In private equity, 2021 has been a year of extraordinary investment. It looks certain that this will be a record trillion-dollar investment year. Marcus Shah, Partner in the Private Equity practice with expertise in interim CFO appointments, meets Simon Hill, an experienced Partner at Liberty Corporate Finance, an organisation which has supported dozens of deals this year. Simon delivers an expert view of the state of play in PE now – and in the immediate future. We also gathered perspectives from Chris Neale, Partner at Phoenix Equity Partners and Abhishek Majumdar, Investment Director at Inflexion Private Equity.
Simon, what factors have contributed to this remarkable year in PE?
Well, there are several. At a macro level, there is a lot of capital in the PE sector. Add to that the fact that, thanks to Covid-19, two or three sectors are quite difficult for investment. Aviation, leisure and certain sub-sectors of other industries have become, while not uninvestable, a much tougher proposition. This means that the areas where you could put your capital to work have got smaller.
At the same time, others – such as tech businesses, healthcare and financial services – have done well, so you have capital chasing sectors that are even more popular than before. If there is too much capital chasing too few assets, prices are going to go up.
Many funds, particularly in mid-market land, didn’t do a huge volume of deals in 2018 and 2019. Brexit was looming, there was an election in the offing, and it made things a little slower. Many funds will tell you they didn’t do quite the volume they’d have liked. As Chris Neale, Partner at Phoenix Equity Partners pointed out:
In the mid-market most deals are between founder entrepreneurs and PE funds, and for the former, the decision to partner with a fund like Phoenix is a complicated one, and often decided upon after much deliberation over many years. Non-financial factors, such as family milestones, are often a major driver of deal activity. As with many of us entrepreneurs’ our lives have changed immeasurably over the past couple of years, as has their risk/reward appetite. For many it seems like an ideal time to make a decision on the future of their businesses, and for those who are keen to expand and take advantage of opportunities to grow, partnering with a PE fund is a strong choice.
People came into 2020 with the election over and a bit more certainty around Brexit, and they were planning to start to deploy again. A couple of months later, everything ground to a halt for Q2 and Q3 because of Covid-19. By 2021, many funds hadn’t deployed at the level they would have liked for nigh on two years.
Funds ultimately need to make a return for their investors and this means they need to deploy capital and buy assets. There comes a point in time where you start to feel a bit of pressure to get on and do some deals.
It is a seller’s market due to the shortage of assets showing resilience and good growth – where you would have paid 12 or 13 times for an asset previously, you might live with paying 14 or 15 times because that is the cost of winning those deals and deploying the fund.
There’s also the individual perspective. If you’ve had a quieter period in 2019 & 2020, coming into 2021 there will be a desire to get on with things; people don’t want to sit around and do nothing; they want to do deals, transact and make a return.
Abhishek Majumdar, Investment Director at Inflexion Private Equity added.
One of the other major factors has been the acceleration of digitisation trends by the pandemic across all sectors but especially in technology and consumer businesses. Some teams and companies have been able to capitalise on these to great effect, for example, driving digital channel sales, hiring remotely, or doing international M&A, which ironically has become easier in some ways – despite travel being more difficult. As a result, there have been a lot of exciting businesses coming to market. At the same time, existing portfolio investments have had plenty to do, so it’s been a busy period for investors.
Does the same apply in the large cap PE firms?
The same pressures are there, but many of the larger funds acted quickly when things started moving after Covid-19 and hit the market hard.
In the aftermath of the dot-com crash 20 years ago, some PE houses did batten down the hatches for about 18 months – then kicked themselves because the people who carried on investing saw brilliant returns. Conversely, when the 2008 crash happened, many houses stuck to a strategy of confident investing because they didn’t want to miss the boat again.
I think there are quite a few funds this time who have done the same thing, even though there will inevitably some prices which prove to be too optimistic in the fullness of time.
To a degree there is an acceptance that what you could have bought yesterday for X is now going to be X plus a bit more and that’s just the cost of being in the market and doing deals. In many cases where they have paid a full price today, they will still sell it for at least the same multiple in the future, so a high price in of itself is not necessarily pressurising returns.
Surely the whole point of an investment is to create value and increase your returns?
Yes, and in lots of cases you may have paid a big price for a business, relatively speaking, but actually it is outperforming its business plan and growing very well.
If you are buying an asset that is performing well, you will bring additional strategic input and capital for M&A, but to a large extent you are relying on that businesses carrying on doing what it was doing. If between you buying and selling it, it grows its profits two or three times, then even at a high price today, you will still make a sensible return.
“Being creative, selective, and thoughtful are even more important when valuations are high. This drives a focus on outstanding teams in exciting markets where there are options on top of the core plan – digitisation, M&A, internationalisation, talent strategy – the list goes on. For these businesses there is still plenty of opportunity to drive value,” Abhishek Majumdar said.
Chris Neale added: “The other comment I’d make is that PE funds are bringing more to the transaction relationship than just finance. We invest in markets and business models we understand in detail and where we know we can add value and/or scale. This is a strong mitigant to the need to pay higher prices. It is also increasingly a point of differentiation for entrepreneurs between PE funds – having a clear answer to how you can help and the evidence to support it, marks out a fund as a credible partner.”
Is PE future-proofed against another recession?
A correction in the market does feel a way overdue. But if there were a recession next year, the people who would be in a better position to weather it would be those who kept deploying capital consistently and started investing again in the summer of 2020. They would now have a spread of businesses owned for a different number of years.
In the event of a recession, you can face problems if you just invested a large proportion of your fund in a flurry of top of the market deals, so haven’t delivered much profit growth and are still highly leveraged from the day one debt position. Once you have owned an asset for a couple of years the business has grown a bit and you can much better wear recessionary pressures.
Will there be sufficient returns in years to come on the investments taking place this year?
In most cases, yes. I can think of a number of businesses that went for very strong prices – yet are already outperforming their growth plans. They look certain to deliver in terms of profit growth, and will no doubt deliver strong investment returns too.
Where you have to be more careful is with assets coming to market that are not as attractive as the ones that have been and gone for big prices. If Company X gets sold for a great price, Company Y and Z think they should go to market too and present themselves as being just as attractive, when in reality they are not.
They should not command the same price because the market should work out that they are not quite so interesting. But there is a risk that some will still trade at punchy prices and will struggle to generate the desired return.
Is there any concern about interest rates?
It doesn’t feel like it. I don’t think we’re going to go back to five per cent interest rates any time soon. If you’re asking whether leveraged assets are able to absorb a percentage or two base rate increase? The answer is yes. If the difference between the present base rate and a per cent or two higher is a problem for you, you’re probably struggling already.
What other factors could affect the sector?
In terms of economic risk factors, anything that has a big impact on the global debt markets – such as the Evergrande situation in China at the moment – could be a problem.
On a UK level, every year there’s noise around a capital gains tax increase. People take stock of their personal positions in the run-up to March in anticipation that something is going to happen, but so far very little has changed – but it feels like eventually the Treasury will do something here. If there are negative changes to taxation for owners, you might find many entrepreneurs who were going to sell decide to just hang on for another couple of years, and this would inevitably lead to a drop in volumes.
Abhishek Majumdar said “Environmental, social, and governance factors are now top of the agenda for boards and teams, and this is a theme that will only increase in relevance. The other big theme is talent – finding and retaining the right people is more important than ever, but tougher than ever, even for successful companies.”
Do you think 2022 investments could surpass 2021 and set another record?
I’m generally positive and optimistic. Even though you might expect things to slow down a bit, the sense is that there seems to be a continuing stream of assets prepping to come to market in Q1 and Q2 of next year.
If you do have to buy at a punchy price – which often you do nowadays – you should buy the best asset you can, to give you the best chance of a good return. The risk is higher for people who pay over the odds for assets that turn out to be average. They should still make a return – but maybe 2x rather than 3x.
Thank you so much for your time and insights Simon, Abhishek and Chris.
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