global buyout activity, on the other hand, declined amid a challenging deal-making environment.

These are the key findings from Bain & Company, the world’s leading advisor to PE investors, in its eighth annual Global Private Equity report, released last week at AVCJ Sydney Forum.

In 2016, buyout-backed exits around the world dropped 23 percent in value and 19 percent in count from 2015 and fell even further from the record levels of 2014. But, asset sales of $328 billion in disclosed value from 984 deals actually constitutes an extremely strong run, helping the industry deliver its fourth-best year ever by value. This decline was not reflective of a worsening exit environment, but was driven mainly by a leaner pipeline of deals ready for exit as the industry has largely worked through the backlog of assets invested prior to the global financial crisis.

“Given that exits flow from the deals done in previous years, the decline in exit value and count in 2016 wasn’t much of a surprise,” said James Viles, who is a leader in Bain’s Australian Private Equity Practice.

“After several years, the industry has finally normalized through the exits of the massive deals done in 2006 and 2007, like a snake digesting an elephant-sized meal.  So, while not quite the blowout of 2014 and 2015, last year still delivered an impressive showing overall for liquidity.”

With nearly all of the pre-crisis deals exited, buyout firms are adjusting to a new normal with longer holding periods of about 5 years – up from the historical average of about 3.5-4 years. Bain expects this trend to continue in the medium term, as a result of high purchase prices and limited sources of market beta, requiring general partners (GPs) to roll up their sleeves and do the time-consuming work of creating value with their assets.

Buyout investment activity decreased in 2016: deal count declined 18 percent and value dropped by 14 percent from 2015 levels. Record-high asset valuations combined with stiff competition – particularly from corporate buyers – made it tougher for PE firms to do deals and achieve target returns. Purchase price multiples for buyouts rose to an average of 10.9x EBITDA for U.S. deals in the third quarter of 2016.  The difficulty of putting capital to work, combined with ongoing investor enthusiasm for the private equity asset class has led to a new record amount of dry powder, now totaling $1.5 trillion across all PE fund types globally – $534 billion of that targeted buyouts.

Today’s marketplace requires PE firms to put their best foot forward, actively looking to improve their odds of sourcing more of the right deals.  They can no longer wait for an offering to arrive on their doorstep and then react at the same time as the rest of the crowd.

“Deals are undoubtedly hard to come by. On average, studies show that PE firms see less than 20 percent of deals relevant to them in their pipeline,” said Viles. “Finding deals takes a systematic approach starting with developing a sharp point of view about the type of deals the firm excels in doing and wants to find, even before any deal becomes a possibility.  Leading firms then expand their network of the right people in the right places to help them find, diligence and close good deals.”

According to Viles, when deals do materialize, they command high prices.  And with an expected hold time of about 5 years, the margin of error for generating alpha and delivering acceptable returns to LPs has greatly narrowed.  In response, GPs are codifying their battle-tested approaches – what they are good at, what has and has not created value, and where and how their funds have made money for investors – to build playbooks that consist of detailed, sequenced actions taken over time to maximize value from each investment.

In 2016, capital continued to pour into the PE industry, making it the fourth year in a row for solid fund-raising.  In line with demand over the past several years, PE firms globally raised $589 billion in capital, just 2 percent less than in 2015, aided by a surge of 11 mega-buyout funds—those raising more than $5 billion— that closed to raise $90 billion.

But could this be as good as it gets? Many GPs are apprehensive that the industry cannot sustain the torrid pace of fund-raising for much longer. Bain expects that distributions will continue to outpace contributions and LP commitment to the PE asset class will stay strong. However, the fund-raising environment may not be as favorable in coming years, making it important for GPs to focus on what makes them stand out from the pack.

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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.

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