With buyout firms now looking to close deals, there is danger that we face another price bubble.
By Hans Christian Iversen, Managing Director, MorganFranklin Consulting, London
The watching and waiting is over. Following the recession, the private equity (PE) industry in the US and Asia is on the move. Expect a flurry of deals in the European market in the price bracket of up to £1 billion, with those sitting on piles of cash homing in on those with debt-ridden balance sheets.
While this is good news considering the general sluggishness of the merger and acquisitions (M&A) market, take heed that this is not simply the start of another private equity bubble. The old Boy’s Scout motto ‘Be Prepared’ applies to any firm contemplating either buying or selling. Money is cheap but this is merely leading to refinancing of all types and risk is almost being discounted, while the banks are still reluctant to dispose of assets.
Among the larger players – particularly the American funds such as TPG Capital, Carlyle Group, KKR & Co, and Apollo Global Management – that have been working to extract maximum value from their buyout portfolios, there is a growing appetite to close more global deals, however houses are still wary of investing and there are a lot of aborted deals.
The continued availability of cheap debt coupled with sovereign wealth funds (particularly with the Middle East and China turning toward private equity) means there is plenty of buying power in the wings. The oil-rich Persian Gulf sovereign funds are expected to allocate one-third of their money into private equity over the next 18 months. Blackstone Group’s £500 million bid for Pactera Technology International, an outsourcing firm based in Beijing, is an indication of the type of activity to come.
There are lessons to learn in Europe about how to ensure maximum value from existing investments and deliver superior performance from companies within private equity portfolios. Now, more than ever, buyout investors need to know exactly what they are getting for their money. Exits were phenomenal up to the end of 2008 and a few since then have been very good.
So where are these golden deals? In 2006 and 2007, UK firms in particular gathered numerous funds for investments, and these funds were invested in companies at premium prices. Now a raft of private equity companies are awaiting the opportunity to offload such ‘assets’ bought at the height of the boom. During the recession, a fire sale of assets was only enforced when pressure from banks became too difficult to bear. Now valuations are more realistic and private equity firms with cash are looking for morsels from other buyout firms with negative balance sheets. Very few houses have exceeded their mid-2000s fund raising.
While valuations have improved, a return to pre-recession peaks is unlikely. Yet cash-strapped PE houses are ready to offload whole businesses and non-core assets that no longer fit the strategy of slimming down. The private equity industry is looking at itself to buy and sell. On the shopping list are specialist engineering firms in oil, gas, and utilities; health care providers; financial intermediaries; specialist and premium-branded retail goods companies; and telecom, IT, and media service providers.
One perceived advantage of buying from an established PE group is that due diligence will have been conducted by experienced teams that likely worked with management teams and balance sheets, offering some form of comfort. The reality is that there is an acute need to prepare private equity portfolio firms for a change of ownership. With serious questions around how some private equity groups have managed their firms, it is necessary to focus on carve-out from existing portfolios. This requires far closer scrutiny of assets and income, vendors, and employees. Dampened enthusiasm for secondaries, tertiaries and onwards as the investors have been round and round the assets and are looking for fresh opportunities.
Danger signs must be heeded. With cheap credit, this growing interest in buying businesses could create its own bubble. Some over-leveraged buyout firms may be on track to repeat another bubble in European private equity, as prices for companies bought and sold between them are transacted at inflated prices. Companies that are undergoing changes in capital structure, strategy, or operations need to look at how they build and maintain growth.
One long-standing complaint about private equity is the ‘excessive’ fees charged by firms, which have been difficult to justify when returns are poor. However, some of the excessive fees have been squeezed and, since 2006, as new funds have been raised, transaction fees have all but been eliminated as rules have tightened. Such fees are justified only by business efficiency and increasing value for investors. Again, this requires pinpoint focus on enterprise management systems and full exploitation of market opportunities, a fact that some PE houses have neglected at their own peril.
While significant European funds exist, such as EQT and Nordic Capital in Scandinavia, AXA Private Equity in Paris, and AlpInvest Partners in Holland, the market is dominated by Anglo-Saxon funds, and this means more action for London. It is going to get busier, so the industry must avoid making the same mistakes of the early to mid-Noughties.
MorganFranklin Consulting, based in Washington DC and London, is an international services firm that provides business operations, financial advisory, and IT consulting solutions to companies in a wide range of industries including telecommunications, energy, retail, and technology. In 2012, MorganFranklin was named to Consulting magazine’s “Best Firms to Work For” list and the Inc. 500|5000 list of the fastest-growing private companies in America. www.morganfranklin.co.uk