Private equity (PE) funds produced another impressive surge in investment value in 2018, capping the strongest five-year stretch in the industry’s history with $2.5 trillion in disclosed buyout deal value. Limited partners (LPs) remained highly enthusiastic and continued to flood the market with fresh capital. For general partners (GPs), putting record amounts of capital to work meant getting comfortable with a certain level of discomfort when investing. They were paying prices they swore they would never pay and looking to capture value that may prove elusive post-close. The most effective GPs stepped up their game to identify targets and sharpen diligence, while simultaneously planning for the worst.
These are the key conclusions from Bain & Company, the world’s leading advisor to PE investors, in its tenth annual Global Private Equity Report, released today at SuperReturn International.
“The last five years, from 2014-2018, have been some of the best in the private equity industry. We’ve seen some of the highest levels of capital raised and put to work, the most exits and decent returns,” said Hugh MacArthur, global head of Bain & Company’s Private Equity practice. “As good as it all sounds, though, PE firms are working overtime to keep the momentum going. Chronically heavy competition is driving deal multiples to historic highs, and growing jitters about an eventual economic downturn are impacting decision-making. These risks are raising the bar for the buyer to do great due diligence, which involves integrating both the commercial and operational sides of diligence, and to structure deals thoughtfully.”
Private equity in 2018: By the numbers
Fierce competition and rising asset prices continued to constrain deal count—pushing down the number of individual buyout transactions by 13 percent, to 2,936 worldwide—but total buyout value jumped 10 percent to $582 billion (including add-on deals), capping the strongest five-year run in the industry’s history. The performance owed much to an upswing in public-to-private transactions, which globally reached their highest value since the previous take-private boom in 2006–07.
While stiff competition and high multiples made it challenging to find deals in 2018, they also made it a great time to exit. With 1,146 transactions valued at $378 billion, exit activity came in on par with 2017 – still a strong contributor to a historic five-year stretch that has produced unprecedented distributions for investors. The robust performance brought total disclosed exit value since 2014 to $2 trillion, by far the largest five-year total on record.
Despite the steady pace of investment, PE dry powder has been on the rise since 2012 and hit a record high of $2 trillion at year-end 2018 across all PE fund types ($695 billion for buyouts alone). The buildup of excess capital is putting pressure on PE firms to find deals, but the good news is that buyout firms hold 67 percent of their dry powder in funds raised over the last two years. That means the recent deal cycle is clearing out the older capital and replacing it with new.
By historical standards, PE funds attracted an impressive amount of capital in 2018, although the pace slackened from 2017’s record-breaking performance. GPs raised $714 billion from investors during the year—the third-largest amount on record—bringing the total since 2014 to $3.7 trillion. Buyout funds continued to draw the biggest share of capital, but investor interest during this record stretch has been broad and deep, benefiting all variety of funds. LPs remain committed to what has been their best-performing asset class: a full 90 percent say they intend to maintain or increase their PE allocations.
Strategies shaping private equity in 2019 and beyond
Despite another strong year for PE, fund managers continue to face the same challenge: how to put record amounts of raised capital to work productively amid heavy competition for assets and soaring purchase price multiples. Top performers recognize that the only effective response is to get better – and smarter. Bain & Company has identified three ways leading firms are doing so:
- Buy-and-build: Powerful strategy, hard to pull off. Having co-invested in or advised on hundreds of buy-and-build deals over the past 20 years, Bain has learned that sponsors tend to underestimate what it takes to win. Every deal is different, but the most effective buy-and-build strategies share several important characteristics: a sector with low risk of disruption and a company within that generates consistent free cash flow to finance a steady cadence of acquisitions; enough attractive targets to support the combined ambitions of all the consolidators in the space; a platform company with the right foundational infrastructure (e.g., robust IT systems, a strong balance sheet, repeatable financial and operational models, etc.); and acquisitions that are close to the core, rolling up a set of highly related companies to achieve the benefits of scale.
- Merger integration: Stepping up to the challenge. PE funds are increasingly turning to large-scale M&A to solve what has become one of the industry’s most intractable problems—record amounts of money to spend and too few targets. This approach also creates a major challenge: capturing value by integrating two or more complex organizations into a bigger one that makes strategic and operational sense. Bain’s research shows that, while there is clear value in making acquisitions large enough to have material impact, the success rate is uneven and correlates closely to buyer experience. The winners do this sort of deal relatively frequently and turn large-scale M&A into a repeatable model. The laggards make infrequent big bets, often in an attempt to swing for the fences strategically.
- Adjacency strategy: Taking another shot at diversification. History has shown that expanding thoughtfully into the right adjacencies can deliver great results. But devoting time, capital and talent to strategies that stray too far afield can quickly sap performance. Top performers consider adjacencies that are one-step removed from the core, rather than two or three steps removed. They are more closely related to what PE buyout firms know how to do. They also hold the prospect of higher margins for the GP and better net returns for LPs. Increasingly, buyout investors are raising capital for growth equity, long-hold strategies, and sector-focused funds.
A New Normal? Public-to-Private deals on the rise
As private multiples have surged and public multiples begin to price in the threat of a recession, a record number of companies are drifting into private equity’s public-to-private (P2P) sweet spot. These are companies with an enterprise value between $2 billion and $10 billion that could be purchased for a multiple plus take-private premium that is still below the average private-market multiple.
It’s worth considering what it would mean for PE firms and their investors if private multiples remain elevated over the long term. Bain & Company sees several implications:
- Goodbye, IPO exits. If private multiples remain high relative to public valuations, it becomes less attractive to exit via an IPO.
- Public company targets. One obvious place to look for big companies is the public markets. For many large firms, this will likely become an increasingly important target environment, requiring a shift in their approach to deal sourcing, screening and due diligence.
- Even bigger megafunds. Funds are growing in size, and the take-private opportunity in the public markets makes a case for even bigger funds capable of transacting ever-larger P2P deals.
- Democratization of private equity. Given the growth of the private markets and their higher return potential vs. public markets, making private equity more accessible to retail investors is gaining importance. Already, retail investors are struggling to gain exposure to the small and middle-market companies that have been the bread and butter of private equity. These companies are increasingly turning to private financing to avoid the cost and hassle of being publicly traded.
“The trend toward bigger and bigger deals, including large take-private transactions, will require significant changes in how most PE firms operate,” said MacArthur. “A playbook for a $20 billion acquisition is not a simple ‘scale up’ of the playbook firms use to unlock value at a $2 billion company. The bottom line is that firms need to adjust their investment and capabilities to the task at hand. Tackling larger deals successfully means matching due diligence and resources post-close to the increased scale of the investment.”