The case for Europe - Why private equity funds can still find opportunities in a fractured continent

THE CASE FOR EUROPE – WHY PRIVATE EQUITY FUNDS CAN STILL FIND OPPORTUNITIES IN A FRACTURED CONTINENT

According to Bain & Company’s eighth annual private equity report, Europe still offers attractive opportunities for private equity firms with the right approach

Berlin – 27 Feb. 2017 – Brexit uncertainty, crucial elections on the horizon in the core economies of France, Germany and the Netherlands, a continuing migrant crisis and Greece’s sovereign debt back in the forefront: Europe looks to be facing a storm of geo-political turmoil in 2017.

Yet, the eighth annual Global Private Equity Report from Bain & Company, the leading advisor to the private equity (PE) industry, finds that the continent still offers attractive investment opportunities for private equity firms. With appropriate diligence and evaluation of macroeconomic scenarios and by selectively focusing on the right companies – as opposed to focusing on a specific sub-sector or country – PE firms can discover assets that will deliver strong returns in spite of external headwinds.

“We’re often asked how to look at European investments in the context of recent political events,” said Graham Elton, head of Bain’s EMEA Private Equity Practice. “We believe opportunities certainly remain, but investors need the skills to find them, the diligence to work through multiple scenarios, the ability to assess the risks posed by macroeconomic conditions and currency movements, and the confidence and ability to drive post deal value creation.”

Europe offers attractive opportunities for private equity

On the surface, Europe does appear less attractive than the U.S., the main developed-market alternative in which to invest capital. Economic growth in the Eurozone has lagged the U.S. Diverse languages and cultures make doing business across borders more difficult. Any comprehensive solution to the structural challenges of the EU will have to confront a mounting price tag that includes rising sovereign debts, more nonperforming loans in the banking system and severe unemployment in parts of the continent.

Historically, though, PE investments in developed Europe have performed as well as, or better than, those in the U.S. on a returns basis, and European PE investments have also maintained a sizable gap over returns in Europe’s public equity markets.

One of the reasons is that there is an ample supply of companies to buy. The U.K., Germany, France and Italy have a larger number of scale companies per unit of GDP than many other parts of the world. Moreover, lower levels of deal value as a share of GDP in Western European countries, compared with the U.S., suggest that the industry has room to grow.

Bain believes that the region still offers huge potential. Sponsor-to-sponsor deals have been more prevalent in Europe, generating higher returns with less volatility than other types of deals. A Cambridge Associates study of European and North American buyout and growth investments made from 2004 to 2012 found the mean gross multiple on invested capital for the sponsor-to-sponsor transactions was greater than for other deals – 2.6 vs. 2.3. More such deals should not be dismissed as “pass the parcel” but rather as a chance for a second owner to apply different capabilities to a company that has already operated under a professional PE owner and therefore could be a lower risk to acquire.

Some investors also worry about rising levels of dry powder, which could mean that too much capital is chasing too few deals in Europe. But buyout dry powder stands at historically high levels in North America as well and, relative to deal activity, dry powder remains at a more tenable level in Europe: the average duration to use buyout dry powder in Europe is 3.3 years – shorter than North America’s 4.3 years. While some of the dry powder could migrate from North America to Europe, or vice versa, Europe has the more favorable starting point.

To succeed in Europe regardless of which macro scenario prevails, PE investors must carefully place their bets by geography and sector. Among the attractive subsectors will be those that have proven resilient through and after recessions – medical technology, cards and payment, software and healthcare providers among them. Some of these subsectors will continue to outperform if investors have the skills to find and vet them. Diligence becomes even more crucial in this scenario to assess the risk factors and ascertain the correct price for the asset.

Yet choosing the right country or subsector for investment does not guarantee strong returns; choosing the right company matters much more. In all industries, even those characterized by fast growth and resilience, individual company performance varies widely – more so than industry performance.

Once the right investment has been identified, investing amid a large amount of political uncertainty requires careful consideration of various possible outcomes – ‘weatherproofing’ for the choppy waters of foreign exchange risk is paramount.

2016 trends in European private equity

EXITS

Buyout-backed exit value in Europe was down 28 percent for the year, and exit count experienced a 19 percent drop. This decline was not reflective of a worsening exit environment, but was driven mainly by a leaner pipeline of deals ready for exit as the industry has largely worked through the backlog of assets invested prior to the global financial crisis.

In total, general partners (GPs) in Europe pulled in $107 billion in asset sales, helping the industry deliver its fourth-best year ever by value globally.

INVESTMENTS

Buyout investment activity decreased in 2016: globally, deal count declined 18 percent and value dropped by 14 percent from 2015 levels. Europe saw a milder contraction, with deal count down only 11 percent and value dropping 10 percent – a trend driven mainly by steeper declines in the U.K. Despite being whipsawed by economic and political events, investors in Europe quickly got back to business after each flare-up.

Record-high asset valuations combined with stiff competition – particularly from corporate buyers – made it tougher for PE firms to do deals and achieve target returns. The difficulty of putting capital to work, combined with ongoing investor enthusiasm for the private equity asset class has led to a new record amount of dry powder, now totaling $1.5 trillion across all PE fund types globally with $534 billion of that targeting buyouts.

FUNDRAISING

Fundraising targeting buyouts in Western Europe showed no signs of slowing, with a 16 percent rise for the year to $53 billion. Despite the succession of disruptive geopolitical events in Western Europe, many investors continue to believe in the region’s potential to generate strong future returns.

While funds can be classified by their primary geographic focus, many PE funds continue to loosen their investment mandates so that capital can be put to work across regions or even globally. This gives GPs a larger stomping ground and more flexibility should macro conditions deteriorate in any one region. And many PE firms continue to expand their geographic footprint accordingly.

To receive a copy of report or arrange an interview with Mr. Elton, contact: Aliza Medina at aliza.medina@bain.com or +44 20-7969-6480.

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