4 minute read 7 Jun 2018
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Why PE firms need to invest early for effective deal origination

By EY Americas

Multidisciplinary professional services organization

4 minute read 7 Jun 2018

In a world of richly valued assets, identifying the right private equity investment opportunity early is key.

Produced by (E) BrandConnect.

The market is more competitive than ever, with The Financial Times warning: “It is an indication of the feverish conditions in private equity that buyout groups are not only setting new records for fundraising, they are also turning money away at their fastest ever rate.”

Total assets under management grew 9.6% from the end of December 2016 to reach a new record of $2.83t by June 2017. This was more than double the size of the industry at the end of 2006. “With dry powder levels approaching $1t and increased competition from direct investors, we are going to continue to see high valuations,” says Hugo Parson, EY UK & Ireland Global Head of Origination for Private Equity.

Direct investment by sovereign wealth funds and family offices also increases competition. This increases the pressure to find quality investment opportunities that will deliver acceptable rates of return. “The priority for GPs is putting a record amount of dry powder to work, regardless of competition,” states Parson.

Growing complexity

We have witnessed an increase in the number of private equity “secondary” deals (and “tertiary,” and so on) as a percentage of large global PE deals. The complexity is increasing, requiring an ability to drill down from a sector level and through the subsectors to the specifics of each origination opportunity.

Secondary PE buy-outs as a percentage of total buy-outs increased by 75% from 2008 to 2017 (Source: Dealogic. Deals with EVs US$100m and above).

Corporate acquirers with M&A-driven growth agendas also are competing for the most attractive assets. They are increasingly active due to robust balance sheets and are actively seeking more efficient use of cash balances, strong leverage markets and historically high share prices.

Technological disruption, combined with companies’ greater skill in extracting deal synergies, means corporates are prepared to pay higher multiples for premium assets than they would have been in the past, thus enabling them to outbid private equity houses in auction processes.

Consumer goods giant Unilever is a case in point. According to The Financial Times: “The mergers and acquisitions department of the Anglo-Dutch company that produces Dove soap and Magnum ice cream has been so busy in the past three years that if it wanted to give away samples from all these deals, it would need suitcases to stuff them in.” Acquisitions have included specialist skin care firm Sundial Brands, while divestments include the old staple Flora and Stork.

In this environment, private equity houses must identify opportunities where they have a strong transaction edge — both homing in on corporates’ disposals and competing for them in acquisitions — before the broad market picks up on these opportunities.

Origination capability

It is increasingly difficult for fund managers to find proprietary deals at an attractive entry price that attract minimal competition. Pricing upon entry remains one of the most important factors in the success of an investment, with 62% of private equity fund managers seeing valuations as the biggest challenge, according to Preqin.

Managers have responded with more effective deal sourcing and relationship building earlier in the transaction life cycle. A decade ago, it was not uncommon for private equity houses to participate in auction processes in which receiving the “teaser” was the first time the house ever considered an asset.

This is no longer the case, with a clear relationship emerging between the amount of resources devoted at the origination and the rate of return. Research has found that, “private equity and venture capital funds that employ a proactive origination strategy have consistently higher returns, driven by both greater quantity and higher relevance of incoming investment opportunities.”

Origination encompasses both sourcing proprietary deals and, in competitive situations, uncovering angles that can give a house an advantage in its evaluation or business plan execution. The approaches that funds adopt at origination vary widely, from predominantly in-house to adviser-led strategies.

For the latter, EY has developed knowledgeable teams to address and serve the increasing proportion of non-core carve-outs arising from the market dynamics outlined above. Its Global Origination Team focuses on alternative investors: PE, sovereign wealth, pension funds and family offices; the team is involved in the origination and execution of buy-side and sell-side transactions across all aspects of the corporate finance functions.

Origination, fundamentally, is long term and painstaking, drawing on a wealth of focused, sector-based research that can be banked if it doesn’t bear fruit at any particular time and drawn upon later.

To be competitive against leading corporates, not to mention other increasingly diverse private equity participants, private equity houses need origination sources that are both global and granular. The best are able to determine the viability of an opportunity anywhere in the world, before it is available broadly.

Produced by (E) BrandConnect, a commercial division of The Economist Group, which operates separately from the editorial staffs of The Economist and The Economist Intelligence Unit. Neither (E) BrandConnect nor its affiliates accept any responsibility or liability for reliance by any party on this content.

Summary

To compete, private equity houses need origination sources that are both global and granular. And to win, they need to validate opportunities before they are widely available.

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By EY Americas

Multidisciplinary professional services organization