Annual Review 2015: North America at the turning point

As the US private equity industry got 2015 underway it looked for many as if the strong fundraising and deal-making activity of 2014 would continue. However, as the year progressed, opinions started to change.

By November, when news broke that The Carlyle Group was struggling to finance its proposed $8 billion buyout of Veritas, a data storage company, there was no denying that investor appetite for loans used to fund private equity deals had started to wane. A turning point for the market? Many observers thought so.

Gone, or at least weakened, was the bullish mood that had prevailed at the beginning of the year, when GPs were looking to tap the wide-open credit markets to deploy their uninvested capital – $1.3 trillion globally, according to private equity marketplace Palico.

US deal activity in 2015 was fuelled by the pursuit of size and scale to remain competitive, and by the impact of regulatory changes, said PricewaterhouseCoopers. Overall, deals of more than $1 billion accounted for three-quarters of total value, returning to pre-crisis levels for mega deals, the accountant said.

The largest private equity deal announced during the year was the proposed takeover of EMC for $67 billion by Dell, Silver Lake and Singaporean investment fund Temasek, the largest acquisition in history.

Managers were also busy selling investments, creating stellar distributions of realised returns back to LPs in the process. By the third quarter of 2015, GPs globally had distributed $392 billion from realised investments and dividend recaps to LPs, up from $359 billion in the same period of 2014, according to fund advisory firm Triago. Thanks to these distributions, and struggling to find attractive opportunities in other asset classes, investors sought to plough commitments back into private equity. 

According to data from PEI Research & Analytics, global fundraising last year hit $384 billion, compared with $394 billion in 2014, with US mid-market buyout funds of between $800 million and $2.5 billion being particularly popular, according to a survey by placement agents Probitas Partners.

Successful US mid-market fundraisings included Silversmith Capital Partners’ debut fund, which closed after three months on $460 million, above its $350 million target, and Carnelian Energy Capital’s debut fund, which closed on its $400 million hard-cap without using a placement agent. Thompson Street Capital Partners closed its TSCP IV in December on $640 million, above the $500 million target, after using a placement agent for the first time.

Back in the deal market, strong competition for assets continued to put upward pressure on valuations, and deals were getting more difficult to get done. “Last year was not too dissimilar to 2006 and 2007: we saw leverage levels continue to rise, and in correlation with that, we saw purchase multiples rise,” says Monroe Capital managing director Matt Evans.

As a result, financing activity for LBOs began to slow. In January 2016, Thomson Reuters’ US lending report found that the amount of leveraged lending to US private equity sponsors in 2015 fell by 29 percent to $285 billion from $399 billion a year earlier.

The market for leveraged loans has halved in size relative to its peak in 2013, partly as a result of lending restrictions on US banks, but also because of a heightened sense of risk among loan investors.

The effect on the credit markets was partially offset by alternative credit providers, such as private debt fund managers and direct lenders, who saw the opportunity to fill the gap – often willing to lend at higher multiples and with laxer covenants than banks.

Despite their intervention, however, the lending market contracted relative to 2014.

To observers like Jim Zenni, president and chief executive of Z Capital in Chicago, last year’s leverage levels spell trouble for private equity. “What we have today is the beginnings of significant defaults going forward; significant restructurings,” Zenni told PEI in November. “The environment we have today is not sustainable.”

Others believe there is no reason to panic. The same month, David Sulaski, managing partner at M&A and debt advisory firm Livingstone, said: “It’ll just be part of a more normal cycle. At 5-6-7x the earnings, it will cause companies some heartache, but we won’t see anything quite like [2008].”

Evans at Monroe takes a similarly optimistic view, especially in the context of the mid-market.

“It’s not unlike 2009 or so when we saw a lot of the activity disappear in extreme dislocation in the upper end of the mid-market,” he says. “In the lower end, we’ve seen activity be a little more stable with regards to pricing, leverage and other structural terms of debt facilities. Over the last three or so years, there’s been a lot of long-term capital raised on both the equity side, among sub-billion-dollar private equity firms, as well as on the debt side, with the BDCs [business development companies], and the SBIC [small business investment company] funds continuing to invest capital in the lower mid-market side of business.”

Whichever way you look at it, by the end of last year there was no denying that the market had entered a state of dislocation. Some saw this as a positive development, which would help restore a sense of perspective, help rid the market of some of the excess capital flowing in over the last few years and reduce competition for assets to a more sustainable level.

The pessimists saw an early sign of more trouble to come. Given the extreme volatility battering markets at the time of this article going to press, even long-term minded market participants like private equity investors must be hoping that a degree of stability can be restored quickly.