Recent investment activity in private equity was much lower than at the peak between 2005 and 2010 and will lead to a drop in exits and limited partner distributions, according to Bain & Co.
The market is in a period of “normalisation” that will last for the next 10 to 20 years, Bain said in its seventh annual Global Private Equity Report.
Global buyout deal value in 2015 reached $282 billion, the highest amount since the global financial crisis, but still far below half of the value reached pre-crisis in 2006 and 2007 of $686 billion and $674 billion, respectively.
The deal spikes in 2006 and 2007 have now been digested by the industry. “Past investments are the fuel that stokes the fire of future exits,” the report said, adding that this drop in the last five-year period “portends a coming falloff in exits over the next five years.”
There was $1.83 trillion in global buyout value between 2006 and 2010, and just $1.21 trillion between 2011 and 2015, the report said.
Bain suggested ways for fund managers to differentiate themselves and “stormproof” their portfolio.
With some LPs, such as the California Public Employees’ Retirement System that is seeking to shorten its general partner roster, a strong GP strategy becomes increasingly important, it said. GPs could zero in on investment sweet spots, so they can find the deals best suited for their “unique strengths, capabilities and past patterns of success.”
Fund managers could also capitalise on macro trends by developing “thematic investment insights.” By doing so, they could find long-term sustainable growth in businesses and sectors.
PE firms are also applying value-creation models. “It used to be that you could take the deal model, trim it by 15 percent and still wind up with a reasonable return,” Bain & Co's global private equity practice head Hugh MacArthur said in a statement. “Today, the need to transform the value of the assets is more acute than ever – sometimes you need to get the year five number in year three to realise an attractive payoff.”
Assets purchased by GPs in the last two or three years are “particularly susceptible” to difficult times, Bain said, as they were acquired during a time of high multiples and stellar economic conditions that support quicker exits. GPs would have to stormproof their assets once they realise they may have to hold them for longer than expected, and they will feel the burden of outperforming their peers, MacArthur said.
GPs should revisit their due diligence process to determine if the original incentives to invest in an asset still hold true, and what adjustments may be needed to stay through a down-cycle.
Another thing to do is tighten up the balance sheets of their most important portfolio companies, mainly seeking to better their capital structures, Bain said.
“Smarter GPs will explore ways to tap still-accommodating credit markets to refinance portfolio-company debt with covenant-lite loans or bonds that will pinch less if a recession hits,” it said, also advising fund managers to take cash from the balance sheet to pay down debt ahead of a slowing exit environment.