10. PE Industry Flashcards
What were the key takeaways from 2012?
(1) 2012 was a flat year for PE globally (N.A. buyout deal value 2009-2012 CAGR = 23%), as recoveries in deal activity, exits, and fundraising did not gain momentum
(2) Competition for deals remains fierce with 4,800 active PE firms looking to invest $1 trillion of dry powder and increasingly favorable credit conditions (~5.7x EBITDA)
(3) Deal making increased in North America as GPs gained confidence in the region’s continued growth and debt markets strengthened over the course of the year
(4) Worldwide exit activity in 2012 fellow below the pace of the previous two years due to corporations’ hoarding cash in the face of macroeconomic uncertainty and volatile equity markets; only sponsor-to-sponsor exits were up in 2012
(5) Bifurcated fundraising success: a few GPs were able to reach their targets quickly while the large majority struggled
(6) Over the long-term, PE funds continued to outperform public equity markets by a healthy margin on average, with top quartile PE funds performing significantly better
(7) Size of deals consummated in 2012 remained concentrated in middle-market investments valued between $500 million and $5 billion
What are underlying trends within the PE industry?
Positives: Industry is poised to benefit from strengthening fundamentals; there appear to be early harbingers of a private equity revival
(1) Credit markets are very healthy and open for business to finance new LBOs
- Leverage levels have increased (~5.7x EBITDA) as a result of declining cost of debt, NOT loosening credit standards
- Record-low interest rates with investors yearning for yield
(2) Clouds of uncertainty about the economic prospects for key PE economies have begun to lift
- Increased GP confidence
(3) Heinz & Dell buyouts are very encouraging signals
- GP’s don’t want “to get left behind”
Negatives: However, the downturn still has prevailing problems today
(1) Too much dry powder (~$1 trillion) chasing too few attractive investment opportunities, keeping deal multiples high
(2) GPs sitting on backlog of assets they are eager to sell, which stretches holding periods and pushes down returns
- Ever-increasing overhang of assets to be sold (10,260 buyouts between 2003-2007 and only 4,057 exits 2008-2012
- Increasing pressure on GPs to return capital to LPs (median holding period 5.1 years, 1.5 years longer than in 2007)
- Diminishing chances to profitably exit from big holdings from the boom-year vintages that continue to languish on portfolios
(3) GPs looking for new funds from tapped-out LPs must devote more precious resources and partner time to the task
Why didn’t more big deals get done in 2012?
In short, because pervasive macroeconomic uncertainties weighed heavily on GP’s animal spirits in all major regions around the globe
What will drive returns going forward?
Historically, returns have primarily come from “beta” (GDP growth, expanding multiples, leverage).
Going forward, leverage will continue to provide a lift for returns, but other key sources of beta—GDP growth and multiple expansion—will not supply the boost they did in the past. GPs investing today will need to apply the power of alpha, or active value creation, to achieve superior returns in the future.
Two growth initiatives that are especially well-suited for PE are:
(1) Potency of Pricing: Bain estimates that a 1% increase in the realized price a company commands for its goods and services results in a 15% boost to pretax profits. By contrast, a 1% increase in sales volume has just half as much impact on the bottom line
(2) Supercharging the sales force: Bain estimates that the gains that flow from a focused and effective sales force can boost pretax earnings by between 20% and 25%
What is your outlook on the PE industry?
The early harbingers of a PE revival are more in evidence this year than they have been since the global financial crisis. The biggest factor favoring a pickup in PE investment activity in 2013 is the big “open for business” sign hanging over the global debt markets
(1) Credit Markets “Open for Business”: Continued record-low interest rates and creditors’ yearning for yield coming off a strong debt market in the second half of 2012 make lending conditions for leveraged buyouts and other debt-financed deal making as attractive as they have ever been
- Investors of all sorts are hungry for yield wherever they can find it in today’s climate of sustained near-zero interest rates, and they are flocking to buy new debt issuances from PE borrowers
(2) Corporate M&A Poised to Accelerate: Signs of a renaissance in corporate M&A activity bode well for a stronger market for PE-backed exits (despite flat global corporate M&A $2.3 trillion)
- Looking to invest their extensive cash reserves into financing their future growth, deep-pocketed corporate acquirers have traditionally been the biggest buyers of PE assets
- There are enough new sources of strength coalescing to push exit activity to a significantly higher level over the next 12 months (IPOs, strategic sales, sponsor-to-sponsor)
(3) On the stalled fund-raising front, some large LPs are raising their target PE allocations in their quest to boost overall portfolio returns
- Fundraising has been in a flat trend since 2009, but there is a scent of optimism among GPs and LPs; 86% of LPs surveyed said they planned to commit as much or more capital as they did in 2012
- Take advantage of the denominator effect – increase their PE numerator as overall portfolios increase in order to keep the same proportion of total asset base
What is your outlook on exits in 2013?
PE firms are increasingly eager to sell the aging assets locked up in their portfolios and return capital to LPs. Outlook is by no means uniformly bright, but from strategic sales to sponsor-to-sponsor sales to IPOs, there are enough new sources of strength coalescing to push exit activity to a significantly higher level over the next 12 months
(1) Strategic sales are poised to ride a renaissance in M&A activity
(2) Sponsor-to-sponsor deals are filling the pipeline of GPs as other sources of deals have slowed
- A large concern is the skepticism of whether the new PE owners will find ways to create value that the original PE owner did not extract already
- But management is already accustom to working with sponsor and is able to generate alpha; banks are willing to extend more credit to proven companies that have already been PE owned
(3) IPOs are ripe for a rebound in North America
- Brightest signs of life on the IPO front are in the US, where the strong run-up in the public equity indexes in 2012 and YTD has lifted stock prices to all-time highs
Why do you think corporate M&A is poised to accelerate in 2013?
(1) Low interest rates
(2) Strong corporate balance sheets (record levels of cash)
(3) Readily available debt
(4) Pressure from shareholders for management to put cash to work to fuel growth
- Organic growth is appearing to be elusive, so growth via acquisition looks more attractive
What is your outlook on fundraising?
Curb your enthusiasm. Unless there is a major increase in deal value (such as the potential revival of public-to-private deals (accounted for 90% of the increase in total buyout deal values; since 2007, the end of the take private deals contributed to 83% of the drop in total deal value), it is not clear that the PE industry needs more capital
PE industry today is putting to work ~$100 billion of buyout equity capital around the world. Globally, GPs raised $79 billion, $78 billion and $88 billion in buyout capital in 2010, 2011 and 2012, respectively
- GPs have covered the difference by chipping away at the still-large mountain of dry powder already committed to them
- At current levels, dry powder is sufficient to support approximately 3.1 years’ worth of investment activity
- Thus, if fundraising were to accelerate a bit, the PE industry would be at equilibrium
What should you consider when analyzing an LBO?
1) Cash flow generation / operating improvements
2) Debt capacity
3) Multiple expansion / valuation
What should you consider regarding cash flow generation?
1) Look at revenue and cost drivers
- What are the products and how do they make money?
- What are the costs and how can they be controlled?
2) Growth
- CAGR in revenues, EBITDA and net income (organic or acquisitions?)
- CAGR in market
3) Profitability ratios
- Gross margin
- operating margin
- profitability margin
- return on assets
- return on equity
4) Efficiency ratios
- CCC: receivables days, inventory days, days payable
- Asset turnover = revenues / total assets
What should you consider regarding debt capacity?
1) Leverage ratios
- Debt to EBITDA (8x)
- Debt to equity (2:1)
- Debt ratio = total debt / total assets
- Coverage
2) Liquidity ratios
- Current ratio
- Quick ratio
What should you consider regarding multiple expansion?
1) Public comps
2) Precedent comps
What Makes A Good Business Model?
A good business model is one that allows a company to sustain a strong reputation for quality, reliability, and the ability to operate profitably and with solid cash flows in good times and bad. As I have discovered through fundamental company valuation, some of the characteristics that underscore a good business model include:
(1) Generates sustainable, growing cash flows
- Growth: constant evolution of product offering and entry into nascent markets
- Predictable Revenues: customer loyalty and long-term, renewable contracts with customers that pay reliably
- Predictable Costs: high operating margins which can provide flexibility; automation which allows costs to be more predictable
(2) Limited business risk and with a strong, defensible market position preferably sources of revenues are protected by Intellectual Property with few substitutes
