The folks at PitchBook have crunched the data for U.S. private equity deal activity in the first quarter of this year and have outlined some very interesting early trends for 2016:
1. Private equity’s “buy-and-build” strategy continues to be a significant portion of the private equity investment activity with add-on investments representing nearly 70% of the private equity investment activities in Q1.
2. Macro-economic uncertainty and a competitive middle-market lending environment continues to reduce the use of debt in private equity deals in Q1.
3. While deals in the lower middle market may require additional effort, funds continue to find attractive valuations in this segment of the middle market with a bit less competition.
4. U.S. PE-backed sales saw a dramatic decrease in Q1 (as compared to the same period in 2015) with only 198 completed sales and not one PE-backed IPO!
5. PE-backed exits remain robust in the healthcare, business-to-consumer, and financial services sectors.
6. Private equity fundraising remains strong. Of the 71 U.S. private equity funds closed in Q1, 98% of all these funds either hit or exceeded their fundraising target. (More info on this trend from PitchBook can be found here.)
7. The median size of U.S. private equity fund vehicles in Q1 were larger relative to prior years.
8. Notwithstanding the increased median size of fund vehicles, limited partners appear to have an increased appetite for smaller fund vehicles (between $250 million to $500 million) with focused and niche investment strategies.
9. There is a higher success rate of private equity fundraising due to increased limited partner demand for established fund managers and for new managers with unique/specialized strategies.
(For additional information from PitchBook, please click here.)
Thus, while private equity deal activity was off to a slow start in Q1, the strong fundraising environment demonstrates limited partners’ continued confidence in private equity as an asset class and in the ability of private equity managers to carefully and creatively execute on their focused strategy in an otherwise uncertain economic time to generate consistent and attractive returns for its LPs.
A slowdown in the manufacturing sector may lower multiples thereby making manufacturing assets attractive to private equity buyers. The Mid-Market Pulse, published by Mergers & Acquisitions in conjunction with RSM US LLP, predicts continued growth in manufacturing, but at a slower clip than other industries. This slowdown in manufacturing is triggered by many factors, including the appreciating US dollar, collapsing commodity prices and rebalancing of the economy in China.
The general slowdown in manufacturing growth may bring valuations down to a level where manufacturing assets become more attractive to private equity buyers. According to S&P Capital IQ, EBITDA multiples for buyout firms in the US in 2015 had an average of 10.3, and was higher than the 2007 pre-recession multiple of 9.7. As valuations decrease for manufacturing assets, deals from private equity should increase accordingly. While valuations remain high, strategic buyers may still be effective in acquiring manufacturing assets.
The automotive industry, however, is an exception to the general slowdown of manufacturing, and 2015 saw a doubling of car sales since the recovery started in 2009. Manufacturers supplying the automotive industry have also benefited from this trend. Some experts believe manufacturing companies supplying the automotive, aerospace and building products industries will be especially attractive to buyers.
2016 is a seller’s market, according to the panelists at our recent Hot Topics events. Investors, dealmakers and advisors came together in Boston and Los Angeles to discuss what’s on the horizon for private equity in 2016, including the impact of high valuations and rising interest rates on M&A activity, and the regulatory hurdles facing the financial institutions supporting the industry.
In Boston, panelists included:
• Gregory Bondick, Managing Director at Windjammer Capital Investors
• Jason Fennessy, Director at RSM US LLP
• Jay Hernandez, Director at Harris Williams & Co.
• Kevin Jolley, Managing Director at MHT MidSpan
• Matthew Keis, Managing Director at Gemini Investors
• William Nolan, Managing Director at H.I.G. Capital
• Andrew Shiftan, Managing Director at BHC Interim Funding, LP
The panelists had the following observations and predictions for middle market M&A activity:
Recap of 2015 – The past year had a healthy volume of M&A deals, with valuations in many instances at levels not seen since 2007. For many PE funds, fundraising was strong, giving these funds ample capital to deploy in 2016. The credit markets were also friendly to buyers with healthy balance sheets, giving many buyers sufficient cash to deploy on M&A activity. The health care and health care IT sectors were big winners in the past year, as companies and investors became increasingly familiar with the Affordable Care Act and corresponding investment opportunities. Brewery and SaaS-based businesses also drove high multiples.
The Year Ahead – The panelists agreed that while growth may have moderated, it is still a seller’s market. That said, sellers’ expectations may have started to exceed the market reality and valuations are likely plateauing. Despite this realization, the metrics driving deals will hold true. The middle market and lower middle market are a good place for buyers seeking reasonable valuations. Buyers who are flexible in terms of the capital structure of an acquisition and can provide certainty related to the closing of a transaction will continue to be more successful in competitive bid processes.
M&A activity will continue to follow growth sectors. The panel agreed that the natural and organics, outdoors, pet product and business services industries would remain hot. The pet products industry, for example, is growing faster than GDP and appears not to be affected by market cycles. The industrial sector will likely not fare as well, and finding growth here may be challenging. The revenue of companies in this sector is often tied to the oil and gas industry, which is hurting, and the U.S. dollar, the strength of which hurts companies who have operations offshore.
From a lender’s perspective, 2016 will continue to present challenges as banks, business development companies (BDCs), SBICs and insurance companies compete to deploy capital. Uneasiness will remain in the high yield market related to macroeconomic conditions such as the price of oil and China’s economy. At the upper end of the credit market, there is a lack of liquidity. Larger institutions are holding debt in industries like oil and gas that are not faring particularly well. Lenders are also facing regulatory pressure related to balance sheet requirements. The panelists agreed that only time would tell whether this uncertainty would trickle down to the middle market.
Speakers at our Los Angeles event included:
• Brad Meadow of SPK Capital LLC
• Andrew J. Howard of Shamrock Capital Advisors, LLC
• Naeem Arastu of Solace Capital Partners
• Saif Mansour of Breakwater Investment Management, LLC
• Brad Holtmeier of CriticalPoint Partners, LLC
• Yem T. Mai of Marsh Risk & Insurance
• Tracy Washburn Bradley of Fortis Advisors LLC
• Margaret Shanley of CohnReznick LLP
• Vince R. Lawler of Bernstein Private Wealth Management
Here are some of the key takeaways from the discussion:
Deal Environment – In general, 2015 was a sellers’ market with buyers competing for fewer quality assets and generally buyers paying top dollar in the process. With relatively modest economic growth forecasted in the U.S. for 2016, the consensus at the event was that corporate strategics would continue their strong pace of M&A activity in 2016 in an effort to acquire revenue streams to bolster their profits. Private equity funds would also deploy their abundance of “dry powder” in this environment on the buy-side (platform, add-ons, and growth investments), but would continue to do so only in a very selective and careful manner. Entrepreneurs and private equity funds will likely continue to seek opportunities to sell their companies, but should be aware that the high valuation environment may be showing signs of compression.
Valuations – Valuations remained high throughout much of 2015 and, in general, the increasingly elusive high-quality assets should continue to demand higher valuations in 2016. With that said, portions of the middle market (especially the lower middle market) showed signs of valuation misalignment between buyers and sellers during the latter part of 2015, and the general consensus is that this disconnect would likely continue in 2016. As a result, this misalignment has resulted in the increased use of earn-outs in the latter part of 2015 and will likely continue in 2016, especially in the life sciences and biotech sectors.
M&A in a Rising Interest Rate Environment – The general consensus is that the Federal Reserve’s anticipated gradual increase of interest rates should not dampen M&A activity in the U.S. in the short term, and that debt should remain generally available notwithstanding the volatility in the debt markets over the past few months. In the long term, however, there was some concern as to whether a higher interest rate environment in the near future might impact a private equity fund’s internal rate of return on companies bought today but sold in a higher interest rate environment in the future.
Preparing to Buy and Sell – Notwithstanding the competitive environment for desirable companies, the general view was that it is essential for companies approaching a sale today to engage in a thorough sell-side diligence process before engaging with prospective buyers. Such a process allows the seller to identify any issues that may impact the value of the business or the ability of the seller to close the transaction quickly. As noted during the discussion, the failure to identify and address issues before engaging with prospective buyers could result in a broken deal process, which could negatively impact the company’s business and valuation. On the buy-side, it was suggested that it is equally important for buyers to be patient throughout the process and invest the time to thoroughly understand the seller’s business and build stronger relationships with the seller’s management team – an evaluation and building process that may, at times, last more than a year. Spending that investment time, however, allows a buyer to fully understand the challenges and opportunities facing a company and gives the buyer the opportunity to be transparent with the buyer’s lending sources.
2016 Forecast – There was a cautious optimism that the M&A environment will continue to remain strong in 2016. Corporate strategics will remain active on the buy-side, who will likely do more “carve-out” transactions in 2016. PE firms will keep deploying capital, but they’ll continue to be patient and disciplined in their buy-side activities. Firms will also address the perennial issue of the “portfolio company overhang” and, in doing so, will continue to sell companies into a market with so many willing buyers. The new norm of rep & warranty insurance will continue in 2016 as more and more buyers obtain these policies in an effort to remain competitive for quality assets.
In light of President Obama’s historic announcement in December to revisit and revise the U.S.-Cuba relationship, U.S. firms interested in this emerging market will need to understand the current landscape and keep abreast of changes as the new U.S.-Cuba relationship evolves. Although many believe that U.S. firms will not be investing in the region for many years to come (see the recent article in Pensions & Investments entitled “No Gold Rush for Cuba Despite Diplomatic Thaw” found here), the private equity community is (or should be) closely following developments in the region in light of the number of potential opportunities in Cuba, which, according to one commentator, such opportunities could be anything “because Cuba needs everything.” In that regard, my colleagues in our Washington, D.C. office (Douglas Dziak, Alexandra Lopez-Casero and Lindsey Nelson) recently held a fantastic webinar that provides an extremely helpful overview of the existing U.S.-Cuba relations, the policy changes proposed by President Obama (and the new business opportunities coming from the President’s actions), and the political hurdles facing the new U.S.-Cuba paradigm. You can access the webinar where we answer your questions about investing in Cuba here. As noted in the webinar and referenced article, there are a host of issues that will obviously need to be addressed before U.S. firms start investing in Cuba, including, among others, the U.S. Congress’ removal of the existing embargo, convertible and non-convertible currency in Cuba, and legislative and other changes in Cuba with respect to foreign investment.
It has been said that “Rome wasn’t built in a day,” and the same is true for Havana with respect to U.S. investment in that country. But, notwithstanding the time and challenges ahead, U.S. firms interested in this emerging market would do well to start their preparations now by keeping close attention to the evolving regulatory, financial and political landscape impacting the U.S.-Cuba relationship.
Unlike those in the venture capital community, private equity funds have historically been generalist rather than industry specialists. Yet, over the past few years, private equity firms have begun to tout their industry expertise to differentiate themselves in an otherwise crowded and competitive marketplace for LP dollars and deal flow. In fact, at Nixon Peabody's recent Hot Topic roundtable event in Los Angeles (see post), I asked our panelist whether they thought specialization matters. And, in response, some panelists noted that specialization did give private equity buyers an advantage over other non-strategic buyers in today’s competitive landscape. So, the query is whether such specialization matters beyond getting your foot in the door. A report published by Cambridge Associates concludes that “declaring a major” and specializing does, in fact, matter. According to the report (which can be found in link following this post), sector-focused managers outperform generalist managers on both an internal rate of return (“IRR”) and multiple of invested capital (“MOIC”) basis – sector specialists (in the consumer, financial services, health care and technology) returned an aggregate 2.2 times MOIC and a 23.2% gross IRR, handily outperforming generalist investments that returned an aggregate 1.9 times MOIC and a 17.5% gross IRR. Moreover, it appears from CA’s research that such sector-focused managers outperform their generalist colleagues regardless of the fund’s size or investment size. CA’s report can be found here. So, perhaps declaring a major might help not only in terms of winning competitive deals, but also in a fund's returns.