U.S. Private Equity 1Q16 Breakdown Report by PitchBook
Activity slows, as strategies evolve
While 2015 as a whole finished as another strong year for private equity, the first quarter of 2016 has felt considerable negative effects from the declining activity that began in 2H 2015. Deal flow has continued to slip and exit volume was nearly halved on a quarter-over-quarter (QoQ) basis, yet, despite those trends, fundraising was actually relatively strong on a historical basis. private equity as an asset class has done right by limited partners, providing outsized returns with the added bonus of lower volatility. So, in a sluggish and unpredictable macro environment, the ability of private equity managers to be well received by limited partners speaks to a proven strategy that has comprehensively weathered previous economic cycles.
As we unpack the data of 1Q 2016, it’s easy to take the quarterly trends as a troubling sign of what may be to come, yet the slump in activity could speak to the traits that have allowed private equity to outperform over multiple decades. To clarify, the concerns regarding the quality of inventory, valuations, the strategic competition that has helped induce those valuations—along with where we are in a financial cycle that has for the most part moved higher since 2008—seem to be headwinds for the asset class. But the creativity, the sophistication and the prudence in their strategies is what has empowered private equity funds to provide the returns LPs desire.
The environment will remain competitive and difficult for most managers, yet the slow volume we saw last quarter mostly speaks to managers re-assessing what has become an uncertain macro and deal landscape. If you’ve raised a tremendous amount of capital for energy investments, when do you pull the trigger given the current price volatility and wave of Chapter 11s? If you are a manager oriented toward deep value and operational enhancements, where do you spend, or where do you cut spend to strengthen the balance sheet of your target company? The list of concerns can go on and on, and as funds address these questions and develop strategies in response, dealmakers will probably move slower, rather than faster. We hope the data and insights in this report help inform your decision-making process in 2016, and as always, please reach out with any questions, comments and suggestions at [email protected].
Private Equity 1Q activity remains subdued
After seeing private equity deal activity endure an inflection point and trend lower in 2015, activity in 2016 to date has experienced quite the hangover. The first quarter of the year saw $130 billion invested across 680 transactions, representing quarterly declines of 8.4% and 23.3%, respectively. On a yearly basis, 1Q deal value was down just over 12% with counts down more than 28%. Retrospectively, we saw the macro clearly move lower in 2H 2015, yet gauging where the U.S. and global economy will go in 2016 has become a rather impossible task. The S&P 500 index began the year in the red before rebounding some 11% since February. The U.S. dollar, which has served as a headwind for companies selling outside of the U.S. due to its increasing strength, recently declined against a basket of currencies, highlighted by the 5% YTD decline we’ve seen in the DXY index. Interestingly, however, U.S. treasury bonds have continued to receive significant capital flows, with yields on the 10-year declining from over 2.2% to around 1.7% thus far in 2016. Further, noninvestment-grade corporate debt rebounded a bit last quarter. In a positive light, the rebound in high-yield debt has incentivized some buyers to re-enter the market, subsequently lowering the required yield of new issuances, which can open up a window for private equity to better price debt packages at the higher end. That said, we don’t view the highyield bounce as a signal of a sustained recovery, but what appears to be more of a “buy-the-dip” trade.
What the above examples highlight is a seesawing external environment that makes modeling out the various postacquisition scenarios a fairly strenuous task. Nailing the macro thesis before completing a deal is never a simple task, yet today, managers will either have to pay a hefty multiple to win quality assets, or devote a significant amount of time and effort to help rebuild and grow distressed or tier-2 assets acquired at lower valuations. So, although a tremendous amount of capital remains to be deployed, and firms are typically incorporating the probability of a black swan event manifesting during a hold period, dealmakers are forced to move more carefully before pulling the trigger.
If you survey a group of dealmakers, you’ll likely encounter a split in sentiment, with some claiming to have remained busy through 1Q, and others acknowledging the rather slow environment the numbers show. However, being busy doesn’t necessarily translate into a plethora of announced or closed transactions. Deals in the upper size buckets and those of the highest quality are likely in auction processes with multiple strategic and financial bidders. To gain advantages in an auction and offer incentives to selling companies such as the ability to close quickly or secure lending packages sooner, bidding firms need to be able to complete various types of diligence earlier. This keeps private equity shops busy, especially if this is occurring in multiple processes, yet diving into diligence early and assuming the costs without the certainty of winning the transaction can keep many private equity firms on the sidelines.
Moving through the remainder of 2016, GPs will need to be creative throughout the entire deal process, from sourcing to closing to, ultimately, portfolio management. We’ve certainly harped on the quality of supply currently coming to market and the justifiability of the multiples asked for, and thus, sourcing will remain pivotal for GPs to find both quality and affordable prices. Deal flow could stay subdued through the year, yet older firms with more robust networks may well be able to mine out cleaner middle-market transactions as they arise.
Being able and willing to deploy an operational strategy will also be important for both sourcing and postclosing performance. Lower-middle-market deals, that, in many cases can be done amid less competition, can help GPs locate more attractive valuations, yet there is also the potential that such deals will require more time and hands-on work from the fund. With that in mind, transactions closing between $25 million and $100 million represented 26% of all 1Q deals. We still have plenty of room to run in the year, yet 2015 as a whole saw transactions in this size bucket represent just 22.5% of all activity. Deals in this range also continue to be a haven for add-on acquisitions, which accounted for 68% of all 1Q buyout volume, more than any other year we’ve tracked to date. The buy-and-build strategy will continue to be essential for private equity buyers as they look to position portfolio companies to endure any dip in the economic and business cycle.
New normal for multiples
Deal multiples & debt levels
While deal multiples subsided a bit in 2015, the 10x valuation-to-EBITDA figure recorded last year still holds at pre-recession levels, while the median debt percentage used in transactions has edged below. With deal flow as low as it is thus far into the year, it’s difficult to gauge where valuations will ultimately end up, but we think we’ll continue to experience a new normal where cleaner business coming to market will garner outsized multiples similar to the 11.5x we saw in 2014. Businesses marketed with any type of “hair” or concerns around the quality of their current and future earnings, among other metrics, will garner significantly lower prices.
As sellers have been able to take advantage of hungry, acquisitive buyers, the best assets have likely been sold and thus anything a bit more speculative will also face difficulties from the debt side. Everyone is certainly aware of the difficulty banks have had pushing debt to institutional investors, yet a competitive deal environment has forced middle-market lenders to accept much lower rates of returns, a risk they’ll be forced to more closely scrutinize in the near future. Keeping this in mind, 2015 saw the median deal debt percentage move lower to 56%—preliminary 1Q numbers have it at roughly 54%. Nonetheless, a large amount of capital remains available for lenders to deploy, and while they may be more careful given the quality of companies in the market, we’ve seen a few special-situation vehicles come to market and fare well. LPs have also opened up space within their credit portfolio for similar opportunities. PineBridge Investments recently closed its Structured Capital Partners III fund at $600 million, surpassing its initial $500 million target. The fund will look to target junior capital securities including mezzanine debt and structured equity issued by middle-market businesses. KKR, Carlyle and Oaktree have also raised oversubscribed multibilliondollar vehicles to invest in the debt or equity of distressed businesses as we’ve moved to the later stages of the credit cycle. While this may not lift the debt percentages of completed deals, it does highlight the ability of savvy investors to step up and help support lower tier-businesses in a period where traditional capital may not.