Few would argue that we are, right now, in a hot M&A and private equity market. Fuelled by liquidity in the private equity world (dry powder stood at over $1 trillion at Preqin’s last count) the ready availability of debt and a corporate appetite for acquisitions, worldwide M&A increased by 5 percent by number in Q1 2018 over the same period in 2017, with numbers forecast to increase by 8 percent in the second half of the year, according to Intralinks Deal Flow Predictor.
This is having an inevitable effect on M&A valuations – in 2017, average M&A EBITDA multiples hit their highest recorded levels, at 10x in North America and 7x in Europe, PitchBook figures suggest. And what’s striking is that, in a reversal of historic norms, private equity is often paying more for deals than strategics. In the UK, for example, private equity deals were struck at an average 13.5x EBITDA in Q2 2018, considerably higher than the 11.6x for the overall private company universe and higher even than FTSE All-Share valuations of 12.9x, according to BDO’s PCPI.
With the re-emergence of all-equity underwritten deals in some instances (with a plan to raise debt following the deal), plus a hefty dose of cov-lite (86 percent of new institutional loans issued in Europe in H1 2018 were cov-lite, up from just over 8 percent in 2007, according to LCD, S&P Global Market Intelligence), it’s not surprising that many private equity houses and their advisors are considering the future with some degree of trepidation, given the pain many suffered in the aftermath of the global financial crisis.
“There is a mismatch between the quality of assets and the price currently,” says Ewa Bielecka Rigby, head of value enhancement at LDC. “In a year or two, we will see the next wave of restructuring. The money you can borrow on the market is extremely cheap and that can hide a lot of problems.”
Indeed, there is a growing feeling the music will have to stop – it’s just a question of when. “Capital structures are as rich as they could be for debt,” says Amanda Good, partner at HgCapital. “We’re not yet seeing any signs of contraction in the financial world and that is driving incredibly high valuations – there’s still a lot of flex in capital structures. But these will inevitably change at some point. We’re at all-time high levels of debt and that’s not sustainable.”
Watch participants at our Operating Partners Forum discuss what the asset class will do when the next recession hits.
Yet while there is a sense of inevitability about a future turning of the cycle, there is also a degree of confidence that private equity could weather a turning of the economic cycle reasonably well.
“Today’s capital structures are very similar to what we saw in 2008,” says Jim Corey, managing partner at Blue Ridge Partners. “Yet the financial crisis is still very much in peoples’ minds. There are bubbles rising in various parts of the market, but one of the key lessons from last time around is the importance of moving quickly. Private equity is better prepared to react promptly to a change in conditions – firms know they need to take costs out of the business and make deep cuts.”
Many point to structural changes in the make-up of today’s firms versus 10 years ago. “Private equity has done a lot of work around operational improvement in the years since the crisis – they have hired people in-house to drive operational change,” says Mike Mills, partner, KPMG. “That means there is a lot of focus even at pre-deal stage today about how operational change can drive value, 100-day plans have evolved into value creation plans and firms now look at a three-year horizon.”
This greater pre-deal preparation is also behind the increased use of advisors to test downside scenarios. “We are involved more and more in recession-proof due diligence,” says Mills. “Firms are looking at cashflow and how they can squeeze out additional working capital. They are much more focused on these areas than 10 years ago.”
This external work complements and helps inform internal conversations around the effect of a recession on a company well before deals are completed. “There is no deal team or investment committee discussion that doesn’t include an analysis of what a downside or recession case would look like,” says Fredrik Henzler, partner at Partners Group. “We take the development of the industry and its competitors as a proxy for examining what effect a V-shaped or U-shaped recession would have or what a drop in EBITDA or cashflow would do.”
Firms are also creating plans for different scenarios – in fact, as Good says, this was one of the main lessons her firm learned from the crisis. “From an operational perspective, you can’t always expect that Plan A will happen,” she says. “This is especially so when looking at organic revenue growth. You have to question whether the budgets will be there the following year. Will companies spend more with you next year if their budgets get cut? You have to devise a case for if there might not be as much money to spend on your products or services. You have to have a Plan B that might be very different from your original investment case.”
They are also looking at which sectors or niches are likely to weather any future downturn better than others. “You can’t create a company that’s recession-proof,” adds Good. “You have to look at industries that are more recession-resilient. For us, that’s areas such as technology that provides critical workflow services businesses – you can’t turn off the back office in patient healthcare records, for example. You have to know what kind of industries you, as a firm, are going to be more comfortable with if a downturn hits.”
With the right operating partners on board, private equity firms should be in a better position to manage portfolio companies in a crisis. “One of the big lessons we learned was that it’s not enough to buy a company and then just let the management team run with it,” says Bielecka Rigby. “That only works in one in 10 instances. We have to apply our own skills and experience to help management teams to deliver better results. Operating partners, which have become a much more common feature of in-house teams, bring a lot to the table, from increased focus and monitoring and changing targets when conditions shift through to being at the top of the game all the time.”
Whether these changes in the make-up and priorities among private equity firms mean the industry’s portfolio weathers the next downturn better remains to be seen.
As Mills says: “I don’t know whether private equity businesses will be recession-proof in the event of another crisis.”
Yet it’s clear what happened 10 years ago is still imprinted on many executives’ minds. And perhaps one sign of a more cautious approach at a time of high valuations is that many firms we speak to not only acknowledge the fact that prices will have to reduce at some point, but are also making the assumption in many investments now that their exit multiples will be lower than those at entry.