What would you do with $1.2 trillion? That is the question the global private equity industry, which at the end of September was sitting on a record level of undeployed capital or “dry powder”, must answer.
Alongside this $1.2 trillion figure, estimated by research firm Preqin, the industry has reached leverage levels only seen immediately before the recent financial crisis.
As well as volatility returning to public markets, should investors and company chief executives considering mergers and acquisitions be buoyed by potential activity? Or should they be fearful looking at what happened the last time so much money was sloshing around the sector?
“A lot of sponsors [fund managers] have raised smaller funds post-crisis,” says Alasdair Warren, head of the financial sponsors group at Goldman Sachs. “And many have rationalised the size and focus of their organisations.
“Many are also aiming to invest their new funds over the next three to four years and certainly faster than many achieved for some of the larger pre-crisis funds.”
Mark Calnan, global head of private equity at investment consultant Towers Watson, says many funds have changed their approach. “Private equity is pretty warm in some areas,” he says. “There is a lot of ‘dry powder’ and there are certain areas where capital is burning holes in pockets, but most managers have learnt lessons and are more disciplined in their capital deployment now compared with 2006-7.”
Managers have also become more specialised. “A decade ago, many private equity funds were generalist in their approach,” says Mr Calnan. “Now they are more specialist and focused. It’s no longer just about waiting for the marketing material from the banks, acquiring funds will spend time looking at potential targets way before they come to market. In these situations, they’re getting an unfair advantage versus competitors, which can turn into a better result for their investors.”
In a world as unpredictable as financial markets, especially with central banking life support being removed, few will say for sure where private equity money will be in six months’ time.
There is a lot of ‘dry powder’ and there are areas where capital is burning holes in pockets, but most managers have learnt lessons
However, if investors are to get their promised returns, capital will have to be deployed. Worldwide mergers and acquisitions (M&A) activity by the end of October had already reached $2.8 trillion, up 47 per cent on 2013, according to Thomson Reuters. Private equity funds should be careful not to miss the boat.
“The sectors private equity funds will concentrate on are energy, healthcare, infrastructure – in essence, what people need. The demand is there,” says Bilge Ogut, head of private markets in Partners Group’s European private equity team.
He says investors want to see private equity firms work with portfolio companies to create value in this extraordinary sustained low interest rate environment.
But do they want huge amounts of leverage again? “The challenge in the last downturn wasn’t just the quantum of leverage,” says Goldman Sachs’ Mr Warren. “It was the covenants attached to the debt and the small proportion of equity in the capital structure, especially for cyclical businesses.”
Along with the cost of debt being much lower, at least for the time being, private equity managers are now being more thoughtful about the appropriate proportion of equity and the structure of the debt.
“Now leverage is being handled differently,” says Ms Ogut. She believes private equity managers are careful in the way that cash flow earned can be used to pay down the debt.
But buying and managing companies is just half of private equity’s job. Cycles keep turning and companies need to be either floated or passed on. There are records here too.
Across Europe “exits”, where a company is either taken public or sold on, reached €97 billion by the end of October, according to Preqin. Only 2011 saw higher with €107 billion worth of exits, but with a couple more months still to go, it is widely anticipated 2014 volumes will exceed this.
However, market conditions may still determine private equity’s impact on M&A. Floating a company is not a decision taken lightly, says Ms Ogut, and if the recent return of volatility to public markets remains or even increases, other options will be sought.
“If a company floats and the stock price falls dramatically, even if it is mainly due to volatility in the market, the reputation of the private equity company that floated it is at stake,” she says. “In the case of prolonged volatility, we will talk to investors and consider a strategic sale instead. That said, IPOs [initial public offerings] are still being considered for the moment.”
By the end of October, some 69 exits through public flotations had been transacted worth a combined €23.7 billion, Preqin data shows. Should the 20 per cent in extra volume many expect to transact by the end of the year happen, 2014 would beat last year’s record value of €27.1 billion by more than €1.5 billion.
“Market volatility has picked up in recent weeks,” says Mr Warren, which has made it more challenging to execute IPOs. “As a result, we expect more sponsor assets to be sold to other sponsors and strategic buyers.”
Large market capitalisation strategic M&A is also expected to pick up further as we move into 2015, across a broader range of sectors. “In turn, this should produce more primary opportunities for sponsors, as corporates rationalise portfolios or need to make anti-trust disposals,” he says. “So long as CEO confidence is not undermined, we do not expect the recent spike in market volatility to impact this trend.”