Perspectives 2016: Europe's fears over market valuation

Europe funds raised 411

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A clear concern came out of this year’s Perspectives survey: LPs are worried about pricing. Across all three regions, investors cited “extreme market valuations” as one of the top three macro issues likely to impact private equity over the next year. More than 40 percent of European LPs chose this as their top concern.

“There’s no doubt that valuations are in high territory,” says Antoon Schneider, a partner at Boston Consulting Group.

These high valuations have resulted in a vibrant sellers’ market. In the first three quarters of 2015 the total value of European exits stood at more than €105.6 billion and the average exit value reached a record €344.9 million, according to data from the Centre for Management Buy-out Research.

However, deploying capital has not been easy. To the beginning of November GPs deployed $78 billion in 579 European deals, compared with $101.5 billion deployed in 827 transactions in 2014, according to Dealogic. By value, private equity transactions were 17 percent of European M&A activity in 2015 to 9 November, compared with 24 percent in 2014.

Jonny Myers, global head of private equity at Clifford Chance, is seeing intense competition for deals.

“There is a lot of hunger to get deals done and it’s a strong sellers’ market,” he says. “Competition is driven by significant corporate activity and some funds comfortable with a lower return than traditional private equity in certain sectors. So you have got new entrants into the markets, you have got the lower return funds, you have got the corporates. It’s a busy buyer marketplace.”

The buoyant IPO market has also made life difficult for private equity firms.

“When the valuations are high on the equity markets and the IPO market is relatively stable it is a significant alternative source of exit, and therefore is taking opportunities away from buy-side PE,” says Myers.

The question, Schneider says, is this: “Are PE firms being disciplined or also going along with the flow?”

“Every one of our GPs will say that it’s a difficult time to invest,” says Francesco di Valmarana, partner at Pantheon. “Our GPs fortunately seem to have longer memories than their banking brethren and are being quite disciplined and investing to five-year cycles as opposed to three-year deployment cycles.”

According to data from S&P Capital IQ, the average purchase price multiple for European buyouts financed by a leveraged loan between January and October 2015 was 9.2x, down from the average of 10.0x in 2014, suggesting that GPs are not willing to acquire assets at any price.

“Private equity is on balance disciplined, which is why volumes have dropped recently,” says Schneider. “But that doesn’t mean that they’ll never overpay. It can be hard for a private equity firm to be disciplined for too long. They have funds that investors want them to invest.”

Inextricably linked to high valuations is the concern that cheap debt is pushing up prices. Forty percent of European LPs surveyed cited this as one of their top three concerns. The abundance of cheap debt – and therefore the use of increasing amounts of leverage – carries with it several risks.

“The most obvious is increase in interest, [and] people will look at hedging their interest rates,” says Myers. “Other risks are mismatch on currency, so borrowing in one currency, revenue being generated in others.”

With interest rates as low as they are currently, they can only move in one direction, so GPs need to leave their portfolio companies with some headroom.

“These high multiples are fine as long as there is cheap debt available but if you sell five years from [now] and debt is much more expensive, well then you’ll find valuations are probably going to be lower,” says Schneider.

One issue on which European LPs significantly differed from investors in other regions was the weight they gave to geopolitical risks; 50 percent of LPs in Europe classed it within their top three concerns. Just 33 percent of LPs in Asia and 16 percent of US investors included the issue in their top three.

Europe risk poll

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The reason, according to the market sources PEI spoke to, is clear: many of the geopolitical events shaking the world today are on Europe’s doorstep.

“Europe is closer to where much of the [geopolitical unrest] is happening, and thus [European LPs] are sensitised to it,” di Valmarana says.

Uncertainty over Ukraine, the fallout from terrorist attacks in France, political unrest in Greece and mass migration from Syria and parts of Africa are some of the issues at the forefront of European investors’ minds.

“It’s not a likely event, but if the question is, ‘What could lead to a significant loss in company valuations?’ the only other factor I can think of is some large macroeconomic or geopolitical [event],” Schneider says. “[I’m] not sure what else could lead to a significant reduction in valuations over a five-year horizon in Europe.”

Despite their concerns, half of the European LPs surveyed say they intend to increase their allocation to private equity in the next two years, with 40 percent expecting their allocation to remain the same and just 6.7 percent planning to decrease their exposure to the asset class.

“What we’re hearing from many of our LPs is a recognition that the risk premium is well deserved and it pays for itself,” says di Valmarana. “Why have a large exposure to equities, which give you limited upside potential but all the downside of the public markets?”

Alternatives, on the other hand, particularly private equity, have “demonstrable value creation potential” and the ability to ride out cycles. “It’s just got more levers you can pull at different times in the cycle to preserve and then create value,” di Valmarana says. He has found many LPs making up the rest of their portfolio with highly liquid, low-risk investments such as government bonds, which are less likely to suffer at the hands of geopolitical incidents.

“There seems to be a flight to both ends of the barbell because in the middle ground, public equity markets, the view is that the returns that it offers don’t quite compensate for the volatility that you’re subject to and the risk of a significant downside if there is a major event,” he says.