Private Equity Market: Our Investment Convictions for 2018
The first quarter of the year is a good time to look back at the previous year and draw lessons.
If there ever was a fantastic year for Private Equity it was probably 2017! A massive $453 billion was raised globally (1). This success can be attributed to the search for returns with limited volatility in an environment of low interest rates (the 10 year German Bonds offers a return of 0.66%(2); even-newly issued US Investment Grade bonds offer a return of only 3.71% (2) (3)); in this peculiar context, Private Equity is probably one of the rare asset classes to continue to offer double-digit returns.
The first quarter of the year is also a time when we share our investment convictions with our clients. Like all investors in the Private Equity (PE) asset class, we pay particular attention to two parameters: acquisition prices and dry powder (amount of commitments available for investment). However, our conclusions may diverge from the mainstream opinion, which is widely-publicized in the media.
- On the dry powder front: it now stands at $633bn (1) for buyout strategies, which represents an acceptable level (i.e. no more than 3 years of investment). Indeed, many observers highlight the record amounts currently being raised, but few consider the amounts invested by PE fund managers. In 2017, as many as 4,191 buyout deals were closed for a total value of $347 billion, 69% of which involved large companies, with transaction values topping a billion dollars (1).
- Turning to acquisition multiples: prices have been and continue to be a focal point for most savvy PE fund managers. It is true that prices are high, as private companies are sold at multiples slightly above 10x EBITDA on average (4). The media has split a lot of ink on this topic. However, few people realize that, even at this level Private Equity remains a good bargain. Indeed, take the Russell 2000 (5) and look at its average EV/EBITDA multiple: it trades at 18.2x(2). A similar observation can be made in Europe (MSCI Europe Small Cap(6)) with an average acquisition multiple of 12.2x(2).
Besides, although it may be counter-intuitive, large-cap companies (EBITDA above $50m) are less expensive to buy than mid-cap firms. According to the S&P/LCD Global Leveraged Lending Report, large private US companies were bought in 2017 at an average of 10.4x EBITDA, compared with 11.6x for the mid-market segment. Therefore, we feel more comfortable with large-cap buyout strategies whose international dimension provides greater stability in times of volatility and more risk diversification. We stress that these strategies involve highly-sophisticated value creation plans.
Moreover, at the beginning of February, stock market volatility fueled speculation about a downward adjustment. We take comfort from the fact that during the last recession in 2007, PE has demonstrated resilience and has continued to outperform all liquid asset classes, with limited volatility. Investors in PE are not committing to new PE funds being raised with the hope of avoiding the impact of a stock market correction but with the comfort that Tier one PE managers have set their sights on always exceeding stock market performances, with as little volatility as possible.
In fact, PE fund managers certainly learnt lessons during the last recession and most of them are well-prepared for the next one. In spite of attractive cheap debt available in the market, they have used leverage with caution (current average leverage stands at 5x (4)), deepened their industry expertise and fine-tuned their value creation strategies. As such, we believe in their capability to outperform not only listed asset classes but other PE strategies too.
Finally, we believe in the outperformance potential of the Technology sector in the Private Equity world. Above all, Technology is not Venture Capital. Tech funds usually concentrate on innovative companies with a proven business model and positive EBITDA generation. They are less volatile than VC strategies which they usually outperform. We are convinced that digitalization is not the flavor of the month: it is profoundly remodeling companies, creating disruption and therefore opening up endless opportunities. Unlike the buyout segment, we currently favor mid-cap technology funds that acquire companies with strong potential at single-digit multiples, at a time when their large-cap peers are struggling to find targets below 15x EBITDA.
We wish you all very successful investments!
(1) Source: Preqin, as of 31 Dec 2017
(2) Source : Bloomberg, as of 28 Feb 2018
(3) Bloomberg Barclays US Corporate Investment grade index
(4) Source: LCD Global Review – US/Europe
(5) Companies included in the Russell 2000 index have a market capitalization of between $144m and $10,641m (weighted-average of $1,963m)
(6) Companies included in the MSCI Europe Small Cap index have a market capitalization of between $579m and $5,500m