European PE in 2018: beware the bullet

For the first part of our of the unquote" end-of-year roundtable, in which our panellists discuss fundraising, growing multiples and the wider macro-economic landscape, click here.

Greg Gille: How has the evolving debt landscape altered the behaviour of established providers, and what long-term impact do you see on the private equity market?

Shaun Mullin: We haven't quite had the same legacy as other more traditional lenders because we've only been around since the 1970s, so we're less shackled by some of their constraints. Although we have always been flexible, competitive forces dictate that we need to be more flexible and, importantly, be able to differentiate our offering to those of our competitors, but ultimately we need to be competitive. So, it has forced us to evolve and nuance our offering.

There are a lot of pros and cons for different debt products and asset classes. But we think about it in terms of: 'Where is the relative return for the risk you're taking and are we pricing that product correctly?' We needn't necessarily be worried about the emergence of covenant-light, for example. It's fine to put a product in place, so long as it works and stands up to the test of time, but you have to price that risk accordingly. That is probably our bigger concern: that the market is not pricing the risk it is taking correctly.

Mounir Guen: Fund financing is also interesting. We've had leverage at the investment level and at the GP level to help with cash flows, but capital call leverage is relatively new to the industry. Suddenly, people are calling one year's worth of capital cost in one go, after everything resets on the leverage facility. How does an LP budget for that and how do banks budget for this kind of awkward cash flow situation? It drives IRRs up quite healthily – calling the money as late as humanly possible – but you have a situation where, in an extreme example, general partners can draw up to 30% of a fund in one go.

Sam Kay: I've even witnessed an investment that was made using a facility and then realised before the GP had called the money from the underlying LPs. So LPs get a return without having had to fund it themselves.

Gale: We are very eloquently describing the "bullet" [editor's note: see part one, in which Guen warns "no one knows the bullet that kills you"]. This is exactly what happened in 2007-2008, where an apparently benign environment encouraged people to continuously find riskier and more fragile ways of structuring things. And that's fine while the music is still playing and I'm still dancing, but as soon as the music stops the fragility that's been built into the system becomes apparent. This leverage-on-leverage approach – making late-cycle investments where underlying return prospects have come down so you find more exciting ways of leveraging in order to juice those investments – is really dangerous.

Mullin: I completely agree. We have advisers coming to us and asking: "Do you want to do the opco debt, the holdco debt, or shall we talk to your colleagues around fund finance?" It's systemic leverage and we haven't even gone into asset finance. All the way through the stack, it's leverage upon leverage.

Peter Gale: As an LP, you can influence GPs, but you don't have control. You can try to put governance in place, but there's not really one body that speaks for the industry. So people will get away with what they can, in terms of gearing. Everyone wants leverage because they think it's a risk-free way to juice up the IRR, which is, in reality, irrelevant – it's the money multiple that matters. All you can do is vote with your feet. We have voted. We are doing very little in the large buyout space. We're concentrating on the smaller end of the buyout and growth markets, where the industry was when I started investing 25 years ago.

Do the right thing
Gille: A continuing theme has been that many LPs have ramped up their co-investment activity. To what extent is that driven by the opportunity for increased governance and influence over strategy?

Gale: We do 50/50 in terms of co-invest and commitments, as are many of the big Canadian investors. For us, it is specifically to get control over the investment strategy, to avoid over-leverage and to concentrate on secular growth drivers. A very large element is the governance aspect: it's actually making sure we're doing the right thing. We can't do that through the blind-pot system, but we can by partnering on a co-investment basis.

Kay: It has indeed happened in Canada and some wealth funds are also taking the same approach. But it's also beginning to happen more in the UK. You have some of the larger UK pension funds beginning to pool assets together, and the local government pension schemes have been encouraged to do just that. One of the outcomes we're seeing now as a result of that – which is becoming more prevalent in infrastructure, credit, real estate and more gradually private equity – is that these pools are beginning to invest direct and are becoming more active on the co-investment side.

Guen: The nuance is the governance on the investor side. The Australians and Canadians – and actually the Dutch and British too – have been quite creative. By changing the governance, it allows an investment professional to invest directly or indirectly. It allows better control of the portfolio for the investors to have the risk they feel comfortable with and it's not as fee-driven. People think the growth of co-invest is fee-driven, but I don't think so. What we are seeing, as a result of this change in governance is that this definition of general partner and limited partner in the next couple of years will fade.

Kay: To an extent, it actually supports the argument that the market has matured in quite a healthy way over the past 10 years since the financial crisis. You have alternative capital through debt funds and less traditional banks, which can smooth the downside because they're not so concentrated on covenants; LPs are able to look more closely at underlying assets and have more control via co-investment; and new groups that are more understanding of what investors need are coming to the market. So it can be argued the core of the industry has matured in a good way, and become healthier and more robust for the challenges we're all predicting are going to hit.

Great alignment
Gille: Are there any types of funds in particular that are likely to perform particularly well?

Gale: In this modern environment it's all about aligning yourself with the secular trends – technology, aging population in the west, the growth of the middle-class in the east – that cannot go away. For us it is about aligning ourselves with people who think in a similar way and are aware of the problems we've been discussing, such as over-leverage, and who are doing something about it. The escape routes tend to be at the smaller end of the buyout environment; the growth managers. In part it's a macro decision, but it's also about people who are cautious of what this means on a micro level and cautious about the predating model. Going forward has to be about creating exciting alpha and that needs real skill. The tide will go out, and then we'll see who has that skill.

David Menton: When speaking to LPs, we don't just talk about sector expertise, but about our thematic approach and sub-sector focus. You can't just sit there and say "healthcare" anymore, because publicly funded healthcare has a big squeeze on it. For 15-20 years, everyone chased that. Now it's healthcare technology or diagnostics, for example. It's very niche. I would imagine this could be more challenging at the larger end of the market. Our investment in Kinapse, for example, culminated from a piece of targeted analysis around big pharma and the impact of the end of the "patent cliff" on margins, which is why we targeted outsourced services into the life sciences sector, to help them drive efficiency.

Guen: It's all about skillset and finding X-factors. That can be an individual with an exceptional mind that simply has the vision to take companies to a fantastic place. But it can also mean an actual firm that has put in place really good healthy governance, looks at interesting themes, has principal protection and a good dialogue with its investor base. From a geographic exposure, Europe is very exciting right now. The Nordic countries, the French, the Dutch and the Italians have been consistent long-term producers. Germany is underweight relative to its GDP and public market weighting. The Spanish had a problematic period, but now they're very dynamic again. And, of course, the UK is a real safe pair of hands. The one thing that's missing from Europe, which is fascinating because in the United States it's the trend, is super-speciality on a pan-European scale.

Kay: Although first-time funds are in vogue at the moment, it is still harder for them to raise funds. A number of the first-time funds that people talk about are groups that have been going for a while; either on a deal-by-deal basis or as a team that decide to start their own business. It's much harder for groups to emerge from other avenues now because the costs are so much greater to start up. The regulatory environment is more challenging. We would act for teams, 10 years ago, for whom private equity investing was a completely new concept. That's not so much the case now.

Looking into 2018
Gille: What are your key expectations for 2018?

Menton: The key challenge is fluid politics. Continued uncertainty – whether it's in the UK, Europe or further afield – is something that will ultimately colour the backdrop. It's hard to know if that will have a direct impact on our industry in the next 12 months, or whether it will take longer. Relatively anaemic growth and inflationary pressures combined could well create a far tougher environment in the latter part of 2018 and beyond.

Mullin: Despite being the conservative lender, I'm feeling optimistic about 2018, and that's largely predicated upon capital flows. There is a lot of money in circulation and that will drive general corporate activity and M&A volumes. We'll probably see bigger deals done, with more take-privates and more bolt-on acquisitions for consolidation and multiple accretion. In terms of financing, my overarching concern is that we will see continuing loosening of terms and decreasing absolute returns as that flow of capital finds its way into both debt and equity. We'll also see more innovation in terms of financing structures at both asset and portfolio level as the hunt for yield evolves.

Kay: The next 12 months will be a year of two halves. We're going to have a very good environment for fundraising to begin with and at some point it's going to pause. People will take a bit of a breather at some point. From a UK perspective, that will be based on the broader economic environment, where there will be more of a shock to the market. We will see continued bifurcation in the market between the big groups, which will consolidate assets and do well in terms of fundraising, and other groups, for which it will be more of a challenge as the big brands absorb a huge amount of attention and LP bandwidth.

Guen: It will be a healthy year. There is this shadow of Brexit, but the statistics still look healthy for the UK and Europe. The GP community is confident and is rolling ahead as if tomorrow is going to be even better. The weight of money coming in from the LP community is quite high and that's going to increase, with new capital coming from different parts of the world. The first half of 2018 will be carried by 2017 momentum, but at some point there has to be a reality check and a pause to recalibrate. With everything peaking, there are issues creeping in and someone has to start addressing them. I'm positive on 2018 but there are a few things we have to keep an eye on.

Gale: It will be a fantastic year, as long as we don't have a shock from the macro – although there's a mounting risk that will happen. The fundraising of the large GPs is a terrific barometer for the top of the market. LPs are using a rear-view mirror to invest, however much they say they are looking forward. It's the track record that gets analysed and the reason is that it's easier to do that than to look forward and try to imagine. Everything is signalling a short-term top to the general buyout market – we are all going to have to work harder to maintain our premium returns.

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