European private equity outlook: building on the momentum

Despite concerns about macro-economic volatility, and the sense that it was more than ever subject to micro cycles making quarter-to-quarter visibility particularly challenging, the European private equity industry can start 2015 with a certain spring in its step.

Activity garnered momentum across the spectrum over the past year, following an already positive 2013. On the deployment side, overall dealflow remained on an even keel to finally settle at around 1,500 transactions at year-end, according to preliminary figures from the unquote" proprietary database. But given the vast amounts of capital ready to be deployed, added to the well-documented improvement in financing opportunities, the overall value of European transactions built upon the uptick witnessed in 2013 with a further 5% year-on-year increase to €93bn.

The buyout market showed the strongest signs of recovery - driven by a particularly good showing from the UK – with an 11% rise in dealflow to 550 transactions and a more modest 4% bump in value to €81bn.

But, more importantly, 2014 mainly impressed thanks to GPs' ability to harness tailwinds and show strong results in the one area that will ultimately matter the most to their future: distributions.

"One of the high points of last year in Europe was undeniably the sustained exit activity, which itself was very much a continuation of what we started to see in 2013," says Neil Harper, chief investment officer for the AIP PE funds-of-funds team at Morgan Stanley (pictured). "Players in the buyout market and beyond took advantage of active capital markets and active strategic buyers to divest a significant number of assets. For our program as a whole, across 2013-14, we had a record year of distributions to our investors."

The sentiment is echoed by Christophe Bavière, CEO of fund-of-funds and direct investor Idinvest Partners: "We have had a record year for exits on the direct side of our activities – including in the venture space, which is traditionally more challenging. All this meant that 2014 was a record year for cash distribution for us. And benchmarking the market when looking at our funds-of-funds activity shows that the year was an excellent one for other managers as well."

Managers' diligence in capitalising on two crucial windows of opportunity paid off. The IPO craze that saw players such as CVC and Charterhouse bank on public markets appetite with a slew of listings in the first half of 2014 was certainly evident when looking at figures from the unquote" database: flotations continued the meteoric rise initiated in 2013 with another 55% uptick in terms of volume, while the overall value of European private equity-backed listings more than doubled year-on-year. No mean feat given that most of this activity was concentrated in the first eight months of the year, prior to a swift mood change among investors. Meanwhile, attractive terms and conditions and an influx of institutional capital on the debt markets further allowed GPs to return significant amounts of cash to their investors via dividend recaps.

Locked and loaded
Beyond bragging rights and promises of carry, these record levels of distributions are widely expected to eventually make their way back to managers' coffers as re-ups. Given the current market volatility and low-yield environment, private equity is standing out as a safe haven compared with other asset classes – perhaps ironically given its traditional remit and LPs' past allocation strategies. "There has never been so much capital available for private equity – people have been talking about a ‘wall of debt' in the aftermath of the crisis, but it would be more accurate now to talk of a wall of money," says Antoine Dréan, chairman of placement agent Triago and founder and CEO of online private equity platform Palico.

GPs certainly benefited from a revival in interest for European opportunities, with players such as Permira, Bain, Altor and EQT seeing their fundraising efforts across the line, while the likes of PAI and Bridgepoint made considerable headway with hefty first closes. Harper expects this improved fundraising environment to persist as 2015 unfolds. "From a GP perspective, 2013–14 saw a slightly better environment for fundraising compared to the previous three or four years. People are finding it easier to raise capital, especially in the more sought-after geographies such as the UK, the Nordic region or Germany," he says.

This does not mean that talks of a bifurcated and sometimes punishing market now belong to the past; while the supply of capital is healthy, demand is equally plentiful. "The market remains selective and comparing the amount currently targeted by managers on the road to past allocations, we can expect that nearly a dollar out of two will not be raised," warns Dréan. "Many funds are actually more hindered by congestion in the market than by serious issues with track record. Meanwhile, the most successful managers are oversubscribed before they even go out to market as they benefit from a high re-up rate."

Stand out from the crowd
Making it to the top of the pile on LPs' desks more than ever requires bullet-proof CVs, but investors are also increasingly urging their managers to make concerted efforts to stand out from the crowd. "There is still a dearth of sector-specialised buyout groups. We need more sector-focused funds – in a built-for-purpose way – not just a bunch of bankers that were previously covering a particular sector and decided to launch a fund, but a mixture of investors and operating specialists with the appropriate resources to execute a real hands-on strategy," says Harper.

More generally, adventurous GPs ready to take risks and pitch differentiating propositions should be the ones that walk away with the prize in the coming months. Echoing thoughts from other LPs, Harper calls for more innovation and advises managers to shake things up: "The European private equity market is remarkably non-innovative, particularly in the buyout space, which is a shame. You do not see that many new teams, new strategies, people willing to spin out and try new things, and so on. The difference with the US in that respect is noticeable."

This piece of advice is one that Dréan is keen to pass onto GPs currently on the trail as well – and particularly to first-time funds. "Institutional investors are ready to listen to fresh, exciting stories coming from new teams that stand out – as long as the theses are substantiated of course," he says. "Relying on the big brand names isn't sufficient given the amount of capital they have to put to work, especially when taking into account the risk diversification element. This is already the case in the US and we are starting to see evidence of this in Europe as well."

While many GPs will spend the year ahead focused on navigating this challenging fundraising market, those that managed to do so successfully in recent months will have to figure out ways to deploy these war chests wisely. One of the key themes that emerged in 2014 was that of rising valuations, with fierce competition fuelled by credit availability for larger transactions and a relative paucity of top-shelf investment opportunities. This might have spelled good news for managers in exit mode, but left many observers wary of a lack of discipline on the buy-side.

Fast forward to the start of 2015 and the current macro-economic outlook could be a factor forcing GPs to exercise caution – with higher levels of uncertainty around global growth prospects and concerns about deflation in the eurozone and the UK. But, as Harper notes, whether or not this will lead to a cool-down in the private equity market is hard to predict: "Credit is still available and large-cap multi-country generalist funds still have a lot of capital on their hands – it is terribly hard for investors having raised large sums of capital to sit on their hands and not put it to work. Discipline is a scarce commodity in the investing world, and I would not be surprised to continue seeing episodic indiscipline at the larger end of the market this year."

This could be further driven by the level of interest for European assets displayed by international trade buyers with deep pockets throughout 2014 – with transactions such as KKR selling the remainder of Alliance Boots to US-based Walgreens, or, more recently, Blackstone and PAI Partners divesting United Biscuits to Turkish player Yildiz Holding.

Foreign competition
Bridget Walsh, head of UK private equity at EY, also expects competition from overseas investors to remain high in 2015 despite the aforementioned growth forecast concerns: "We have spent time a lot of time with investors in China and Canada, and there is definitely a lot of capital outside Europe chasing yield. We expect to see this trend continuing, with more global capital targeting Europe in this environment. That definitely means more competition coming in on the buy-side."

But some LPs are adamant that managers should not be swayed by a fear of losing out and the urge to put their dry powder to work. "GPs must focus on maintaining discipline – the expression ‘money burning holes in people's pockets' is very true in private equity," Harper says. "Managers worry a lot about pace of deployment and some of their investors can give them feedback that pace is disappointing from time to time. I find this worrying: our mission is to back people who wait to find the right opportunity at the right price with the right upside. Pace is just a derivative of the state of the market – it is fine for people to do nothing for a year because there is nothing worth doing."

Thinking outside the box, maintaining discipline, making the right decisions in an uncertain environment... The keys to building upon the momentum garnered in the past couple of years sound – perhaps paradoxically – like a reminder not to forget why private equity became so popular in the first place. And they certainly seem like an effort to address one of the main criticisms levelled at the industry in recent months: the risk of seeing the asset class returning to some of the excesses of the boom years, with unreasonable entry multiples, an over-reliance on leverage and the temptation to raise ever larger funds regardless of economic cycles.

Idinvest's Bavière is convinced that 2015 will be make-or-break in that regard. "The coming months will be incredibly selective and will shine a stark light on what private equity is truly about: delivering a strategy for growth in the long term. This year will be all about these fundamentals - not quick flips, luck and financial engineering," he says. "This ‘back-to-basics' approach – being able to act on a deep understanding of the entrepreneurial projects that we back – will apply to the whole industry, be it venture, buyouts or even private debt."

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