General Partners Expect Deal Flow to Slow This Year as Pricing Concerns Escalate
Fundraising to Remain Strong in 2015, Especially for Those with Proven Track Records
Following a record-setting year for deal flow in 2014, private equity fund managers are cautious going into 2015, as the investment environment is slowed by pricing challenges and intense competition.
However, optimism still abounds as private equity exits generated a record $568 billion in 2014, according to Preqin, giving private equity funds a strong track record to point to with investors who are likely to continue to view private equity as an investment vehicle of choice in the coming year.
A stronger economy has helped drive up portfolio values, but with the stock market off to a volatile start in early 2015, some experts question whether market performance will be indicative of private equity performance this year. These and other concerns were examined in the sixth annual PErspective Private Equity Study
, conducted by the Private Equity practice at BDO USA, LLP, which polled more than 125 senior professionals at U.S. private equity firms in November and December 2014. The survey found that fund managers are generally less optimistic about the investment environment this year. Although 56 percent of respondents characterize the markets as somewhat or very favorable for private equity firms looking to invest this year, it’s a significant drop from the 72 percent who shared this confidence a year ago. Additionally, more than one-third (36 percent) believe that the investment environment is “somewhat unfavorable,” up from 24 percent in last year’s study.
Deal flow will likely slow, with only 8 percent of fund managers surveyed expecting to close more than five deals in 2015. Survey respondents’ ‘outlook regarding deal quality has been declining year-over-year: in last year’s survey, 14 percent of fund managers expected to close more than five deals, down from 21 percent in 2013. The vast majority (87 percent) of private equity sponsors expect to close between one and five deals this year, with the largest percentage (30 percent) of fund managers predicting they will close only two new deals in the year ahead. Funds with more than $1 billion assets under management (AUM) are more aggressive – with 32 percent expecting to close more than five deals and 51 percent saying they will close between three and five deals.
Capital Pours In, With Family Offices Leading First-Time Commitments
The private equity market has been, and will continue to be, a highly attractive investment option. Coller Capital’s Global Private Equity Barometer shows that almost two-fifths of Limited Partners (LPs) are planning to increase allocation targets to focus on private equity in 2015. Fundraising was historically high in 2014 and is expected to remain strong this year. A majority (74 percent) of fund managers say they are receiving new commitments from LPs, up from 61 percent last year.
The majority of first-time financial commitments are coming from family offices (59 percent), followed by pension funds (22 percent) and institutional investors (10 percent). Funds with $500 million to $1 billion in assets under management (AUM) are the most likely to report receiving the majority of first-time commitments from pension funds (63 percent).
A successful track record is critical to securing financial commitments, heavily outweighing other factors. For the second year in a row, a majority of respondents (59 percent) rank track record as the most important factor LPs use to evaluate General Partners (GPs). The management team (16 percent) and operating experience (15 percent) are cited as the next highest ranking factors.
Eager to Spend, But Is the Price Right?
Deal flow may slow this year, but fund managers are looking to make bigger investments. One in four fund managers plan to spend between $101 million and $1 billion in new deals and add-on acquisitions in 2015, up from 17 percent in 2014. Another 42 percent expect to invest between $30 million and $100 million. In 2014, PitchBook reported that the median deal size was $47.7 million—up from $39.4 million in 2013.
Fund managers are eager to build their portfolios, with 95 percent seeking add-on acquisitions in 2015. More than one in five (22 percent) report spending the majority of their funds last year on add-on acquisitions, while the majority (67 percent) dedicated more to new deals.
But finding the right deals at the right price remains a pressing concern as pricing challenges have continued to escalate over the past three years. Forty-two percent of fund managers say pricing will be the top challenge facing their firm this year, up from 39 percent last year and 15 percent the year before. With valuations in flux across industries, PE funds are navigating a highly volatile pricing environment rife with disconnects between buyer and seller expectations. Fund managers cite identification and quality of targets as their second greatest challenge in 2015.
Portfolio Company Performance Generally Positive in 2014
Fortunately for GPs, 2014 was a good year for portfolio performance. A majority of private equity fund managers (75 percent) say that they experienced an increase in the value of their entire current portfolio, including all funds, during the past 12 months. One in eight (12 percent) say the value of their portfolio stayed the same in 2014 and only 13 percent report a decline. Among funds that report an increase, 34 percent say they saw an increase of 6 to 15 percent and another 34 percent report an increase of 16-25 percent.
However, fund managers still had reason for concern regarding portfolio performance: nearly one-third of fund managers say that more than 20 percent of their portfolio companies are performing below forecast or expectations. Comparatively, in last year’s survey, 20 percent of fund managers reported that one-quarter of their portfolio companies were underperforming. Even so, fewer bankruptcies are expected in the year ahead. Only 3 percent of fund managers indicate that they will declare bankruptcy for one or more of their portfolio companies in 2015, compared to 12 percent who say they had done so during the prior 12 months.
Exit Timelines Shrinking as Funds Eye Strategic Buyers
Global private equity exit activity hit a record high last year of $445.7 billion, according to PitchBook. Exit activity should remain solid this year as well, with 41 percent of fund managers expecting it to be a main driver of deal flow this year, falling just behind private company sales and capital raises (43 percent).
Exit timelines have shifted accordingly. While the seller’s market might suggest that shorter holding periods will be the norm in 2015, more than half (58 percent) of fund managers this year anticipate average holding periods for their current investments to be longer than they were a year ago. Those with longer holding periods most commonly report an increase of 13 to 18 months (39 percent). A majority of fund managers (73 percent) say the gap between buyer and seller pricing expectations remains the top challenge in exiting current investments, followed by financial information uncovered by buyers’ third-party due diligence providers (17 percent).
But for many, exit timelines are shrinking. Forty-two percent of fund managers anticipate shorter exit timelines, of which 29 percent think holding periods will decrease by seven to 12 months and 42 percent expect them to decline by 13 to 18 months. Funds with less than $250 million AUM are even less inclined to hold investments, with 63 percent expecting shorter hold periods this year.
Exit routes remain fairly consistent, with 41 percent of respondents saying they have the same exit preferences as a year ago, but where change has occurred, the market is skewing more heavily toward strategic buyers. One-quarter of those who have adjusted their exit assumptions are intensifying their focus on selling to strategic buyers, while 18 percent are putting more energy toward financial buyers.
Fund managers echo a similar sentiment when asked about the most lucrative exit options. Most (73 percent) fund managers believe strategic buyers will pay the highest prices over the next 12 months, compared with 14 percent who think it will be financial buyers. Fund managers report a conservative outlook on IPOs, with only 9 percent saying public markets will generate the greatest returns in the coming year.
Asia Remains a Hotbed for Cross-Border Transactions
t was an active year for cross-border transactions in 2014. Thomson Reuters reports that, at $1.3 trillion, cross-border M&A activity was up 78 percent over 2013. Looking ahead to the next 12 months, more than one in four private equity fund managers (28 percent) expect to pursue cross-border deals.
This year’s study identifies Asia as the most attractive area for new investment opportunities outside of North America for the second year in a row. Forty-one percent of respondents gave Asia the top spot, a slight increase from 32 percent last year. This doesn’t come as much of a surprise: Thomson Reuters data shows that 2014 was the best year on record for deal making in the Asia-Pacific region. The United Nations Conference of Trade and Development reports that, last year, China surpassed the U.S. as the world’s largest recipient of foreign direct investment for the first time since 2003.
South and Central America remain areas of high interest as well, with 30 percent of fund managers saying these regions present the best opportunities for investment. This is especially true for smaller-sized funds, with 45 percent of respondents with less than $250 million AUM ranking these areas highest, as did 43 percent of respondents with $250 to $500 million AUM. One-quarter of fund managers across all fund sizes believe Continental Europe offers the most attractive opportunities.
On the opposite end of the spectrum, the outlook on Eastern Europe has soured. Only 1 percent of respondents say it’s the best region for investment opportunities outside of the U.S., down from 13 percent last year. This may be due to regional unrest driven by ongoing conflict between Russia and Ukraine, as well as Western sanctions impacting the Russian economy.
As fund managers evaluate and execute cross-border deals, they indicated the top challenge as the availability of local resources (27 percent) and regulations impacting cross-border acquisitions (26 percent). Other cited challenges include cultural nuances (19 percent) and gaps between buyer and seller pricing expectations (11 percent).
Manufacturing Remains a Top Investment Target; Rising Valuations Expected for Technology, Healthcare & Biotech
For the third year running, the largest percentage of fund managers (34 percent) cite manufacturing as the industry providing the greatest opportunity for new investment during the next 12 months. Another 22 percent say natural resources & energy will offer the most attractive opportunities; fund managers with $500 million to $1 billion AUM (39 percent) are particularly keen on opportunities in the natural resources & energy sector. Fund managers’ projections for investments in the healthcare & biotech and technology industries remain relatively flat when compared to 2014, with 15 percent and 18 percent, respectively, identifying these industries as the leading investment targets for the year ahead.
However, valuations have been a sticking point. Fund managers believe that technology (70 percent), healthcare & biotech (67 percent) and manufacturing (37 percent) are the most likely sectors to see valuation increases during the next 12 months. Conversely, retail & distribution (57 percent), natural resources & energy (53 percent) and financial services (52 percent) are among the industries most likely to experience decreasing valuations in 2015.
Other major findings from the BDO PErspective Private Equity Study include:
The SEC recently completed a two-year review of private equity firms, with a particular focus on the expenses and fees that private equity firms charge investment clients. The ramifications have rippled through the industry. At the end of 2014, the two biggest private equity firms announced that they would start disclosing all fees and, in October, Blackstone announced it would stop charging accelerated monitoring fees.
This year’s survey finds respondents taking similarly proactive measures. A majority of firms (57 percent) are enhancing internal controls, including corporate governance and compliance actions. More than one in three (39 percent) are increasing communications and disclosures to their LPs about fees, and an equal number are monitoring agreements. One quarter are updating their Limited Partnership Agreements with more clarity around fees, and 19 percent are appointing a chief compliance officer.
Managing Regulatory and Compliance Complexities:
Forty percent of respondents cite Dodd-Frank as having the most significant impact on their fund followed by 24 percent who point to the Patient Protection & Affordable Care Act. Despite these regulatory challenges, fund managers generally feel confident that their staff is equipped to navigate the regulatory waters: Nearly half (46 percent) report having a dedicated chief compliance officer at their firm, with another 7 percent planning to hire one in the next 12 months. Most firms (74 percent) intend to keep compliance staffing levels even with last year.
Hiring on the Rise:
Private equity professionals expect to add to job growth in 2015. A majority (78 percent) plan to increase professional staff headcount at the operating company level and another 54 percent say they will increase administrative staff. At the fund level, 48 percent of fund managers say they will increase employee count during the next 12 months.