The other day, I went to have breakfast with the managing partner of one of Europe's most successful – and longstanding – mid-market buyout groups. There was plenty of food, but as the conversation advanced so our appetites diminished.
We met in the board room, with the croissants and Danish pastries already waiting. My host wasn't keen: “This doesn't look particularly healthy, does it?” he observed as he lowered himself into his chair, and you couldn't really disagree with him. He grabbed a roll, poured himself some herbal tea, then started talking about the realities of running a European mid-market fund in the current environment.
His assessment went something like this: at current valuations of 10, 11 or 12 times earnings, buying medium-sized companies at sensible prices in Western Europe had become extremely difficult. And given the “crazy” amounts of cheap debt being made available to buyout targets, understanding how adequate returns could be achieved from these deals was no picnic either – especially if you took into account that in the coming years, the cost of debt could rise substantially and trading conditions might worsen.
Finding European companies of sufficient scale that had not yet passed through the hands of a private equity owner was becoming harder, too. Secondaries? Yes, there really was no shortage of those, but value creation was obviously more difficult than with a primary investment. And as for finding untouched businesses with all the right characteristics, when everybody else is trying to find them too: that was a different ballgame altogether.
Keeping his firm's powder dry wasn't really an answer either: limited partnerships have strictly defined investment cycles, the capital they raise must be seen to be put to work. Holding off for six months or even a year will hardly make the task any easier, not with the amount of competition in the market place. And the longer you wait, the more pressure will build as the end of the fund's investment period draws closer.
Pausing only to refill his cup, my host then reminded me that the managing partner wasn't the only person in the firm to feel the pinch: the deal guys were painfully aware of it as well. Pursuing new investments only to run into a phalanx of rival suitors time and time again can be a demoralising experience even for the most positive of investment teams – especially if, as was true for his own firm, your target return had not been lowered yet. Managing such frustrations and remotivating the deal team every time a promising process ended in failure was a big job requiring a deft and diligent touch.
Of course, to look on the bright side for a moment, you could cheer yourself up by concentrating on exits for the time being. Given that the shortage of compelling targets was making buying assets a nightmare, selling portfolio companies at full prices was like shooting fish in a barrel. “As long as we can get the company out of hospital, we're going to sell it,” joked my host, before adding with more seriousness that rarely had the firm's investment portfolio shrunk to such a small size. No wonder the earlier fund's performance figures were looking great – but with exits outpacing new investment so comfortably, you had to wonder where tomorrow's realisations would be coming from.
At least the limited partners seemed oblivious to it all. Happily banking record distributions, all they seemed to be thinking about was how to secure more of the same. “We had a sophisticated investor in here the other day asking how to get a $300 million commitment into our next fund. $300 million from a single source into a mid-market fund!” The managing partner shook his head more in disbelief than regret: “There's no way we can accommodate that.”
And so he went on. It might have been just one of those mornings, but I came away thinking that forward-looking mid-market GPs have plenty on their plates right now.
A few days later, I met the head of investor relations of one of his competitors. Without naming names, I related the gist of what I'd been told. My contact was sympathetic: “My colleagues are telling me similar things, especially those in the UK.”
If you invest in the European midmarket, life is clearly much more than croissants and pastries.