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Jan 30 2013 | 2:56pm ET
According to Altius Associates, the U.S. buyout market faces a challenging environment of rising purchase price multiples for high quality companies, while in Europe, GPs have innovatively found sources of capital amongst sovereign wealth funds and public fund managers willing to bridge the pre-IPO gap.
The investment advisory and management firm also reveals that private equity flow in China, Peru and Colombia is set to boom while private credit strategies have begun to attract the attention of LPs as funds focused on distressed and primary issuance of debt emerge.
Altius highlights asset pricing and over ambitious fund managers as key challenges facing the infrastructure market. However Altius believes the secondary market, which is on track to challenge the record fundraising year of 2009, should mature and become more efficient in the future.
Here is more detail on each of the ten challenges:
1. European Buyouts
The challenge for European buyout managers is and will be to find a profitable way to exit the boom year deals. Altius believes that of the three established exit routes (public markets, trade sales and secondary sales), the IPO market remains largely closed with financing almost certainly not available for financial sponsors to be realistic buyers in a secondary transaction. Indeed a full trade sale of one of these large businesses is theoretically possible but problematic given the current economic environment in Europe and with vendors wanting to receive cash rather than paper.
Charles Magnay, Partner at Altius, commented: “In many cases the clock has reached the five year mark and is very definitely ticking. GPs have been forced to become increasingly innovative in seeking liquidity and, thankfully for the asset class, have been successful in this regard in a number of cases. They have looked for ready sources of capital and found them amongst sovereign wealth funds and public market fund managers willing to bridge the pre-IPO gap – often corporates from Asia.”
Altius also believes that there are remaining assets which, for a variety of reasons, have either not found the right buyer or are not yet ready to be moved on, perhaps needing more time for further deleveraging. However the majority of high quality and strategic businesses are saleable even in an environment where the public markets are effectively closed.
Magnay said: “We applaud GPs for their ingenuity in tapping these alternative buyers and believe that, just as the secondary market has improved the exit options for the lower mid-market, so this development will open up a broader range of strategic options at the larger end of the buyout market for years to come.”
2. U.S. Buyouts
Altius believes the U.S. buyout market faces a challenging environment of rising purchase price multiples for high quality companies, which over the last year have hovered at around 9.0x earnings before interest, taxes, depreciation and amortization (EBITDA) and sometimes more. This is as a result of an increasing number of private equity firms competing for high quality deals, the efficiency of a more intermediated market, and the improvement in accessing debt for leveraged buyouts.
Altius cites improvement in bank financing and capital markets that have allowed debt multiples to increase from an average of 3.0x in 2009 to 5.0x EBITDA thus far.
Brad Young, Executive Director at Altius, said: “Fund managers must be sure their investment thesis is solid as there is less room for mistakes when higher prices are paid. A good fund manager must be able to make meaningful improvements to portfolio companies and use leverage effectively to balance risk and return. The challenge for limited partners will be identifying those private equity firms that are best poised to outperform in a more expensive and more competitive environment.”
3. Secondary Market
Altius believes the challenge for the secondary market will be to find attractive opportunities in an increasingly transparent and crowded market. In the first three quarters of 2012, an aggregate of $15.7 billion was raised, which is on track to challenge the record fundraising amount achieved in 2009. However Altius believes that an inflow of large amounts of capital into a segment can often create issues.
Chason Beggerow, Partner at Altius, said: “The high level of fundraising has been supported by an equally high level of secondary transaction value. Currently there is a good supply of deals, as European financial institutions have started and are still looking at shedding private assets from their balance sheets due to regulatory concerns and public pension plans are utilizing the secondary market to actively manage their private equity portfolios and exposure. While the supply has been good, sellers are more strategic and as a result, pricing has remained firm.”
Altius thinks that as the secondary market continues to mature and becomes more efficient, secondary funds/buyers will need to look for ways to differentiate themselves. Indeed these secondary buyers will need to find areas of inefficiency where there is less competition in an effort to generate strong returns consistent with past returns in the secondary market.
4. Real Assets
Altius cites a number of challenges facing investors today within the infrastructure market. Asset pricing is one issue, especially for core brownfield assets as the asset class is seen as a “safe haven” with the promised yield viewed as an attractive replacement for low-yielding fixed income securities. As a result, capital is rushing into the space, pushing up asset prices and reducing future returns.
Reyno Norval, Senior Associate at Altius, commented: “Real assets are often exposed to regulatory risk and with lower returns, there is less headroom for manoeuvring should there be any adverse regulatory action.”
Another challenge highlighted by Altius is the divergence of returns expectations that core infrastructure will provide to a portfolio. Altius believes that some managers are unrealistically projecting mid-teen IRRs and yields of 5% or so, while more conservative managers are targeting an 8-10% IRRs with a similar yield.
Norval concludes: “For investors exploring direct investment into infrastructure assets or projects, a key challenge is acquiring the necessary resources and expertise to properly assess the investment opportunities. Many investors underestimate the time, cost, and experience required to build the capabilities necessary for successful direct investing.”
5. Private Credit
Altius believes private credit strategies have attracted the attention of LPs and more broadly, the investor community.
Elvire Perrin, Partner at Altius, said: “Investors are looking at ways to enhance their returns on traditional credit and fixed income portfolios, which have displayed very meager performance over the last couple of years due to the very low interest rate environment in most of Europe and the US. The market dislocation created by the increasing regulatory pressure on banks has created a space for non-traditional debt providers as well as opportunities for distressed credit sales. Indeed, the conditions attached to bank rescue packages by the European Competition Entity and the new regulations being implemented are forcing banks to exit or decrease their level of activity in private equity and leveraged lending.”
Altius thinks that with the very uncertain and challenging macro environment, the premium for investing in private credit strategies above public credit strategies is one of the highest in history.
Perrin continues: “On a segment level, we are seeing the best opportunities in the small and lower-mid market where the issue of refinancing will be the most acute. The market has been quick to spot the opportunity and a plethora of funds focusing on distressed or primary issuance of debt for the private equity industry has emerged.”
Altius thinks that many of these funds focused on distressed or primary issuance of debt have been set up for the first time by ex-investment bankers or hedge fund managers diversifying into private equity type investing or even mezzanine focused funds where risk/return profiles are more attractive than in the traditional mezzanine space.
Perrin concludes: “Many will not be able to raise the capital they are looking for and therefore will not be viable firms. When looking into the very specific segment of the market, investors should keep in mind the major risks related to first time funds and adequate experience.”
6. Emerging Markets
Nearly all emerging markets have a need for healthcare, infrastructure, education and basic technology that facilitate business. Altius believes that the more attractive regions, such as Southeast Asia, politically stable countries in Latin America such as Peru or Colombia, and the emerging African countries like Kenya or Nigeria have increasingly younger populations with increasing levels of disposable income that will drive consumerism.
Perrin commented: “Foreign direct investments in emerging markets tend to flow quickly in and out of the regions and it is important for private equity investors to avoid the herd mentality flows of capital. The one challenge that affects all of these regions, despite the differences in demographics, proximity to developed markets, and an abundance of natural resources, is fundraising.”
Altius believes that the private equity sector benefits from a healthy ecosystem where fundraising is roughly in balance with or less than the opportunity set. Since fundraising ebbs and flows there will always be regions that are underserved and others that are over capitalised. In the past few years, Altius thinks that three areas have become over capitalised by private equity: Brazil, Turkey, and Southeast Asia (mainly Indonesia). In these regions, Altius has seen large funds being raised by global investment firms as well as several regional asset managers and now they are having difficulty deploying this capital. The funds that raised over USD1.0 billion in Latin America have either been solely dedicated to Brazil or virtually dedicated to Brazil since few other Latin American countries offer large market investment opportunities.
Altius has seen how investors are now turning to countries such as Peru and Colombia, which have been private equity capital starved until the past 12 months, and it appears several funds will be raised at record sizes in those markets in 2012. Turkey and Indonesia have raised record amounts of capital in the past two years but most of these funds are very young. On the contrary, countries such as Mexico and virtually all large countries in Africa excluding South Africa have had extreme difficulty raising capital.
7. Asia Private Equity
Altius believes that as financial markets in China are slowly liberalizing, China has emerged as the largest private equity market in Asia during the last couple of years. Foreign investors have long had only access to the Chinese market by off-shore constructions, as private equity investment by local investors only became possible in 2005 when new legislation to facilitate this was implemented.
The RMB market includes industries and industry sectors not accessible to foreign investors and offshore funds; conversely for local investors, it is difficult to make commitments to offshore funds. Private equity has, therefore, become increasingly popular with local fund raisers as well as with local investors, mostly large and cash-rich sovereign funds.
8. Compliance And Regulation
Compliance with various levels of governmental regulation is an eternal challenge for the industry; but Altius believes that the coming year will be an annus horribilis in this regard with too much regulation happening too fast to be fully digested and absorbed by the industry. Amidst the sea of regulatory proposals facing the industry are: i) Solvency II, a fundamental review of the capital adequacy regime for the European insurance industry; ii) Basel III, a long term package of changes to the original Basel Accord on the strength, soundness and stability of the international banking system; iii) MiFID II, the expected update of the Markets in Financial Instruments Directive (“MiFID”); iv) consultation on the EU Pensions Fund Directive (“IORPII”) which could have far reaching consequences for both the funding of pension schemes and the way in which they are managed.
Most significant perhaps is the fact that in July 2013 the Alternative Investment Fund Managers Directive (“AIFMD”), the main new piece of regulation affecting the private equity industry, will become effective even though the European Commission only published its draft implementation measures just before Christmas, leaving most firms little time to prepare for implementation .
In the UK the timing awkwardly overlaps the transformation of the UK Financial Services Authority into two new authorities on 1st April 2013. Altius thinks that the Directive offers little flexibility for member states but some are proposing to introduce additional measures to those required by the EU. Germany, for example, removed the rule that exempted smaller managers, a move that could harm its venture capital market. For non EU organizations, the directive will still have implications due to the restrictions on being able to market products in the EU. Outside of Europe, the US is still coming to grips with the significant regulatory changes enacted in 2010: the Dodd-Frank Wall Street Reform Act, and the Foreign Account Tax Compliance Act (“FATCA”) designed to combat tax evasion by US persons holding investments in offshore accounts. The impact on PE firms of these continues to be deep and has added to the regulatory burden on the industry at a difficult time.
9. Client Services/Reporting
Altius believes there is an increasing need for transparency across GPs and private equity advisors. Standardized capital call and distribution templates, which were released by Institutional Limited Partners Association (ILPA) two years ago, are taking root in the industry and several leading GPs have begun to adopt them. The level of uptake has been promising so far and has been led by several institutional LPs. There has been a complementary movement on a standardisation in fund reporting, with an increasing number of GPs either adopting industry body templates, or moving closer towards more investor-friendly forms of reporting with regards to their fund structures and holdings.
Jenny Fenton, Chief Operating Officer at Altius, said: “Standardization and transparency in the industry have been increasing in momentum since the global financial crisis and we expect the trend to continue as LPs are now more conscious of the risk and compliance considerations in their portfolios. The increasing demand for transparency affects not only the direct GPs, but also advisory firms and intermediaries. There is more interest from clients on issues ranging from increased compliance at the investment due diligence stage, to management fees and carried interest charges, to performance attributes, though to risks inherent within their underlying portfolio company holdings as well as ESG.”
10. Investor Relations
Altius believes that a major shift in GP-LP relations in the private equity world is taking place. Stung by the abrupt valuation shifts and mark-to-market losses through the financial crisis, LPs now demand more information, with greater transparency and on a more regular basis as the price for continuing to support their GPs.
Eric Warner, Executive Director and Head of Investor Relations at Altius, commented: “Most major GPs are now meeting with significant LPS on a quarterly basis, with full portfolio reviews, including all major changes, cash flow statements and details of drawdowns, distributions and any valuation changes. As a result of this pressure, most PE firms have had to increase their establishment in IR teams significantly; many have doubled their staffing in the last five years, and this trend is set to continue given the rapid change in compliance and regulatory standards across the globe.”
Organizations such as the International Limited Partners Association (ILPA), which monitors and comments on these matters on behalf of global LPs, have gained members, staff, traction and credence throughout this period. Altius believes that most GPs of any standing have had to comply with the standards for reporting and Advisory Board activity as a result.
About The Author/s:
Altius Associates currently advises and manages over €18 billion in private equity funds for clients based in Europe, North America and Asia-Pacific. It has a team of 44 professionals based in London, Richmond, VA and Singapore.