Can private markets boom if public markets bust?

By

Herb Engert

Ernst & Young LLP New York Office Managing Partner

Leader of more than 9,000 NY-based EY professionals in providing quality client service. Passionate mentor to EY professionals and entrepreneurs. Diversity and inclusion advocate. Foodie. Dog lover.

12 minute read 1 Feb 2018

Private equity is in a unique position to fuel growth. Our EY Global PE Watch 2018 reveals what executives need to know.

Since the last economic downturn, private equity (PE) has seen record-setting growth. Indeed, the industry’s assets under management have grown nearly 80% over the last decade, reaching roughly US$2.7t. The sector’s role in the economy continues to grow. PE firms now own stakes in more than 13,000 companies across the globe. They employ more than 20 million people, and for each additional million dollars they invest, they create an additional 10 jobs.(1)

With the days of financial engineering of investments gone by, and a growing need for value creation through transformative growth strategies, PE is now in the unique position to fuel positive equity. The EY Global PE Watch 2018 explores the possibilities and reveals what boards across industries need to know to position their companies for growth.

Despite the rising prominence of PE, there is significant room for even more growth. While the gap is narrowing, the value of PE portfolio companies is estimated to be equivalent to just 3% of the US$81t in publicly traded shareholder value.

Meanwhile, the universe of public companies is shrinking. In the US, for example, the number of listed companies has declined by 50% over the last 20 years. Thus, the opportunities for private companies to remain private is growing dramatically, driven in large part by widespread experimentation and innovation within private capital.

There are still a number of critical similarities between the PE industry of a decade ago and now – most notably, PE’s “secret sauce,” its model of concentrated of ownership and the alignment of stakeholder interests. However, the industry has transformed in other important ways that can represent significant opportunities for savvy companies and their boards.

Our report reveals three ways PE firms are positioning themselves for the future, by increasing their ability to fund companies at all maturity stages, focusing on new kinds of partnerships and improving the attractiveness of companies leaving PE ownership.

1. Josh Cox and Bronwyn Bailey, Private Equity Investment and Local Employment Growth: A County-Level Analysis, 2016

People walking to work with briefcases in New York City.
(Chapter breaker)
1

Chapter 1

A response to market needs

PE firms are increasingly able to fulfill funding requirements for companies at all stages of maturity.

While there are – and will remain – many successful single-strategy firms and “pure play” PE shops, the market is increasingly moving toward firms that can build on their expertise in one area and apply it to another. The result is an industry that is not only more responsive to its investors’ needs, but also able to provide capital and resources for a much wider cross-section of businesses than ever before.

Ten years after the global financial crisis, only now are PE firms seeing the same levels of pre-financial crisis fundraising. This is driven by a wider appreciation of their risk/return profile, their diversification benefits and most importantly, the evolution of a broader array of private market strategies.

The last decade has seen a dramatic broadening of the purview of PE and the widespread adoption of private market strategies designed to address a broader array of companies’ funding requirements.

For example, large PE firms are increasingly moving down market into the growth capital space and executing other minority stake deals, partnering with family owners and entrepreneurs to accelerate a company’s growth. And at the opposite end of the spectrum, PE firms are developing and launching “core” PE funds, with lifespans anywhere from 5 to 10 years longer than a typical PE vehicle. This allows for long-term investment in more mature companies that might not be a good fit for a traditional PE fund and its average 5- or 6-year holding period.

One of the fastest-growing strategies since the last peak is private debt, which has grown from 16% of the aum of the largest PE firms to nearly one-third, and which provides a good example of how PE can quickly fill gaps in the market.

After the onset of the financial crisis, authorities imposed stricter regulation and capital requirements on banks, creating an opening for non-bank entities to provide needed capital to companies, particularly for smaller companies and in the middle market, where funding mechanisms are less efficient. Today, PE firms manage nearly US$600b in private debt assets, about a four-fold increase from 2006.

Office workers seated at a desk reviewing papers.
(Chapter breaker)
2

Chapter 2

A focus on partnerships

PE firms are partnering with their customers, competitors and strategic acquirers in new ways.

Megadeals and massive public-to-private transactions were an attractive strategy to escape the bidding wars, auctions and high valuations of the pre-financial crisis peak. Firms were often able to mitigate risk by the use of club structures that spread it across two or more sponsors. The megadeal era reached its pinnacle in 2007 with the US$44.4b buyout of Energy Future Holdings.

Today, firms are more disciplined in deploying capital. As a result, deal activity remains well below the 2006-2007 peak.

Instead of club deals, which raise complexities around governance and decision-making, general partners of PE firms are turning to their own investors to co-invest on larger deals where additional capital is needed ─ the same pension funds, family offices and sovereign wealth funds (SWFs) that invest in their commingled funds.

These investors are increasingly building the infrastructure and skill base required to effectively partner with PE. Many are now able to add value to a deal in a ways that other financial sponsors can’t, such as specific industry expertise or knowledge of a particular asset, or the potential to hold assets over longer periods.

Ten years ago, the universe of potential deal partners was a lot smaller than it is today, hence the large number of PE consortium deals. However, with increasing interest in co-investing by companies, pensions, SWFs, family offices and others, firms now have a lot more choices than they did prior.

With increasing interest in co-investing by companies, pensions, SWFs, family offices and others, firms now have a lot more choices than they did prior.

Similarly, PE firms are also beginning to increase their partnerships with strategic investors, which is creating opportunities for companies and their boards. For strategic investors, there exist significant benefits to partnering with PE, including deal flow they might not otherwise have access to, and the ability to take on deals they might be priced out of on their own. Deals can even be structured so that at the end of PE’s natural holding period, corporates can have an option for sole control of the asset.

Businessman looking at his smart phone.
(Chapter breaker)
3

Chapter 3

A focus on returns

Companies exiting PE ownership are more attractive and competitive than ever, the result of PE’s increased emphasis on operational value creation as a driver of return.

One under-looked dynamic of PE’s evolution over the last decade is that the quality of companies exiting PE ownership has increased. In its early incarnations, PE was able to rely on financial and governance levers in order to achieve its alpha. Today, the levers are clearly different.

Today’s levers are clearly different. Firms are looking to operational value-add in order to create returns.

Firms are looking to operational value-add in order to drive returns. To achieve this, they’re employing a range of different approaches, including working with senior industry executives, developing their own internal operating teams or hiring outside functional experts with deep expertise across a range of competencies including finance, HR, supply chain and pricing.

Many of these initiatives are increasingly digitally driven, as PE firms work with portfolio companies to help them better harness and utilize their data. As investee companies enter the PE ecosystem with varying levels of sophistication, firms are helping them to better define and articulate their digital strategies, developing enhanced customer experiences, integrating their front-office systems with their back office IT frameworks and helping them put into place robust cybersecurity measures.

While data analytics is at the center of most of these initiatives, it’s important to note that there are other important components. Robotic process automation (RPA), artificial intelligence (AI), Internet of Things (IoT) and other emergent technologies are all making their way into the PE ecosystem.

The result is that companies that have emerged from the PE crucible are more attractive than ever to strategic acquirers. Evidence lies in the increasing proportion of sales to strategics. In 2007, secondary buyouts (sales of PE-backed companies to other PE firms) accounted for 46% of exits by value. In 2017, strategics accounted for 65% of the value of the sale of PE-backed companies, and secondary buyouts just 24%.

A woman in a scarf checks her phone in front of a currency board
(Chapter breaker)
4

Chapter 4

Building for the future

The days when PE could make desired returns through just market growth and financial engineering are gone for a while, maybe for good.

The PE industry has evolved dramatically over the last decade in a number of important ways – in terms of its breadth of strategies, its value creation capabilities, its partners and its overall reach and level of integration into the broader economy. Today’s PE industry is more transparent, liquid and diversified than it was a decade ago.

Perhaps one of the most important, but least appreciated, insights is the degree to which PE-backed companies weathered the last crisis – indeed, default rates and performance relative to PE’s public counterparts show that it weathered the downturn remarkably well.

And while excesses certainly existed, the industry’s overall resiliency and agility is a testimony to PE engine’s twin drivers: its highly disciplined and aligned governance structure and the long-term investment horizon.

PE firms have the remarkable capacity to not only transform companies in good times, but rejuvenate and stabilize them during downturns.

With more than US$600b in dry powder now available for new investments, its prominence will only grow, as will the opportunities for companies to partner with the industry. As the asset class continues to evolve, it will discover new ways to transform companies and create value across economic cycles.

Summary

PE firms have a remarkable capacity to not only transform companies in good times, but rejuvenate and stabilize them during downturns.

About this article

By

Herb Engert

Ernst & Young LLP New York Office Managing Partner

Leader of more than 9,000 NY-based EY professionals in providing quality client service. Passionate mentor to EY professionals and entrepreneurs. Diversity and inclusion advocate. Foodie. Dog lover.