European PE in 2017: fundraising tailwinds and growing leverage

Greg Gille: It has been a turbulent 12 months, politically speaking. How has buy-side activity been and what were the key takeaways for the private equity industry from 2017 as a whole?

Peter Gale: A key takeaway was surprise at how benign the year was, from an economic point of view, a market point of view and therefore a private equity point of view. It was a very pleasant year, in terms of the conditions and performance.

David Menton: There has been a continued drive from private equity firms to deploy capital, supported by significant net inflows of new LP capital into the marketplace; GPs continue to hold a lot of dry powder. However, the number of high-quality assets that come to market appears relatively flat year-on-year. Therefore, the supply-and-demand dynamic plays a major part in driving pricing, with GPs particularly focused on acquiring high-quality assets with a high quality of earnings and predictable revenue streams. Debt funding from alternative providers is increasingly providing support to the GPs who are acquiring these assets, which in turn fuels an increasing willingness to pay high prices in M&A processes to secure the deals.

Shaun Mullin: It was a relatively slow start to the year, coming off the back of the Brexit vote, as well as elections and various other factors. But momentum has picked up. We try to get a view of where the capital is coming from and where the capital is going. There have been quite a lot of first-time funds raised by proven practitioners, which are of record size. That capital needs to find a home, whether it is equity or debt. This demand, combined with scarcity of quality assets in the market, has meant we are seeing some interesting behaviours coming through. Smaller-sized EV companies structurally don't warrant as much leverage, but it's creeping up nonetheless. And as you move up in the EV range, there is far more cash chasing those assets and pushing both EV and leverage multiples up.

Sam Kay: It's been a resilient year. We expected it to be tailing off in the UK and to be comparatively stronger in other parts of the world, but that hasn't been the case. I'd exercise a note of caution in assuming that's the case throughout the market: there is a split between groups that are able to raise new funds and do very well, and other groups that will have to work a bit harder. Broadly, it has been, and still is, a strong fundraising market. It's also a diversified market, with a range of new products that are available, so there's a lot for investors to be interested in.

Mounir Guen: There are peaks across the board – in terms of prices, volumes and distributions. Since the financial crisis, distributions have quite significantly outweighed capital calls. It's feeling unbelievably positive, but no one knows the bullet that kills you and where it is going to come from. Control investing has a lot of clout, and through control you can work through problems. More importantly, the banks are less involved than before. The breaking of covenants used to mean the end of an investment. Today, they are less involved in that activity and you have other organisations that don't use that structure. General partners understand the power of control and the ability to add value, so they're willing to pay high prices and move investments forward.

Split personality
Gille: How are wider market trends impacting on the fundraising landscape?

Guen: This is a very bifurcated system; 20 firms account for 60% of all money raised, and those 20 become continuously bigger. They are currently being backed by investors with net return targets of 11% or 12%. There's very good money in the pocket, as well as good valuations, but what happens with quality assets is that one firm can sell to another – making 2.5x money – rather than being dependent on other exit routes. The acquirer's funding base is fine with that, as long as the GP can structure that return profile for the fund to meet the net return targets. Consequently, there is a push for larger funds to be more AUM driven, so the quality of the asset and control over that asset become critical. But if the smaller and mid-sized funds constituting the other 40% of money raised started taking this selection mentality it wouldn't work.

Kay: In the UK at least, there is an element of insulating against the uncertainty of Brexit. Some of the larger GPs are accelerating their fundraising plans, because you will have more uncertainty in 2019 compared to 2018. From a legal and regulatory standpoint, 2018 is relatively certain: you know the environment you are in and have a reasonably upbeat market. You get to 2019 and there is greater uncertainty, so why not fundraise now? Even pan-regional funds, if they are based in the UK, have to contend with marketing rules, which could all change.

Disciplined approach
Gille: If we were to see a cool down in pricing, where would that originate? Would it most likely come from scarcer financing or increased investor discipline from GPs?

Mullin: It is likely to come from the lenders, who will also look to tighten their financing structures, including reducing overall quantum and leverage, more restrictive covenants and tighter control around leakage. The catalysts for that could be numerous, ranging from greater regulatory scrutiny as they probe deeper into underlying asset classes, or from tapering and interest rates and/or currency depreciation that moves us into a tougher economic environment, which starts to move the needle on forbearance and default rates. That will force managers to reassess the risk-adjusted return of their loan books as they take stock of underlying performance through the cycle.

The bigger picture
Gille: How optimistic or concerned are you, when it comes to macro factors?

Mullin: We are quite optimistic. However, it still comes down to asset and manager selection, and who you're backing, and it has always been thus. In a high-tide environment everybody looks good; it's when the tide goes out that you get concerned and you work out what your good assets are and what aren't. We are less bullish around service sectors and anything that's got a consumer slant to it, but more bullish on others. The global financial crisis is still very fresh in a lot of people's minds and the corporate memory is long. As a bank, we have the ability to look across various asset classes and, importantly, what's going on in terms of consumer behaviour as a lead indicator. You can see a bit of strain coming through in various places, and looking at where inflation is going in the UK, that is going to start hurting people. I believe inflation is probably a little higher than people think, especially in areas such as food-price-inflation, which is starting to ramp up very quickly.

Menton: I certainly wouldn't have said I was optimistic on the outlook for 2017 at the beginning of this year, but at the same time, I haven't been surprised by the continued cycle in the private equity market over the past 12 months – the continued level of deployment of capital and valuations. We launched Synova in 2007 and invested Fund I before, during and after the global financial crisis, which encouraged investment discipline and made us more cautious from the outset – remaining very realistic about the downside on every investment even post-crisis – having experienced economic shock after shock. Being at the smaller end of the market, we focus on high-growth, niche businesses within specific sub-sectors in an attempt to decouple ourselves as much as possible from the macro. The key for us is how we identify and invest in companies we believe are resilient and are going to be protected in any type of negative scenario. We can't predict how deadly the bullet could be. Is it going to be a global financial crisis type of bullet, or just a cyclical downturn? That's what we had to build our firm through, so we are always cautious that it's a scenario we have to consider.

Guen: Within private equity, there was one particular GP that called 2008 to the dot and stopped investing. They don't exist anymore today because the net gross spread was so huge and the returns were impacted dramatically as a result. The industry realises there will be a day where the macro picture changes because things are cyclical, but until that day it will remain active. The confidence we have in private equity is that, if a dramatic situation happens, we have the skill-set and an infrastructure to work through it.

Gale: The industry as a whole appears to still be very optimistic. But the times of greatest optimism are when you've got to be the most cautious. I'm not proposing the right course of action is to do nothing, but one has to be wary that the good times don't last forever. Looking in the rear-view mirror and assuming that things over the next investment cycle are going to be exactly as they were over the last is dangerous. There are secular changes roaring through the world. There is one global economy and we are all subject to exactly the same fundamental forces of change. The amount of change that's going to take place during the next 5-10 years is going to be absolutely outstanding and it's uncontrollable.

Check back in the coming days for the second part of the unquote" end-of-year roundtable, as our panellists discuss challenges ahead and the risks associated with certain emerging leverage products

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