PwC: Crystallising returns

With high prices and fierce competition for assets, PwC Germany partner Dr Oliver Schulte Ladbeck, head of business development for PwC Europe Deals, considers whether GPs can sustain the current level of returns

Uncertainty is now the new normal globally. In Europe, two of the largest and most mature private equity markets are currently bedevilled by it. Almost three years of talks have done little to clarify the UK’s route to leaving the European Union, and in France, the Yellow Vest movement is creating turmoil and shows no sign of resting.

This current turbulence combined with tight competition for assets and rising asset prices begs the question: can the current levels of historically high returns last? We asked PwC Germany partner Dr Oliver Schulte Ladbeck to polish his crystal ball and tell us what the future looks like.

Looking forward, will we continue to see the same level of high returns?
As an asset class in general, irrespective of the time period, private equity yields higher returns than any other. In the low interest environment, the success of private equity has attracted even more capital. We’ve seen massive fundraising over the past years. In 2018 there was north of $700 billion of new funds raised ranging from pure play LBO vehicles to adjacent funds – mid-market, longer term and debt vehicles.

Fund managers have always seen volatility and market uncertainty as a chance and opportunity. Currently, every GP will say they need to focus on discipline but none of them are telling investors to expect lower returns. For core funds, GPs are holding on to the 20-25 percent IRR, or a 2x money multiple. There’s a very positive outlook for returns, irrespective of the possibility of a softening in 2020 that people within the deal community are talking about. There is abundant dealflow in Europe, with a stable middle market and record levels of large-cap opportunities, good deals and good returns, which is creating a virtuous circle of distributions and LP commitments that contribute to the overhang of dry powder.

And for new products?
In the past decade, the private equity industry has recognised the need for diversification in order to be able to put all that capital to work. For adjacent funds, the jury is out on whether returns are sustainable. We will see a bifurcation in the market. There will be some firms that have a “right to win” because their adjacent strategies are closer to their core capabilities, industry or sector focus. And some will fail to live up to their promise.

What about LP return expectations: are they rising?
Most of our recent discussions we have with LPs are not about higher return expectations – and what would justify these anyhow? – but about co-investing. The interest and appetite in that field has risen significantly. They are trying to get educated on individual assets and understand the value proposition and work out which GPs in their network they should reach out to. They still trust their GPs to generate promised returns, but co-investing is a function of making sure more funds are being deployed at pace. A side effect, of course, is not having to pay the management fee and avoiding that leakage is clearly a benefit as well.

GPs are willing partners for such co-investing. With dry powder somewhere between $1 trillion and $2 trillion, there is increased competition for a finite number of opportunities. Therefore, GPs are hunting for larger transactions. There are obviously other things they need to provide in order to be successful in a multi-billion dollar process, but getting additional firepower and the right partner is clearly a benefit.

In such a hot market, what else do managers need to win the deal?
Today, GPs must spend much more time on generating dealflow. The industry is undergoing a huge professionalisation in terms of deal sourcing and GPs are investing more time and money into building networks and seeking interaction with potential sellers way ahead of a process and often preempting before assets have come to the market. In addition, most GPs are looking at a larger number of information memoranda to spot those businesses where they can make a difference – on the basis of industry focus and experience for example.

In the past they probably had a six-month lead. Now it’s probably closer to a year that they will spend building a relationship with a potential seller and examining ways to crystallise deals without going through broad auctions. We see sell-side auction processes where GPs have to qualify before being invited in. Increasingly, GPs need to demonstrate industry expertise and differentiate themselves.

Another phenomenon we are seeing is larger PE funds teaming up with strategic partners to be able to pay a premium for the synergies identified. In that context you need to have developed trust built on industry specialisation. One of the decisive factors is that a manager understands from the outset where the deal should be headed. In the past, making a company better was a game of chance. Now the GP has to really focus on operational improvements. Winning teams are better qualified and have broader value creation capabilities. Up-skilling is the core issue managers face today.

The whole GP world has become much more complex. They need a broader bench of operational experts – be that external service providers, internal industry experts or professional operational teams – that they can bring in earlier to handle a more complex due diligence process.

Before the 2008 crisis, most of the return was managed through leverage and banking on multiple expansion. That has changed dramatically. Now there is a very strong focus on the value creation potential of an asset and holistic, forward-looking business model evaluation encompassing cost saving, digitisation, the disruption risks and areas of expansion.

In the past, due diligence focused exclusively on historical numbers. A week after closing the operational due diligence team arrived. Now we see teams engaged way before the auction actually starts. Before the deal is signed, parties have invested a lot of time and money to prepare for day one of ownership with a full-blown business plan.

How has that impacted managers internally?
There are more origination-focused partners. Managers are introducing operational experts much earlier to the conversation. Today, I deal with three guys [from a GP] rather than one, which tells me the complexity is increasing.

What does this increased deployment of GP resources mean for future returns?There are multiple effects. GPs are better prepared and have a much better view on how to unleash value from an investment. In any other environment this would push returns up. But with increased dry powder we also see increased multiples with an average around 11x EBITDA. GPs are having to pay away a little bit of that value creation potential and are holding the asset for longer. Buy and build is an obvious strategy that allows the GP to mitigate these historically high buy-in prices, reach synergies and create a business that’s attractive to future strategic buyers. GPs are still hoping to hold onto the same 20-25 percent return.

Given where we are in the cycle, can the level of dry powder be sustained?
What’s the alternative? LPs put money back into public equity markets? More LPs will seek to partner with GPs. Fund infill will remain high and GPs will need to find a way to invest that money. It’s easy for GPs to raise money. Even funds with average historical performance have not had difficulty in raising new and larger funds. The level of competition for deals is going to remain high.

Is it focused within particular sectors?
There are some industries where we have seen more activity than others. Traditionally, pharma has seen little private equity activity given the lack of debt financing for what has been considered as equity associated risk – ie, R&D. That has changed a bit. There’s lots of activity in industrial products, lots in consumer but less focus on bricks and mortar retail, quite a bit in healthcare services by houses with specialised capabilities. With digitisation being a strong trend there’s a huge focus on tech deals such as in the area of fintech and software companies, generating superior growth rates mainly by taking away market share from other industries. These are great targets for a buy and build strategy.

You mentioned industry concerns about a downturn. What would that mean for returns?
A growing number of market participants seem to believe that we will see a softening of the market in 2020. The general expectation in the industry is that it would be great for prices. In terms of debt financing, if that breaks away completely it will impact deal activity. Will that really be the case with interest rates where there are currently? Will there be a complete breakdown of the LBO market? Highly unlikely.

In any case, the asset class will be much better prepared than in 2008 thanks to the professionalisation of the industry, the focus on the value creation story, and the longer-term perspective. Due to increased scrutiny on the investment from the outset, portfolios are likely to be less harmed by a downturn. GPs may need to hold the asset longer but they are unlikely to fail on return targets if they extend the holding period by one, two or three years. With lower public valuations take private deals become more attractive again.


Valuations are a bonus for disposals, not a driver

It is a sellers’ market, but if a primary transaction originates from the sale of a family business, the dynamic is not triggered by high valuations. Price doesn’t prompt the founder to sell, which is often a decade-long process related to family internal dynamics, and trust in the buyside. None of the corporate boards that we’ve dealt with have decided to dispose of a trading asset because of the pricing environment. That decision must be embedded into an equity story that the board has presented to its shareholders, is measured against and must honour.

Corporate boards don’t focus too much on the timing of the valuation cycle. Large corporate mergers will not be held back by valuations. We see a number of carve-outs that are driven by an overarching corporate strategy and now they have the benefit of doing it in an environment of high valuations, but that’s not the deciding factor.

Do you see any hesitation among GPs concerned about buying high and being forced to sell at a lower valuation come any future downturn?
No. We’ve been told by investment committees that they are doing calculations that include multiple contraction scenarios. It’s been factored into their models and investment decisions from the outset. Whether that leeway is big enough to capture what happens in the market is unknown. But there seems to be a relatively prudent approach in the industry.

Looking forward 10 years, what can we expect to see in terms of returns?
From a corporate finance theory point of view, technically, at some point in time you would expect there to be an equalisation of capabilities and a new normal for returns. Competition would drive the market to a place that’s fair for the risk-return profile and achieving current returns over a long time period would not be sustainable.

However, there is a counter argument. Given past performance, I would expect the industry to find a way to stay ahead of the game and still deliver better returns than those offered by the stock market.

Over the past 30 years, as the corporate environment has changed, the private equity industry has evolved from an LBO model through to a multiple expansion paradigm and is now focused on value creation. Private equity has demonstrated tremendous stamina, creativity and an ability to adapt to market conditions, and it continues to attract a large portion of financial industry talent.