Mid-teens net IRR the ‘new normal’

High prices and lower debt multiples will take their toll on returns, according to research from alternatives manager Partners Group.

The combination of high entry prices and lower debt levels will result in a “new normal” of net internal rate of returns in the mid-teens, according to Partners Group’s “H2 2016 Private Markets Navigator”.

“This is low compared to long-term net IRR expectations for private equity in former times, which sat in the high teens,” the firm said.

High entry prices “continued to be a hallmark of the LBO deal environment in H1 2016”, at around 10x pro forma trailing EBITDA in both the US and Europe, reaching as high as 14x for larger transactions, the report said. Today’s average purchase price exceeds those in the pre-crisis peak years.

However, unlike in 2006 and 2007, today’s high entry prices are accompanied by higher average equity contributions – around 50 percent in Europe and more than 45 percent in the US, compared to around a third pre-crisis.

“In the US, where equity participation has traditionally been lower than in Europe, this is a direct result of regulatory intervention impacting the banking sector. In today’s market, many banks are no longer able to underwrite highly-levered transactions.”

Partners Group said that in the current environment it is focusing on “companies that have largely preserved their value over several cycles” and will continue to hold their value in future periods of volatility.

“These are typically companies with long-term recurring revenue streams, sticky customer contacts and highly visible cash flows,” it said.

The firm said it is targeting “growth-focused investment opportunities” in sub-sectors where growth is around two to three times higher than the overall growth rate in that region or sector. Most opportunities fitting its investment criteria are in the mid-cap space, it said.

Key sectors in North America include business and industrial services, and healthcare, including healthcare outsourcing.

In June Partners Group agreed to acquire global pharmaceutical services provider PCI Pharma Services from Frazier Healthcare Partners. Partners intends to work with PCI’s management team to add more specialized offerings to the product range and expand the company both organically and through add-on acquisitions, it said in a statement at the time.

Partners Group is broadly focusing on the same sectors in Europe, although the firm observes “one major difference” between the US and European markets.

“Whereas many US opportunities arise from companies breaking with tradition in order to do things differently, many European investment opportunities still have business models that can be broadly described as ‘traditional,’” the report said.

“In several cases, the updating of that business model – through the process of digitalisation for example – offers a clear value creation path for hands-on and capable private equity managers.”

In July Partners Group teamed up with Caisse de dépôt et placement du Québec (CDPQ) and CIC Capital Corporation on its largest European direct private equity deal to date, acquiring French residential property management services provider Foncia in a deal valuing the business at €1.833 billion.

Following the acquisition, which is expected to complete this month, Partners Group will hold a majority stake in Foncia on behalf of its clients, and will lead the company’s board, as reported by Private Equity International.

Focus areas in Asia, where the firm’s investment appetite is “still driven by the growth of the middle class and attendant growth in demand for services, goods and social infrastructure”, include healthcare, consumer sectors and financial services.