Lending to a sluggish pace of deal flow in Q3, financial sponsors are illustrating more aversion to risk and taking extra care to pick their spots in what remains an aggressive valuation environment.
The fact that there hasn’t been a big shutdown in the financing market for a long time is top of mind, and generally leading to more caution about likely deal activity over the next period of time, said Sumit Rajpal, global co-head of the Merchant Banking Division at Goldman Sachs.
“From a near-term perspective, the financing markets are beginning to show, especially on the second lien side, perhaps some discretion on the weaker credits,” Rajpal said. “That is obviously the viable lifeblood of our industry. We, personally, are absolutely a little more cautious.”
Arguably, that discipline was reflected over the last three months by a slowdown in aggregate activity, both in capital deployed and in deal volume.
The third quarter produced 597 closed and announced deals totaling approximately $61 billion in disclosed value, down from 633 transactions totaling approximately $85 billion of disclosed value in the first quarter of last year, according to data provided by Thomson Reuters.
Deal multiples across industries have stabilized in the 11x to 12x range on average, said Ian Fowler, who co-head’s Barings’ Global Private Finance Group: “When you’re at this kind of multiple, you’re really priced to perfection. It’s so critical for sponsors to execute on strategy. Any kind of miss from an execution standpoint can result in multiple compression.”
Depending on the deal, significant adjustments to cash flow may or may not materialize, which means multiples could be a lot larger, Fowler said. “Converting those adjustments to cash is the single biggest threat.”
“There will absolutely be carnage in the market because of the craziness we have seen for the past four or five years,” Justin Kaplan, partner at Balance Point Capital, said during a panel discussion at PartnerConnect West conference in San Francisco on Sept. 24.
That’s not to say deals aren’t getting done for quality companies in the foreseeable future.
“Big picture: Great assets are still trading like great assets,” said Bob Baltimore, managing director and co-head of the Harris Williams Business Services Group. “Every day that goes by we’re certainly closer to a recession. [But] the market is still humming and there’s still tons of capital on both the private equity and lending side.”
Bain Capital, alongside firms including Blackstone Group, Advent International and KKR, accounted for some of the 10 largest announced and pending deals by U.S. sponsors over the three-month period, Thomson Reuters data showed.
“In general we’ve found 2019 to be a robust year—both in the quality and quantity of transactions,” said David Humphrey, managing director of Bain Capital’s technology, media & telecommunications vertical.
Bain in July bought a majority stake in Kantar from advertising agency WPP, valuing the market-research unit at $4 billion. The same month, Bain invested in Parthenon Capital’s merger of two portfolio companies, Zelis Healthcare and RedCard. The transaction valued the new healthcare-fintech company at approximately $5.7 billion, Buyouts reported.
Speed and Certainty
One archetype for investing that has continued to work well for Bain, Humphrey said, is the firm’s ability to behave like a strategic buyer. Using existing platforms to make acquisitions or investing behind and merging two companies simultaneously has better positioned the firm to pay full and robust prices in certain instances, he said.
“When you look at the competitive environment for deals, one axiom for that is price and the other is speed and certainty,” Humphrey said. “There has certainly been a number of instances this year where processes were preempted or businesses transacted in a pretty short period of time. We’ve used that tactic, but very selectively in situations where we feel like we know the business really well.”
Other industry executives agreed.
“There’s a lot of self-awareness in the market,” said Jeremy Schein, managing director of Corsair Capital. “You’ve got to be careful, but aggressive if you like the asset.”
“The PE universe has really tried to ever-increase the speed to which they get to a bid. But that’s not in exchange for price,” added Harris Williams’ Baltimore. “That’s a reflection of the fact that they’ve gotten so deep in certain industries that they are able to more quickly identify opportunities in front of them.”
Buyers are articulating what they want to underwrite much sooner than they did years ago, Baltimore said: “The PE universe has definitely done a good job figuring out where they’ve got a right to win.”
In what remains an elevated price environment, the “jewel assets” in high-demand will continue to demand premium valuations, Schein said. Those assets are drawing fast, tightly-run processes, in which one or two firms often get ahead by not only spending resources, time and money, but sometimes, by taking risks that others won’t, he said.
Schein said he expects it will be a busy next three months based upon the level of deals coming to market at the tail end of summer through September. However, he added, “it doesn’t mean that anybody can sell anything.”
For many assets, he said, “you’re still in this environment of there being a relatively big bid-ask spread.”
That’s partly a result of the run-up in public market comps, Schein said. Sellers believe their companies in the private markets ought to see the same rise in valuations, he explained: “We’re seeing deals starting at one place frequently ending up in another place … I think there will be a decent amount of breakage.”
While cautious about cyclical growth elements in a valuation world that is exceptionally elevated, Goldman Sachs’ Rajpal said his firm is focused on finding longer-term secular growth in pockets of industries and companies that have what he characterized as “embedded growth optionality.”
The next generation of PE needs to take advantage of the industry’s governance model in a way you can’t in the public markets. This means providing companies with resources and opening doors to new geographies or lines of business that companies themselves have not considered, he said.
“If you want to deliver a top-quartile return in this valuation environment, it goes well beyond what has now become the traditional PE toolkit,” he said, whether that’s pricing, sales force or information technology, for example. “Equity checks have gone up to 50 to 60 percent, from 20 to 35 percent. In that world and environment it’s very important to go beyond that traditional toolkit.”
“In order to gain conviction in today’s environment, you need to have a clear understanding of how you’re going to create value post-close,” said Billy Gonzalez, who co-heads business development efforts for Audax Private Equity. “We look for companies where underlying organic growth can be augmented by M&A.”
More sponsors are recognizing it’s a highly intermediated world, Gonzalez added, lending to a greater frequency of PE-to-PE dialogue well before assets come to market. “Folks are trying to tip the balance of a process in [their] favor” before a process occurs, he said.
Rajpal also said he’s observed firms buy back companies that previously owned, where there is deeper familiarity with management teams and assets.
Baring’s Fowler agreed that PE groups are increasingly targeting properties they’ve owned in the past as they grow in fund size, typically outside of a process: “If you take this angle or perspective that there’s more uncertainty about where we are in the economy—and if you’re trying to reduce your risk—finding something you know well makes sense,” Fowler said. “Especially if you think there’s more meat on the bone.”
In Fowler’s view, it’s the covenant-light deals—typically within the upper-middle market—that are the most vulnerable in the late stages of the economic cycle. These deals will be unable to address performance issues early on, he said. “When you have a covenant, something’s not going right, but you’re catching it early enough that everyone comes up with collaborative and collective solutions … Documents with no covenants or loser terms are going to be in a liquidity crisis. It’s just not a good place to be.”
In Humphrey’s view, there’s no such thing as “recession-proofing a portfolio.”
“That said, for several years we’ve been really contemplating the construction of our portfolio with the macro environment in mind,” Humphrey said. “But it affects different industries differently. Some are more acutely exposed to cycles than others. … We’re very cognizant of industries that have more exposure to that volatility, but there’s no magic formulation.”