Capital kept pouring into private equity last year. Private market fund managers, including those dealing in private equity, real estate, infrastructure and natural resources, raised around $900 billion in 2019. The aggregate value of buyout deals reached $551 billion.
US stock markets outperform PE for first time
For the first time in a decade, the S&P 500 delivered higher returns than private equity, according to Bain, which worked with Professor Josh Lerner of Harvard Business School and State Street Global Markets to analyse performance. US buyout funds delivered a pooled net internal rate of return of 15.3 percent in the 10 years to June 2019, while the S&P 500 PME generated 15.5 percent in the equivalent period.
Several factors were behind the upward momentum in US stocks’ performance, including strong growth in the US economy as well as more business-friendly tax and monetary policies. US equities also “benefited from a global flight to quality as bad news in Europe – Brexit, sovereign default scares, the threat of recession in Germany and Southern Europe – drove investors to seek solace in the S&P 500”, Bain noted. Bain predicted, however, that double-digit returns in public markets are unlikely to persist over the long term as we near the end of a cycle. Investors are aware of this and will continue to allocate more capital to private equity, believing in its “outperformance” over other asset classes, the report noted.
Public markets’ outperformance “raises questions about how private equity can stand out and remain attractive to investors”, Hugh MacArthur, global head of Bain & Company’s private equity practice, said in a statement accompanying the report.
Multiples and leverage continue to rise
GPs are using more leverage to finance increasingly expensive deals. Earnings multiples rose to a record high as leverage surpassed levels seen in the run-up to the global financial crisis. The average US buyout enterprise value to EBITDA multiple increased last year to 11.5x. This represents 56 percent of the total deals in 2019, an increase of 10 percent on the figure for the previous year.
High levels of debt usage have been a driver of increased EV/EBITDA multiples. More than 75 percent of buyout deals in the US utilised debt that is more than six times EBITDA. This is significantly higher than period after the 2008 global financial crisis when their share did not exceed 25 percent, according to Bain.
Commenting on credit funds, Patrick Schoennagel, a managing director in Houlihan Lokey’s debt capital markets team, said such funds are willing to put historically high leverage on companies they deem to be “bulletproof assets”.
Schoennagel noted that the level of debt used in a transaction is highly dependent on the quality of the asset. “In many instances, it is easier to obtain relatively loosely-structured financing bids at circa 7x leverage for a business deemed highly attractive than solicit interest for more lender-friendly structure at 4x for something more industrial and cyclical in nature.” He added that whether that trade-off is appropriate will only be obvious once such funds and their portfolios have been tested in a significant macro-economic downturn.
Multiple expansion no longer the driver of buyout returns
Since 2010, multiple expansion has been the main driver of buyout deal returns in the US and Western Europe. That is now slowing – the spread between entry and exit multiples stood at 2.5x in 2019, similar to 2018 levels, according to Bain. That spread was 3.4x in 2009, revealing that GPs increasingly need to find new levers for value creation whether through M&As, cost efficiencies or entering new product lines or geographies.
Bain’s analysis of 65 fully realised buyout deals invested in 2009 through 2015 revealed that the average margin was well below the deal model forecast, and the majority failed to meet their projected margin expansion. Even more worrisome, noted Bain in its report, is that for deals where margin improvement was a critical factor in the value-creation plan, more than three-quarters did not meet the margin target.
McKinsey noted in its report that the industry has evolved in a few noteworthy ways – such as the rise of GP stakes fundraising, the secondaries market and the build-out of fund adjacencies. GP stakes fundraising nearly tripled to $9.4 billion in 2019, from $3.4 billion the year before, led by Dyal Capital Partners’ $9 billion haul for its latest fund dedicated to the strategy.
Meanwhile, interest in GP-led secondaries remained strong in 2019. Transaction volume in this space reached $42 billion as of the first half of the year, according to data from Greenhill Cogent. McKinsey expects transaction volumes to hit $90 billion, up 35 percent annually since 2016, once full-year 2019 figures are tallied.