This article originally appeared on Forbes.com.
The environment for finding and winning deals didn't get any easier in 2017, but private equity generated a strong increase in investment value during the year. Global buyout value, including add-on transactions, grew 19% in 2017 to $440 billion, supported by a stream of large public-to-private deals. Global deal count, however, was essentially flat, growing just 2% to 3,077 deals. That's off 19% from 2014, the high-water mark for deal activity in the current economic cycle, as PE funds wrestled with a number of market challenges.
This disconnect between the value and number of deals done reflects a stubborn dynamic affecting deal making in most regions around the world: While funds have ample money to spend, they have too few attractive targets to spend it on. As discussed in Bain & Company's Global Private Equity Report 2018, investors have allocated more capital to private equity over the past five years than at any time in history. Yet as funds try to put money to work, they are hampered by several factors—high valuation multiples, stiff competition and an uncertain macroeconomic outlook that complicates future value calculations. These challenges force funds to be especially selective, and in some cases are prompting them to stay to the sidelines, even as they face growing pressure to do deals.
In many respects, these should be the best of times for PE funds, as both equity and debt capital are flooding into the market. Dry powder, or uncalled capital, has been on the rise since 2012 and hit a record high of $1.7 trillion in December 2017. The debt markets, meanwhile, are red hot, offering general partners (GPs) a golden opportunity to fund transactions with hefty levels of low-cost leverage. The average debt multiple in 2017 stretched toward six times earnings before interest, taxes, depreciation and amortization (EBITDA)—the level at which regulators begin to pay close attention—and several prominent deals carried even more leverage.
If easy money provided an accelerant for deals in 2017, soaring asset prices and fierce competition pumped the brakes on market activity. Average purchase price multiples for buyouts rose to historic highs, making it difficult for GPs to put all that dry powder to work. That is especially true at a time when the macro outlook in the US and Europe raises real questions about how long the global economic expansion can continue.
Competition for assets, meanwhile, is building, as corporate buyers scour the world for growth through acquisition. Corporations have several built-in advantages that improve their odds in competitive bidding, including a lower cost of capital and willingness to pay up for synergies or strategic value. Indeed, private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. What's more, corporate appetites are broadening. Historically, corporate buyers have tended to ignore acquisition targets that don't add scale. But that's changing as company leaders see ways to use acquisitions to serve other objectives, like augmenting product development. These trends mean GPs are facing corporate competition for targets of all sizes, which is boosting multiples in the middle part of the market. Buyers are now paying almost as much per dollar of EBITDA for midsize companies as they are for large ones.
How are GPs adjusting to this new normal of steep valuations and unrelenting competition? Firms are pursuing a number of proactive strategies:
- Looking over the hedge. At a time when the number of sponsor-to-sponsor deals is on the rise, more PE firms are combing through the portfolios of other funds, looking for promising companies that might be coming up for sale.
- Walking among the zombies. Zombie funds are essentially the walking dead: They have stopped raising new funds but are still working through portfolios. Bain has identified 19 of them in North America and Europe with holdings of more than 100 companies that are plausible candidates for ownership change in 2018.
- Picking up the pieces. Corporate carve-outs were the source of around one in five deals in the US and Europe over the past few years. They should continue to provide steady deal flow for buyout funds.
- Taking on a challenging asset. In evaluating risk, GPs will likely need to sharpen their pencils to underwrite more challenging strategies, like chasing higher growth or tackling a tricky turnaround. That often entails building stronger capabilities to manage risk.
- Ramping up public-to-private activity. The value of public-to-private conversions doubled in 2017. As price-to-EBITDA multiples paid in the private markets converge with valuations in the public markets, an increasing number of public companies become potential take-private targets. Public companies tend to be large, and taking them private presents an opportunity for a fund to put a lot of capital to work.
- Building through add-ons. Around half of all deals done last year (up from one-third a decade ago) were add-ons—those where a fund buys a company to "add on" to a bigger platform already in the portfolio. While the firm may have paid top dollar for the original portfolio company, it can buy growth much less expensively by strategically acquiring smaller companies and integrating them into a bigger platform. The result is a scale company at a lower average multiple.
- Taking a long-term perspective. Because the usual five-year holding period makes it difficult to take a long-term approach to value creation, a small but growing number of buyout firms are extending the duration of investments. That gives them a longer runway to nurture growing businesses, integrate acquisitions or make transformative change happen.
Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company's Private Equity practice.