A major report by Grant Thornton has revealed that global economic recovery has made finding good quality private equity deals at good prices more challenging.
The fourth edition of the Grant Thornton Private Equity Report, an annual survey of 175 senior industry practitioners around the globe, finds a new focus on returns rather than entry multiples, secondary buyouts increasing in importance and the significance of management in delivering the new plan.
Richard Ratcliffe, Director at Grant Thornton in the Isle of Man, said: ‘It is vital for investors to understand the impact changes in global economic circumstances have had on the private equity market. This is an important market for many businesses and investors here in the Isle of Man, which makes the data contained in this new report significant and important to the local finance industry.
He added: ‘While the private equity market has benefited from wider exit options, an improvement in the fundraising climate and the easing of debt finance markets, the strong competition for deals that this environment creates has made it a real challenge to find good quality deals at good prices.
‘More competition means one thing: higher prices. Higher prices at entry make it harder to achieve attractive returns at exit. This is driving a clear focus on the question around how sufficient value will be generated to justify the costs and returns associated with private equity capital.’
This year’s survey shows multiples are expected to continue to increase over the coming year. Unsurprisingly, multiple arbitrage is seen as a far less significant driver of value than it once was. Only 2% of respondents highlight it as a key driver, while 66% underline the importance of portfolio company performance improvement. Additionally, most respondents regard themselves as ‘growth investors’, as opposed to ‘value investors’, further showing an acceptance of the need for a transformational approach to portfolio management to build returns in today’s market.
While finding value remains important, it is more about having a strategy for generating performance improvement after the deal.
Mr Ratcliffe added: ‘Today’s ultra-competitive market requires an increased focus on performance improvement if the returns GPs are striving for are to be achieved. GPs will need to consider what impact this may have on their fundraising and liquidity realisation strategies if this emphasis implies longer hold periods within their portfolios.”
Secondary transactions are now a key part of the private equity market. More than two thirds (68%) of respondents believe the level of secondaries will increase over the coming year, with only 3% expecting a decrease. Pressure on buying GPs to do deals and selling GPs to generate liquidity, as well as overall market maturity, are the main drivers of this continuing trend. The results suggest that GPs believe they are more likely to be net sellers than net buyers in terms of secondary deals (66% vs. 26%).
While there may be less value-add potential with secondary assets from the perspective of the buying GP, the fact that a company has already been through a private equity cycle has clear benefits for the acquirer. In a market where deal origination is challenging, a premium is increasingly placed on greater transparency and lower deal execution risk.
Mr Ratcliffe said: ‘The questions of whether sufficient value has been left on the table, and how the perceived value can be unlocked, will feature strongly in decision making for secondary transactions. Understanding how the motivation of the management team may change if they are permitted to realise value as part of the transaction will be a key consideration in addressing these questions.’
More than three quarters of respondents believe that buying a good company in an average market is better than buying an average company in a good market. Much of what defines a good company, and indeed a key reason for GPs paying a premium, comes down to the strength of the management team in GPs’ eyes.
In the current environment especially, being able to accurately assess management’s ability to implement the post-acquisition plan is a vital part of investment decision making. Despite this, management issues are the single largest reason for a deal to collapse at the due diligence stage, suggesting that GPs need to assess and address management quality as early as possible within the deal cycle.
Mr Ratcliffe concluded: ‘As part of the origination process, investors are often able to form a good view of the capability of a narrow selection of the senior management team. A far broader and deeper perspective is needed of the entire management team's ability to deliver a new business plan. More emphasis on developing this understanding, ahead of detailed diligence processes, is a valuable step in mitigating deal execution risk.’
Photo - Richard Ratcliffe
