The Deal and Donnelley Financial Solutions recently broadcast “The State of Private Equity: Current Trends and Outlook,” a panel discussion featuring host Daniel Perez (Director of Business Strategy for Venue Virtual Data Room, Donnelley Financial Solutions). Daniel sat down with Andres Saenz of Parthenon-EY Practice, Richard P. Prestegaard of High Road Capital Partners and Shamit Grover of MSD Partners to discuss the current state of private equity and the trajectory of transitions among private equity firms. This is part one of an overview of the hour-long discussion, which is available for viewing online from The Deal.
According to data provider Prequin, “In 2016, private equity-backed buyout deal activity saw an increase in the number of deals but a decline in the total value of transactions.” In 2017, private equity firms continue to face high multiples amid tough competition from strategic buyers and other private equity firms, even in a general state of market uncertainty which may stem from, among other factors, the new administration in Washington D.C. and Brexit.
Increased Competition: A Seller’s Market
Dry powder, meaning cash available to invest, is at near-peak levels of approximately $500 billion across private equity firms in the U.S. These firms are under tremendous pressure to invest these securities and are competing with each other to buy promising businesses going up for sale. The broad definition of a private equity firm has created even more competition because now traditional firms are competing with private equity including pension funds, sovereign wealth funds, family offices and more. More competition means higher demand, leading to higher valuations and higher multiples. In the meantime, strategic buyers with cash in hand are searching for inorganic opportunities to grow their business and are capable of placing winning bids based on post-deal synergies. This means more competition, higher demand and increasing purchase prices.
The seller’s market which has emerged is likely to continue and competition may even increase as we move forward.
The Market Spectrum
Opportunities for private equity differ depending on what side of the market you look at. Robust opportunities exist among many smaller businesses seeking to transition ownership, so while deal flow among larger businesses may be down in 2017’s first quarter, some private equity firms which focus on smaller deals have actually seen an increase.[su_pullquote align="right" class="pullquote"]Multiples may be trending on the high side but there is uncertainty about where they will go from here.[/su_pullquote]
Multiples may be trending on the high side but there is uncertainty about where they will go from here. At present, 10x is referred to as a median or average multiple for clearing a private equity buyout deal, some of which would have garnered a multiple of 7-8x only a few years ago, but this depends on the sector and, sometimes, on the size of the business. Generally, smaller businesses are currently seeing average clearing multiples in the 7-8x range according to GF Data, which aggregates information on deals up to $250 million.
Buyers from private equity may be competitive, but they are not desperate. Both private equity firms and strategic buyers are looking for investments, so any business wishing to attract the competitive cash running through the market right now must show reasonable growth opportunities.
Strategic Competition and Specialization Around Subsector
Private equity is competing with strategic buyers as well as an expanded universe of private equity competitors, including private equity of all sizes, hedge funds and family offices, as well as pension funds and sovereign wealth funds that are getting more organized. There are more providers of capital today than just strategic buyers and, as any maturing industry, private equity is seeing more specialization, concentration and organization around the industry. Private equity firms are increasingly narrowing their focus to the specific areas where they excel and have greater ability to create value.
Stiff competition has also led firms to search out opportunities they can develop 12-18 months before those opportunities even come to market so when the time comes to buy, they have already differentiated themselves with a clearly articulated view of how they’re going to create value. They have their M&A strategy lined up, as well as three or four operational initiatives.[su_pullquote align="right" class="pullquote"]Potential buyers are raising different types of funds as well as exploring different areas of the market.[/su_pullquote]
Potential buyers are raising different types of funds as well as exploring different areas of the market—in fact, larger funds are aggressively seeking out smaller deals as competition increases. The trick is how to deploy enough capital to make sense for the firm. Some people create holding companies, find a CEO, have the infrastructure in place and assign a significant pool of capital. Then they purposely go out and do smaller deals they can cobble together to create a platform. This allows firms to get out of their traditional comfort zone and find deals in what is now a more competitive space. These firms are thinking in terms of how many dollars they’re deploying and not about the multiple when they buy, but then they think of an add-on strategy that will average the multiple down over time and deploy more capital.
So what does this look like in the real world? We see it in healthcare providers. A private equity firm may decide to focus on healthcare and start buying up smaller providers in the healthcare industry. There are lots of small practices specializing in dermatology, eye care, etc. These mom and pop providers can benefit from being part of a larger organization, and firms are targeting them as a market for this cobbling strategy. You can see this happening in other industries as well. In the consumer space, for example, there’s demand for authentic, local brands which cater to innovation and smaller assets. If a private equity firm can professionalize such brands and meet the root demand for the consumer, they can create an attractive investment platform.
Next week we’ll look at high-level trends and exit strategies in part two of this series.