Where Europe Outperforms: Private Equity Investment

Where Europe Outperforms: Private Equity Investment

Investors who choose European companies carefully and manage currency exposure can thrive despite, or even because of, potential fractures and turmoil ahead.

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Where Europe Outperforms: Private Equity Investment

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With all the challenges facing the Eurozone, pension funds and other institutions evaluating private equity investments in the region are understandably wary. “Remind us again,” many ask. “Why should we invest in Western Europe?”

Here’s one reason why: Private equity investments in developed Europe have performed as well as, or better than, those in the US on a returns basis. For example, the most recent five-year net internal rate of return for private equity investments was 12.5% in developed Europe, vs. 11.6% for the US. The gap was even wider for the 15-year horizon.

On the surface, Europe does appear less attractive than the US, the main developed-market alternative in which to invest capital. Economic growth in the Eurozone has lagged the US. Among those Euro Stoxx companies that recently reported results, quarterly earnings rose for the first time in four years. 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.

In fact, the region still offers huge potential. Western Europe has more large-scale companies per unit of GDP than many other parts of the world. Most of its countries rank relatively highly on indexes measuring attractive conditions for investment, in part because they have robust regulatory, legal and tax frameworks. European markets have long offered an advantage to investors who have local knowledge and relationships cultivated through a local presence. The diversity of language and culture, challenging as they may be for cross-border businesses, provide natural barriers to entry by outside firms.

Private equity’s strong performance in Europe does not, of course, guarantee smooth sailing over the next 5 to 10 years. Whatever path the macroeconomy takes, though, there are solid reasons to expect that the European market will continue to provide good investment opportunities. Among the attractive sectors 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 sectors will continue to outperform if investors have the skills to find and vet them, even in a scenario where the Eurozone restructures with consequent EU turmoil.

Of course, choosing the right country or sector for investment does not guarantee strong returns; choosing the right company matters much more. Bain & Company analyzed S&P Capital IQ data to determine the annualized total shareholder return (TSR) of leading companies in nine industries from 1998 through 2013. The industry average TSR ranged from about 1% in airlines to 9% in fast-moving consumer goods, a difference of 8 percentage points. But among companies within these industries, the differences in TSR ranged from 11 points to 35 points. Investors with the highest returns in Europe thus tend to focus intensely on due diligence of any deal opportunity, separating wheat from chaff.

Foreign-exchange risks present a separate challenge. Leading investors navigate these choppy waters by integrating all foreign-exchange scenarios into their due diligence and risk assessments of a potential deal. Looking at a target company’s mix of balance sheet and cash flow exposures in and around the Eurozone, and Western Europe more broadly, they probe the target’s supply chain arrangements, especially vendor country locations. They ask to what degree the target has flexibility to hedge or shift those arrangements to respond to different scenarios.

Investors can also factor in their forecasts for currency movements. At the simplest level, when they expect the euro to strengthen, they buy assets in euros or buy import-oriented assets that earn in euros. When they expect the euro to weaken, they buy assets in foreign currencies or buy export-oriented assets that are paid in noneuro currencies.

The winning combination investors look for is a “heads I win, tails I win” macro profile. An Italian exporter with a mainly domestic cost base that is doing well today would look even better with a substantially devalued Italian currency in a post-exit scenario. A German manufacturer with a significant Eastern European supply chain but a resilient domestic base would look better after a breakup, based on durable revenue streams and a significant reduction in costs. The more flexibility and options a business has to succeed under different macro scenarios, and the more macro scenarios with at least one favorable option, the better.

No one knows yet whether the grand EU and Eurozone experiments will endure another generation. But however they turn out, the region still has strong investment potential. Investors who choose their companies carefully and manage currency exposure can thrive despite, or even because of, potential fractures and turmoil ahead.

Graham Elton is the leader of Bain & Company’s Private Equity practice in Europe. He is based in London.


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