Ask the European LP community to sum up the private equity environment in 2016 and two words appear time and again: uncertainty and volatility.
Shockwaves rippled through Europe in June following the Brexit referendum, and the implications of the momentous decision by the UK to leave the European Union have yet to become clear. With elections next year in France, Germany, the Netherlands and Hungary, the future of the EU is far from certain.
“We are looking at the potential implications of political change. We’re looking at exchange rates: what currency the fund is launched in, what currency it will be investing in,” says Angela Willetts, co-head of private equity investment management at Capital Dynamics.
“[We are not expecting] wholesale correction or crisis, but I think we’ll see a lot more volatility going forward as we have announcements, whether it’s with Trump in the US and any political implications there, or with Brexit.”
Despite the unease, 2016 has been another good year for fundraising, as distributions to LPs once again outweighed capital calls, according to advisory firm Triago.
Globally, private equity funds raised $357 billion in 2016 year-to-date, compared with $423.8 billion in 2015. And the average fund size is creeping up, sitting at $621 million for 2016, up from $602 million in 2015, according to PEI data.
“It’s been a busy fundraising period. We’ve been very busy in terms of our due diligence,” says Willetts. “[There’s] still a good, steady flow of cash coming back, good investment opportunities, quicker closings, but maybe a slower investment pace.”
And despite predictions earlier in the year that fundraising might slow slightly in 2017, Willetts anticipates it being as busy as ever.
“A lot of investors are struggling to find a home for their money into private equity. They’ve either been scaled back or shut out of certain funds,” she says.
“There’ll be some investors that didn’t get the allocations they wanted in 2016 so perhaps are looking even more aggressively in 2017.”
Although it’s been full steam ahead with fundraising, the investment pace has been much slower. The value of European private equity transactions fell by almost a half in the first half of the year, according to research from the Centre for Management Buyout Research, with a notable decline in transactions worth more than €1 billion – down to three from 12 in H2 2015.
Overall, 297 deals worth a combined €25.6 billion were completed, compared with 344 deals worth a combined €48.5 billion in H2 2015.
The combination of a stellar fundraising environment and a slower investment pace meant that as at June 2016, global dry powder stood at a record $1.4 trillion. For many, this is worrisome. “Our first concern is the amount of capital in the sector,” says Tim Creed, managing director and head of the Europe programme at Adveq.
“Private equity has outperformed pretty much every other asset class for almost any time period you want to choose, and so that has made the asset class more appealing to other investors. The amount of capital in private equity has been increasing, and whenever you have more money in a segment you’ve got to be more cautious.”
“Something has to change,” Graeme Gunn, head of investment monitoring at SL Capital, told PEI earlier this year. “All our funds we’re invested in have been in exit mode now for three years, so everything has been pushed out the door. So we’re past peak value on exit, but we’re still seeing an increasing volume of exits within our portfolio. When are the funds going to switch back to proper buying again and is there going to be the volume of opportunity there?”
For the second year in a row, European LPs indicated that extreme market valuations are an issue of utmost concern. Coupled with the excess liquidity in the market, it seems safe to say that European LPs are concerned returns could start to come down.
“I would expect there will be quite a dispersion of returns between the really good groups and the not so good groups,” Creed says.
At the British Private Equity and Venture Capital Association annual summit this year, more than half of delegates responding to a live poll said when evaluating investment opportunities, they are not assuming the exit multiple will be lower than the entry multiple. However, several panelists said otherwise.
Willetts, who says Capital Dynamics still expects its managers to deliver double-digit returns, is also hearing that managers are building multiple contractions into their assumptions.
“It’s all about ‘can managers make good returns in whatever environment?’, whether it’s a crisis environment or a boom environment,” she says.
“We’re seeing managers focusing much more on operational [improvements]. If they are
building in multiple contractions in the assumptions, they’ve got to work harder on an operational basis to build value.”
European LPs are also battling against regulatory issues, the most pressing of which is the Alternative Investment Managers Fund Directive.
Forced to comply with the directive but denied an automatic pan-European marketing passport, non-EU managers have to solicit capital from European LPs through each country’s fund marketing rules, known as national private placement regimes.
For some particularly hot funds in the US, particularly in the lower mid-market, the extra compliance and reporting costs involved in marketing to EU investors is not worth the hassle.
“American funds that are very good, let’s say their last fund was $500 million, they’re raising $600 million, existing US investors take the whole $600 million,” Christian Kvorning, an investment director at the alternatives arm of the €31.5 billion Danish pension fund PKA told PEI this year.
“They don’t call, they don’t market, they don’t come to Europe, they don’t contact us, we don’t know of them, they’re gone. That’s not a good situation. And that happens all the time.”
Creed agrees. “We’ve heard many stories of US groups not travelling to Europe or not wanting European investors,” he says, adding that Adveq has a team on the ground in the US which allows it to gain access to GPs many European LPs would never see.
And regulatory and compliance issues are only moving in one direction.
“We often say an institution like us, which both raises and invests capital, needs to be above €4 billion in assets under management in order to have the structure in place to invest institutional capital,” Creed says.
“For the organisations with a smaller amount of capital, it must be quite a challenge to have the appropriate regulatory, compliance and legal skillset to adapt to the constant changes that have been going on for the last 10 years, and we expect to continue indefinitely.”
“Uncertainty” has been the buzzword of 2016, and Willetts doesn’t see any signs of that changing as we go into the new year.
“We have to be prepared for more volatility in public markets and exchange rates and build that in to the process.”