In private equity, as in other endeavors, the start of the year is a good time to look back on the previous 12 months to consider what patterns or themes emerged. How did they fit into broader context? Will they continue, and what sub-issues will follow? What structural changes do they reflect, and generally what can be learned for the future?
Since the financial crisis, each successive year has brought predictions, if not expectations, that M&A generally and private equity specifically were poised to surge. Year-end results, however, have lagged behind beginning-of-year predictions. It was no different in 2013.
Pattern recognition is all-important in private equity. It’s equally important in sponsor-focused legal practices. It provides the opportunity to assess what centrifugal forces and challenges are spinning around sponsors, and how best to assist sponsors in meeting those forces and challenges. Beyond the latest deal-specific or financing-related technology, which know-how sponsors expect counsel to have, here’s a quick look at some broader 2013 themes sponsors face and the possible impact on gearing representations. The themes that emerged manifest the constantly changing landscape.
1. Stalled primary market— Post-financial crisis, historical M&A cycle analysis would’ve suggested accelerating M&A and private equity volumes. But M&A volumes have been flat, reaching an eight-year low in 2013. Global sponsor deal values and volumes have been down since 2011, although quarterly values increased in 2013. The numbers still show a decline if the primary sponsor market--take-privates, corporate divestitures and private deals--is isolated. For take-privates, the opportunity set--public companies less than $5 billion-- has shrunk 30 percent to about 2,350 companies since 2003. Platform buyouts declined to 33 percent of all sponsor transactions in 2013 from 51 percent in 2004. A stalled primary market requires sponsors to be more adaptive and innovative in sourcing, structuring and operating primary deals they find, or finding minority deals. They need counsel who are more than just good technicians, but who can adapt, integrate with them and help find value creatively within the confines of those challenges.
2. Deal metrics— Median valuation-to-Ebitda multiples on deals above $250 million rose to 9.5 times in 2008, then dropped to 7.7 times post-crisis. They’re cresting again, reaching a decade high of 10.7 times in the third quarter of 2013. At these ranges, efficient buy-side diligence exercises and uncovering value creation opportunities take on added meaning. That puts a premium on counsel bringing specialized industry and regulatory-focused expertise into the mix to help uncover opportunities. On deals below $25 million, meanwhile, multiples dropped to 2.5 times, fueling add-ons and arbitrage opportunities.
3. Add-ons— While higher deal multiples contributed to the stalled primary market, lower multiples for add-ons have attracted sponsors with dry powder into that market. The result: Add-ons represented 53 percent of buyout activity in 2013, up 5 percent in 2013, and up from 36 percent in 2004. The median deal size has risen three-fold to $60 million. In add-ons, sponsors act as strategic acquirers, and bringing industry and regulatory group expertise and insights to bear from counsel can make a difference.
4. Inventory— In 1993, when there were about 7,000 public companies, sponsors owned about 350 companies. Now there are about 4,100 public companies and 7,500 majority-owned by sponsors. This basic market architecture and dynamics. Median portfolio company hold time has also lengthened to almost six years. New platform deals get the attention. But the data highlight the need of counsel focused on sell-side skill sets.
5. Exits— It was easier to sell than to buy in 2013, given the deal multiples, and vibrant debt markets let third-party buyers finance acquisitions from sponsors at higher prices. If not sold, investments have been recapped. Secondary buyouts, which were popular post-crisis, fell sharply in the first half of 2013 but returned in the third quarter of 2013, constituting 45 percent of U.S. exit activity. Because of inventory realities, secondaries will rise. Sponsor-backed initial public offerings raised $57 billion from 181 listings, the most since the $58 billion raised in 2007. And there was another $14 billion in the 2014 pipeline at year-end, a 10-year high. Public exits will continue until the market stalls. The paradox: a larger portion of sponsor portfolios consists of public companies. The implication: greater burdens on sponsors and a greater need for sponsor-experienced counsel with public company expertise.
6. Fundraising— Through the first half of 2013, fundraising was near a 10-year low. It rebounded to $126 billion through the third quarter, making it the best post-crisis year. With stronger exit markets, limited partner distributions were cresting, priming the fundraising pump. The average fund size was$1.2 billion in the first half of the year, tripled from 2010, but only three new entrants surfaced. U.S. buyout dry powder reached $475 billion in 2008, an all-time high, but decreased to $330 billion in the first half of 2013. Reportedly, some eight funds raised $5 billion each in 2013, and just four sponsors raised $73 billion combined, surpassing expectations.
The larger story is that fund offerings have gotten far more granular. There are funds reflecting nearly every thesis or sector in many geographies to satisfy LP pantry-like approach. These specialization forces put a greater premium on fund groups that can draw on industry, country and regulatory expertise in the structuring and execution process.
7. Product diversification and geography— The need to manage multiple asset classes increased when sponsor firms started going public. That need is increasing, reaching the mid-market. Sponsors now run capital market, credit, alternative finance, hedge fund, advisory and other operations. Given difficult U.S. deal markets, sponsors scour other countries and markets for deals and idiosyncrasies, focusing on Europe as it stabilizes, China as it finds economic footing and the rest of Asia as it grows. But there are risks and as these structural forces take hold, sponsors again benefit from integrated product, sector, regulatory and country resources.
8. Regulatory and compliance— The days when sponsors operated outside regulatory oversight in the U.S. or globally -- are long gone. The increasing tide of regulation (Dodd Frank, Basel III, Alternative Investment Fund Managers Directive) adds significant demands on sponsors and their in-house counsel, and sponsors can benefit from an integrated, international regulatory approach to navigate these waters.
Predictions for private equity for 2014 are rolling in. Uniformly, they trumpet increased dealmaking. It’s not that simple. Notwithstanding the pundits’ predictions, there undoubtedly will be inflection points during the year requiring sponsors and counsel to assess if recalibrations of various dimension are needed, or if there are added resources or creativity counsel can put at sponsors’ disposal worldwide to better assist them in scoping or executing deals.
An over-arching theme from the cursory review above is just how multi-faceted and complex the forces are that sponsors must traverse. Private equity has had strong ties to the legal industry since its rise 35 years ago. But outside counsel was at times less suited to address certain aspects of the rapidly evolving industry. Early on, sponsors just needed advice on getting deals done. Now, the swirl of issues that a modern-day private equity firm and its in-house counsel must juggle and navigate is staggering.
John Hughes is an M&A and private equity partner at Sidley Austin LLP in Washington, D.C. He co-founded and chairs the ABA Private Equity M&A Subcommittee.