As 2019 approaches, indications of change are emerging in pockets of the private equity industry, but underlying industry dynamics ought to fuel a steady level of sponsor-led dealmaking for the foreseeable future.
“It just feels like Groundhog Day continues, meaning the story is really the same,” said John Dickie, co-head of private equity USA at Aberdeen Standard Investments. “There’s a lot of deal activity. Valuations remain high and we continue to be as busy as we could ever be.”
‘If the music stops…’
“If the music stops here in the overall economy, a lot of GPs are going to be sideways with companies they paid a lot for,” Dickie went on. “That’s the overarching issue. That hasn’t revealed itself yet, but we all need to plan for that.”
M&A pace has remained steady, with announced-and-closed deal count this year at about 2,309, on pace to match 2017’s total of 2,447.
Total disclosed deal value also has continued to rise, Thomson Reuters data shows. For completed transactions, 2018 through Dec. 3 has produced about $249 billion of disclosed PE deal value in the U.S. the data provider said. That tops the $184 billion, $170 billion and $117 billion of reported value in 2017, 2016 and 2015, respectively.
Even as uncertainty looms in a still-frothy market, at least some experts say GPs are well positioned to navigate macro shocks on the horizon.
“We’re long in the tooth in the economic cycle, in the credit cycle, and everyone is therefore wondering when the market turns,” said Justin Abelow, managing director of Houlihan Lokey’s financial-sponsors group. “But something has happened as it relates to PE. … Since the last cycle, PE has vertically integrated as an asset class.”
PE as an industry has effectively integrated with suppliers by creating private debt vehicles, Abelow explained. “Because the PE firms are going to control so much of the credit capital in this next cycle, as it relates to PE, [the impact] will be increasingly muted.”
Overconfidence presents risk
While the PE market isn’t showing signs of a dramatic transformation, continuation or acceleration of certain trends may be a cause for concern. One is buyers’ willingness to pay top dollar for assets.
Whether it’s underwriting future acquisitions, management changes, margin expansion or penetration of new markets, sponsors are taking on more risk, said Brian Conway, chairman of TA Associates’ executive committee and a managing partner in the Boston office. “They’re underwriting more change and more change faster.”
“Most sponsors if they are at all prudent are assuming a contraction in exit multiple,” Conway said.
That being the case, in Conway’s view, one of the greatest risks in today’s market is overconfidence, which he said may be partly a symptom of the fundraising market.
It isn’t that large funds underperform, Conway said. Rather, if a fund of a given size doubles or triples the amount raised in their next fund — and that size ultimately encourages them to change their strategy — there’s risk of a problem, he said.
“For the last several years PE firms have been able to raise more capital and often in increasing frequency,” Conway said. “Those are the kinds of times, when you look backwards, when people make mistakes; when [people] get overconfident.”
Conway pointed to a relatively new phenomenon: “Large-cap PE firms that didn’t invest in technology or growth historically are now buying TA portfolio companies,” he said. “Maybe that suggests a shift in their strategy.”
Public-market volatility: effect on PE
Recent public-market volatility is also top of mind among investors.
“Once public equity starts rumbling downward, it brings the whole valuation [issue] into the forefront,” Mike Chirillo, senior managing director at Antares, said.
“Interest levels have increased here in 2018, and certainly we’re looking at continued rate increases given the employment in labor markets,” Chirillo said. “That, too, puts a ceiling on where we are on purchase-price debt multiples.”
Darren Abrahamson, managing director of Bain Capital Private Equity, says the dislocation taking place in certain public-market sectors may present opportunities in 2019.
For example, in industrials, there’s heightened awareness about where we are in the cycle, and especially those affected by tariff-related issues, he said.
At the same time, in sectors like technology, strong fundraising and dry powder will continue to keep competition and valuations high, Abrahamson said.
From a lender perspective, hold size is also becoming more and more of a significant requirement as sponsors pursue more club deals, added Tyler Lindblad, senior managing director and chief credit officer at Antares.
Among the largest U.S.-sponsor LBOs in 2018, a Blackstone-led group took a 55 percent stake in Thomson Reuters’ Financial & Risk business (now called Refinitiv) for about $17 billion.
Elsewhere, KKR made a $9.9 billion wager on physician-staffing giant Envision, while Carlyle and GIC struck an $11.7 billion deal for Akzo Nobel Specialty Chemicals.
There’s also the question of whether public-market declines will ripple into the private markets.
According to Aberdeen’s Dickie, PE markets are somewhat insulated from big shocks in the public markets.
“There’s just so many investors that want more and more PE exposure, in part because returns have been great, but in part because people are realizing the public markets in terms of the number of companies is shrinking,” Dickie said.
Navigating through the froth
Sponsors continue to focus on things like specialization and creativity to win top-tier assets, as well as add-ons as a common tactic to add value. But there are signs that firms’ consolidation tactics are also beginning to take on a new form.
One particular strategy that appears to help firms avoid frothy auctions, Dickie said, is what he likened to a reverse merger or reverse add-on.
“The founders of the initial, smaller platform are actually the ones that have teed up the larger platforms,” he said. “The smaller fish is merging with the larger company.”
In other words, GPs are sourcing investments in specific companies that are smaller than what they should be looking at from a platform perspective, Dickie said. But in each case, they have identified multiple add-on acquisitions, including, in each case, add-ons that are larger than the platform they’ve started with, he said.
By locking down the business of relatively small scale first, it makes the GP more of a strategic buyer of larger add-ons that would be logical candidates for large auctions, Dickie said.
It enables firms to take a business of relatively small scale and very quickly grow the business to medium size. “It’s a wonderful starting point,” Dickie said.
From a sell-side perspective, mindsets are shifting.
Rather than a change in sellers’ willingness to sell, a trend appears to be emerging around what Abelow likened to defensively oriented sales processes. “If one is looking for signs of some change, I would point to the fact that in some instances, there are changes in the tones of sell-side conversations,” he said.
For example, sellers are eager to market companies to narrower casts of buyers as opposed to running broader auctions. This “still creates plausible deniability in the event of failure, by letting [the firm] bring a company back to market without a whiff of a tainted failed process,” Abelow said.
In other situations, sellers are settling for lower expectations, or rather than a majority-stake sale will settle for a minority sale or 50-50 split because of differences in expectations, Abrahamson added.
New themes in financing structures also are emerging.
Lindblad said there’s increasing prevalence of what Antares calls the “senior stretch,” which he described as a hybrid unitranche and senior-debt deal.
In other words, companies are using strictly senior debt and pushing senior-debt multiples past historic multiples and get modest price increasing, he said.
Another growing trend to watch is the entry of a number of direct lenders with unitranche capabilities, Lindblad said.
“You’ve seen pricing come down meaningfully to where it’s competitive within the traditional third-party market,” he said. “We’re seeing the use of unitranche in the market, where historically, we wouldn’t have thought it would be attractive.”
“Credit discipline is at a premium,” Lindblad added. “You must be discerning.”
Update: This story has been updated to reflect Aberdeen Standard Investments’ accurate firm name. A previous version identified the firm as Aberdeen Asset Management.
10 largest announced and pending deals by U.S. sponsors, Q4 2018
2008-2018 pending and closed deal number and disclosed deal volume, in billions
The most active LBO dealmakers of Q4 2018
Top 10 U.S. sponsor deals closed in Q4 2018
U.S.-based disclosed deal value for closed deals by quarter, in billions