At EVCA’s last count the amount of uninvested capital in the European private equity market had reached around €45 billion. However, the volume of funds raised for European buyout investing fell for the second year running in 2002 while the total value of buyout deals continued to rise, most noticeably at the larger end of the spectrum. With investors not expecting the current agonies of fund raising to ease in 2003 and predicting increased deal activity, is the private equity “overhang” really a concern? Louise Cowley reports
t has been said that there is too much capital chasing too few deals in the European buyout market, which is leading to intense competition and spiralling deal prices. But if current fund raising trends continue this phenomena is unlikely to be a concern. According to a report by private equity research firm, AltAssets, funds raised in 2002 showed an overall drop of 30 per cent, compared to 2001. (See Data Room in this issue of evcj).
Compared to venture capital though, buyout funds still look strong. Nine funds raised over €1 billion each with established firms such as Cinven, Bridgepoint, Candover and Barclays all exceeding their initial targets. Although experienced institutions can still raise large, seemingly healthy, amounts of money in a short time this is not necessarily the amount they were originally aiming for; witness JPMorgan’s efforts. According to Thomson Financial Venture Economics, European funds raised purely for investing in buyouts fell to $12 billion in 2002, from $19 billion in 2001.
The seemingly never-ending drop in public market valuations and the reduced value of institutional investors’ public equity portfolios means some are now fully or even over-allocated to private equity. Limited partners are thinking long and hard before committing to any private equity fund, the rapid acceleration in fund sizes has stopped and the typical fund raising period is lengthening.
On average, European funds that closed in 2002 were in the market for just over 15 months, although these figures vary widely depending on fund type. Over three-quarters of the funds that closed in 2002 were in the market for more than 12 months. Time in the market for buyout funds was split: most mid-market funds were able to exceed their fund raising target within 12 months, while mega-funds needed longer. However, more optimistically nearly all buyout funds reached their targets and 65 per cent exceeded it.
Commenting on the fund raising environment, Chris Davison, head of research at AltAssets, said: “There is no reason to expect much different in 2003. It will be tough but it should not necessarily be any harder than last year.” While this prediction is not overly gloomy, it provides little comfort to buyout firms looking to raise capital this year.
Jerome Bouix is director of investor relations at CapMan, which closed CapMan Equity VII on €253.3 million at the end of 2002 after 11 months of fund raising. In his experience only a few investors are reducing their private equity investments, with even less leaving the asset class altogether, but a lot are saying their allocations are already fully committed. He says: “The mood was becoming more optimistic towards the end of CapMan’s fund raising period but this is threatened by the prospect of war with Iraq.”
Charles Milner, head of corporate finance within KPMG’s private equity group, expects fund raising in 2003 to be more difficult than last year, certainly for the first three to six months, with the major problem being the lack of visibility beyond then.
However Milner is not overly concerned: “Even if some LPs are now pulling back from private equity, the typical four or five year investment period of private equity funds mean that capital raised in recent years is still enough to take care of the supply side.”
Ultimately, smaller fund volumes in the buyout market could mean reduced competition and lower deal prices. However, this is not going to come into effect for quite some time and not unless fund raising remains depressed for another couple of years. Even then, if and when the market ever reaches this stage the IPO environment should have recovered and corporates will be back in the game, maintaining prices.
Much attention has been drawn to the attractive returns on investments made at this stage in the economic cycle in the past, prompting many investors to declare 2002 and 2003 vintage investment years. “The expectation is that 2002 and 2003 will prove to have been good years for private equity firms to make investments,” says Davison. And considering the amount of capital deployed last year, particularly in large buyouts, the private equity industry had better hope these predictions are correct.
According to Thomson Financial Venture Economics, in 2002, 156 European buyouts over $15 million were announced, with a total value of almost $55 billion. Although the total value of the deals continues to rise, these figures represent a drop in the number of deals, which returned to 1998 levels. Looking at the UK market in isolation KPMG also found a drop in deal numbers, which were at the lowest level since 1996. Milner says this is not reflective of the private equity community’s appetite or capacity for deals. “The key factors suppressing private equity activity in 2002 have been a combination of high vendor pricing expectations, a scarcity of quality deals and the general uncertainty in the economic climate.” 3i director, Peter Gordon, says: “There was a lot of volume in 2002, a lot of deals to look at but people were discriminating when looking at both quality and pricing.”
While KPMG found larger deals were down in the UK, but sub-£100 million deals held up well, Thomson Financial Venture Economics recorded an increase in European deals at the top end of the scale. There were 29 transactions, valued at over $500 million, that were either completed or announced as pending or unconditional in 2002. The total value of these deals was over $40 billion. According to some sources Europe saw more mega-deals last year than the US, 12 deals with enterprise values of more than $1 billion compared with nine in the US.
Gordon expects the trend for large buyouts to continue. However, he says 3i, which began marketing its €3 billion EuroFund IV last year, is looking to increase its market share in the sub £50 million buyout market in 2003. He advises caution when investing at this end of the market: “You need to be clear about what you’re buying, why you’re buying it and always have an exit in mind. You have to be particularly discriminating.”
Gordon believes there is still a greater supply of capital available to be invested in European buyouts than the flow of deals demands. “There’s still a weight of money sitting in the coffers and a lot of competition for deals,” he adds. However, he is more optimistic about pricing in 2003 and says assets will be more attractive but still of variable quality. Vendor pricing is realigning, says Milner. With a number of vendors, particularly those in the private rather than the public marketplace, becoming more realistic in their price expectations and more committed to completing deals.
While remaining loyal to one of venture capital’s favourite mantras, that proprietary deal flow is essential to avoid overpriced deals, Gordon believes the auction process now offers better odds. “Accountants and investment banks are more discriminating about who they invite to participate in auctions, looking at issues like a firms’ sector experience,” he says. But even with odds of 3-1 rather than 20-1, prices are still going to be competitive.
With M&A numbers at rock bottom, private equity bidders are unlikely to find themselves in the situation where trade buyers can offer higher multiples. Although this is good news in terms of reduced competition and the effect on prices, it also means the exit market, which currently relies on trade sales, will get more difficult. KPMG agrees that the continuing volatility of the capital markets, in reaction to global political uncertainty, means M&A activity is unlikely to recover immediately and buyers are wary of a prolonged downturn. However, Milner observed that the last quarter of 2002 did see a slight pick-up in M&A.
Historically PE ratios are still at relatively high levels and although many corporates are heavily indebted most can handle it. Such companies are not yet in the situation where they must sell assets and, while there’s a chance they can get a better price in a more buoyant market, they won’t do this until they absolutely have to. On the other hand, companies are adjusting to the unsettled economic climate and as they get used to it there will be more activity, although this doesn’t necessarily translate into completions.
Milner says deals are taking longer, with transaction periods already having extended to eight or nine months, it is now not unusual to look at 12 months. “People are quite rightly, acutely aware of the trade cycle. They are taking time on due diligence and waiting to see the results of the next quarter,” he says. In several cases this practise has led to negotiations to lower the deal price, with varying effects on the ultimate success of the transaction.
Milner notes that there were a number of larger transactions around highly cash generative and asset backed businesses, capable of servicing high levels of debt, such as NCP and the Voyager Pub Group deals. He tips secondary buyouts, public-to privates (PTPs) and PIPEs (Private Investments into Public Enterprises) as popular deal types for 2003. Although he warns that PTPs still need a compelling business case, solid management and an exit opportunity to work towards, and these aren’t always in place.
In terms of popular industry sectors KPMG says healthcare, support services and financial services were particularly active UK sectors last year. The drivers behind the growth in healthcare investment are changing demographics and government spending, which has also triggered interest in the education sector. Facilities management also looks set to remain in the limelight as outsourcing continues. Financial services is another area that private equity houses increasingly specialise in.
Despite its shaky image, telecoms is one of the sectors that saw most deal activity in the $500 million-plus arena. Last year’s deals included the buyout of the enterprise, distribution and services business of Alcatel, TDF and Callahan Associates’ acquisition of the Flemish Mixed Intercommunales’ cable network. The sector has already made a mark on this year’s market with Deutsche Telekom announcing that the bid submitted by Apax Partners, Goldman Sachs and Providence Equity Partners for its cable assets was successful.
Although the UK continues to dominate the European buyout market, boasting nine of last year’s 29 $500 million-plus deals, investors are increasingly looking to the continent. In 2002 France was not far behind the UK, with six deals in this enterprise bracket. Germany continues to disappoint, producing just two deals over $500 million (the same number as Belgium and one less than the Netherlands) although many investors still insist its economy will one day deliver bounteous deals. Milner reports he is spending an increasing amount of time on the other side of the Channel: “A lot of the US funds have a truly pan European focus now and the UK is a pond that has been fished for quite some time.”
Overall Gordon is reasonably optimistic and expects the market to stay at about the same level as last year. “Certainly, healthy deal flow this year would be supportive of fund raising efforts. It would show investors that there is plenty of scope for all the money that has been raised over the last couple of years to be productively deployed,” says Davison.
Milner says: “We are already witnessing an increased level of deal activity but whether this will lead to a heightened level of completions remains to be seen.” He sees the uncertainty, now political as well as economic, that has marred the global economy and the private equity world since September 2001, as a dominating feature of this year’s buyout market. Economically, and in Iraq, the situation looks bleak but conversely consumer spending and GDP growth forecasts are still healthy. “It’s a very difficult one