In light of the uncertain and volatile market conditions facing the European Union and the strong structural headwinds the region must contend with, what is a private equity investor to do?
Growth oriented strategies would appear to be out, at least for the foreseeable future. For the medium term, the operative word is “opportunistic”. In the absence of compelling investment themes, managing downside risk will be in order. Some areas of interest include:
Typically in an environment as uncertain as Europe, distressed investment strategies would be well positioned.
However, certain factors make distressed investing in Europe problematic, including the lack of an EU-wide bankruptcy/restructuring regime, smaller debt markets, the heavy use of bank debt for business financing and the disparate legal and social environments of various EU countries. Still, there are a few managers that have demonstrated an ability to make control investments, primarily through equity, or who focus on countries with more developed bankruptcy laws such as Germany and the UK.
In a related area, turnaround managers should be of interest as mid-market and smaller companies can be expected to come under increased pressure in a slow-growth environment. However, the pool of investor talent dedicated to this space is relatively small in Europe and regional differences complicate matters, so the ability to make large investments in this area may be limited.
Direct credit-oriented investments should find a strong pipeline of deals, especially in the mid- and lower-market, as bank lending in these areas flatten or declines and financial performance declines due to the poor economic environment. Larger firms will probably be able to access the debt markets periodically, so the opportunity in that sector will be reduced.
In a related vein, debt associated with private equity-backed buyouts (many of which were financed at levels close to 6x earnings before interest, taxation, depreciation and amortisation at the peak) may present an attractive opportunity if there is a major financing dislocation, similar to what occurred in the US in 2008.
Given the deleveraging that will be forced on European financial institutions over the next couple of years, likely a large quantity of financial assets will be spun off. Talented private equity investors should be well-placed to purchase sound businesses or assets at attractive prices. One opportunity along these lines may relate to CLOs held by European institutions. With reinvestment periods ending for the larger quantity of CLOs raised during the boom, improved credit quality and existing and potential pricing inefficiency, such vehicles may offer an unusual risk-reward tradeoff while avoiding direct exposure to the EU economy.
Also related to the stress in the financial system, secondary private equity deals will be of interest, as increasing regulatory and market pressures on European financial institutions to raise additional capital are likely to force sales of such assets, leading to attractive secondary deal flow.
As noted, within the more traditional buyout sector, strategies predicated on strong domestic growth and robust exit
For the medium term, the operative word is 'opportunistic'.
markets are likely to underperform. However, buyout investments with the following strategies and/or target companies should prove most successful:
- Export-oriented businesses and sectors;
- Businesses that derive a large portion of revenue from higher-growth, near-Europe peripheral regions, such a Turkey;
- Companies with strong cash flows and asset bases that can provide downside protection;
- Buyout managers with demonstrated ability to meaningfully influence the operations and cost structure of their portfolio companies to generate cash flow in a lean, flat-growth environment. Managers that can assist portfolio companies in accessing foreign demand for products and services should also find Europe a target rich environment;
- Investments with low leverage;
- Investments in less-affected areas like the Nordic region or Germany, executed by managers with local expertise
- Defensive sectors like healthcare, insurance and certain financial services products.
David Fann is president and chief executive officer of TorreyCove Capital Partners, a global private equity investment advisory and consulting firm.