The private equity industry completed another robust year in 2016 – in terms of raising capital and deploying capital – and 2017 is shaping up to be a similarly strong year. According to McKinsey & Company, buyout funds raised more than $210 billion in 2016, a 33% increase over 2015. While global private equity deal activity declined slightly in 2016, the trend since the financial crisis continued on an unmistakably positive path, and deal volume was up in North America for the year. The central takeaway from our perspective though is that while this has nominally been another good year for the private equity industry, it has been another challenging year for private equity professionals looking to put money to work. And this challenging environment has further demonstrated the ability of clever deal professionals to make lemonade from lemons when faced with adversity. Some of the trends that we’ve observed over the last year are set out below.
- Private equity investing continues to expand beyond private equity firms. Non-traditional private equity investors continue to rush into private equity. This trend first materialized several years ago when sovereign wealth funds began to make direct investments; today those funds are among the largest and most active private equity investors in North America. Family offices have also joined the fray, in some instances teaming together to invest directly in private equity deals. Similarly, many alternative asset managers that traditionally have been focused on other asset classes have aggressively built out their leveraged buyout businesses. On the one hand, this trend has contributed to the hyper-competitive deal environment noted above; on the other hand, many private equity sponsors have welcomed the additional players into the market by partnering together to bid for larger companies that they would have been unable to underwrite on their own (in the past, club deals among sponsors would have served this purpose but for various reasons club deals have fallen out of favor). These non-traditional investors offer more than just additional capital: for example, they often have valuable long-standing relationships within the industry, either in their capacity as fund investors or otherwise, that can be invaluable to sponsors as they source and win deals.
- Sponsors reinvent competitive advantages in auctions. Given the above trends, competition in private company auctions is as intense as we have ever seen (particularly when coupled with the war chest that many public companies have built up in recent years). One advantage that sponsors have played up recently is the speed with which they can sign and close a deal. In this regard, we have seen private equity buyers be very proactive and user-friendly in auctions, in some cases proposing their own seller-friendly purchase agreements to preempt processes. Even where sponsors do not attempt to do this, they have shown an increasing willingness to eliminate some of the impediments to signing and closing deals expeditiously. For example, many deals are getting done in this market without a traditional private equity purchase price construct; this allows for a quicker negotiation by reducing the back and forth spent bickering over cash, indebtedness and working capital definitions. Sponsors have also gotten creative in how they address “marketing periods” in acquisition agreements, although on that front we continue to encourage our clients to insist that there not be any “daylight” between their acquisition agreement and financing papers.
- Sponsors continue to find creative ways to put money to work. Private equity funds that have been traditionally focused upon leveraged buyouts have diversified over the last several years, and that trend continued in 2016. This has been true in the macro sense (e.g., funds diversifying across asset classes as they build AUM) but has also manifested itself on a deal-by-deal basis. So not only have private equity funds gotten into new fund verticals, but even within verticals they have gotten creative. This has resulted for example on an increased focus on PIPEs, convertible debt investments, distressed energy investing, and other investment strategies that may not have been a focus for sponsors that have traditionally specialized in plain vanilla leveraged buy-outs.
- Sponsors have partnered with strategic buyers. In a similar vein, sponsors have ventured beyond their comfort zone by teaming up with operating companies as they approach potential targets. In this way, sponsors have been able to unlock some of the value of strategic acquirers by partnering with, or investing through, operating companies. This puts sponsors on more equal footing with strategic investors with whom they may be competing in auctions. While we applaud this trend, there are some traps for the unwary: it is much easier for a private equity sponsor to start a relationship with a strategic investor than it is for them to exit that relationship, which for better or worse all sponsors must do eventually.
- Take privates make a comeback. One trend that has been much discussed recently is the manner in which private equity sponsors have tried to get in front of sales processes by targeting companies that are not yet on the block but may be soon. This trend has dovetailed with the renewed popularity throughout 2016 (and into 2017) of take privates. Obviously there are several factors that are driving the increase in going private transactions, but there is no doubt that sponsors are using publicly available information to put themselves in a position where they can approach a company outside of a competitive auction. And perhaps counter-intuitively, sponsors are often able to avoid a frenzied auction with a public company target (notwithstanding the heightened fiduciary sensitivities associated with public shareholders), given the attraction of a more limited sales process for a public company (which can be coupled with a post-signing go shop).
Given the uncertainty underlying an otherwise placid investing environment, our update a year from now highlighting the trends from 2017 should be interesting. Obviously we expect that there could be some updates on the regulatory front (which could be both positive and negative for private equity investors), and also expect that at some point the markets could become more volatile and challenging. And given that dry powder continues to accumulate within the private equity industry, it is hard to see the competition for deals dissipating anytime soon. In other words, there may be no shortage of lemons in the coming year.