- Indicators point to strong economic year in 2017
- Bull market in equities may keep heat on private market prices
- M&A valuations have shaped PE-fund returns
A bull run in public equities, healthy economic indicators and expectations for tax breaks and relaxed industry regulation will keep pressuring already high deal prices in 2017, private equity pros say.
Another popular topic: concern among LPs and others that lofty buyout valuations will bring down future returns from vintage years 2016 and 2017.
PE has been delivering lumpy returns ranging from a median of 8.3 percent for vintage 2006 funds to 18.6 percent in 2002. (See: Lumpy Returns From PE)
The sparkling 2002 returns stemmed at least partly from the year’s weak M&A prices, when GPs brave enough to wade in could get good deals.
As the economy strengthened in the following years, the top-quartile threshold for the best-performing PE funds fell to about 13 percent in both 2005 and 2006 from 28.9 percent in 2002. Top-quartile returns in 2007, the golden year of big and expensive LBOs, came in at a relatively modest 16.2 percent. But in 2009, with blood in the water and little leverage to be had, top-quartile returns snapped back to 21.2 percent.
It’s impossible to predict exactly what the M&A prices paid in 2016 and 2017 will mean for returns from funds launched in those years. But generally the logic should hold that the higher the purchase price, the lower the capital appreciation after the traditional portfolio-company ownership period of four to six years. If interest rates continue to rise, the cost of leverage will also increase, damping potential prices down the road.
To allay LPs’ trepidation, GPs will have to work harder than ever to source deals outside traditional auctions. GPs who find themselves in bidding wars run by investment bankers will need to have more conviction than ever about building value through add-on acquisitions and organic growth.
The good news is healthy tailwinds are expected. Anticipation of an economic slowdown in 2017 have mostly been pushed out to 2018 as the U.S.’s gross domestic product continues to expand at a meager but steady pace.
Plenty of uncertainty awaits in the form of elections and debt woes in Europe, but the tone from GPs appears more positive heading into the new year.
Gretchen Perkins, a partner at Huron Capital, said the latest consumer-confidence numbers have been encouraging, including a boost after the November election. Housing starts are up, but the industry has a long way to go to accommodate a rising population.
For deals under $250 million in enterprise value in the middle market, valuations remain strong as profits benefit from the sustained recovery, Perkins said. She’s expecting a “very robust” year for M&A.
“More and more companies are coming to market now with numbers that are up,” she said. “That contributes to higher valuations. Financing is very inexpensive right now. That also pushes up valuations.”
So while 2017 may be a good year for business, it’s probably not going to deliver lower deal prices unless the stock market corrects drastically. This could happen for a variety of reasons. But so far, it’s still off to the races.
Of course, GPs will continue to find pockets of value out there to work to their advantage, but some will also have to pay up. Look for more add-on deals and buy-and-build models to help lift portfolio-company valuations in a time of lofty prices and lumpy returns.
Bull figures are pictured in front of the German share price index DAX board at the German stock exchange in Frankfurt May 7, 2013. Photo courtesy Reuters/Lisi Niesner