Annual review 2016: Why North America is still pulling in investors

The private equity market reached new highs in 2016 in the US with valuation multiples not seen since 2010 and record amounts of dry powder.

However, investors managed to remain disciplined in their investments. Deal volume was also hit by uncertainty and bouts of volatility in the equity and credit markets, particularly at the beginning of last year.

As of 30 November, dry powder in the US stood at $322 billion, representing 60 percent of the $536 billion global total, which is also a record, according to Ernst & Young, but investors were a little worried about their ability to put the money to work.

“I don’t think where we are with dry powder is unreasonable if people are disciplined when using it,” Bill Stoffel, private equity leader at Ernst & Young, told Private Equity International. “We currently aren’t seeing $20 billion buyouts but we are expecting an uptick in the number of billion-dollar-plus deals, which is the sweet spot for private equity and a great use of dry powder.”

“You shouldn’t look at dry powder as simply a number,” concurred Greg Stento, managing director at Boston-based HarbourVest Partners. “It’s about how investors are using that dry powder, such as the pacing of capital deployment.”

The boost in dry powder was fuelled in part by an expanding investor base for private equity fund managers. Unlike some three decades ago when large public pension funds took up the majority of the investor base for private equity funds, there are now new and varied types of limited partners writing cheques to the managers.

For example, Blackstone chief financial officer Michael Chae noted during the firm’s 2016 and fourth-quarter earnings call at the end of January that retail and high-net-worth investors’ capital account for 17 percent of Blackstone’s total AUM of over $360 billion.

Another reason for the mounting cash in private equity is the strong exit environment presented to GPs by high valuations.

Carlyle noted in its fourth-quarter and 2016 earnings statement that it realised a record amount of proceeds for its investors of $30 billion during the year. It also reiterated its plan to raise $100 billion between 2016 and 2019, having raised $14 billion during the year.

Similarly, fellow private equity giant KKR had a record fundraising year in 2016, with its own war chest of uncalled capital sitting at $38 billion as of 31 December.

The lower volume of deals demonstrates this discipline in investing. It also reflects periods of volatility and uncertainty throughout the year.

According to PitchBook, there were 2,477 completed private equity deals as of the end of the third quarter, which put deal volume on track to fall 18 percent year-on-year from 2015.

“Overall if you look at the M&A market as a whole, it wasn’t one of our strongest years,” CohnReznick’s private equity and venture capital principal Jeremy Swan said. “It was weaker than last year and most years, partly due to the lack of quality dealflow in the market.”

This slowdown was true across the spectrum, including in the mid-market, but it wasn’t a complete surprise, according to some.

“It was largely anticipated that the market would slow down,” Whitney Krutulis, director of business development who sources deals at Chicago-based Sterling Partners, told PEI. “There were less deals and less capital invested, but there’s still a lot of money people are looking to put to work.”

Low interest rates and the availability of cheap debt fuelled high purchase price multiples. PitchBook said as of 30 September, EBITDA multiples reached 11.2x, the highest since 2010 and up from 10.2x in 2015.

US mid-market valuations reached about 11x EBITDA on average last year, according to co-chief executive of mid-market firm Riverside Company Bela Szigethy, who was speaking at a media luncheon in December.

During the fourth-quarter earnings call, KKR head of global capital and asset management group Scott Nuttall said private equity valuations in North America were high before the US presidential election and became even higher post-election.

“With the US in particular, valuation ranges have gone from 4x EBITDA to 9 to 10x,” Nuttall said in the call, adding that finding value in this environment requires more work, but also calls for creativity.

Indeed, some market participants said such high price tags were still worth investing in private equity considering that the asset class continues to outperform other strategies, such as public equity, over the long term.

“If you look at prices in a historical context, they may look full, but in a relative context we see investors having the ability to generate double-digit net returns in our asset class, which is pretty appealing,” said Chicago-based Adams Street Partners’ managing partner and head of investments Jeff Diehl.

The US, in particular, is attractive because the gross domestic product shows positive growth and a stable environment for investing, according to Stoffel. “When you think about private equity globally and where to put your money to make solid, risk-adjusted returns, the US is still the preferred destination.”

With such elevated valuations, the emphasis on value creation went up a few notches.
“Because valuations are so high, firms overall are bidding less on opportunities and choosing to spend time and resources where they’re comfortable paying the market multiple, where they know they have an element of differentiation,” Krutulis said.

Some of the value creation came from add-on acquisitions, which fetched lower EBIDTA multiples, a renewed focus on the value of operating partners, or both.

Private equity is growing its presence in Canada. Last year, the US’s northern neighbour had a record fundraising year, reaching $3.7 billion from the close of 10 funds. That was up $540 million, or 17 percent, from the previous year and a whopping 281 percent jump from a relatively weak fundraising year in 2014.

The largest fund closing for a Canada-focused vehicles last year was Altas Partners I, which hit $1 billion, racing past its original target of $600 million.

But foreign fundraisers remain scarce. As PEI data notes, most of the Canada-focused funds that closed since 2010 were raised by domestic fund managers. Just 8 percent of the total capital gathered in 2016 was raised by a foreign fund manager – notably, HarbourVest Canada Growth Fund by Boston-based HarbourVest Partners collected $279 million at final close in April.

On the deal front, New York-based JC Flowers entered the Canadian market for the first time through the acquisition of CitiFinancial Canada from Citi in November. A source told PEI at the time that the Canadian market is attractive for several reasons, including a more stable and sensible regulatory environment compared with the US.