With the 2020 financial year nearly out of sight, savvy readers will have noticed that private equity dry powder has grown tremendously. The related question that inevitably comes to mind is when will these funds be allocated to new deals, and what will the overall deal volume look like in 2021.
The past year has presented a vast number of challenges in private equity, and, as with other asset classes, an overall difficulty arose in dealing with large volatility and uncertainty. Looking forward, 2021 appears well positioned to show high deal and high exit activity, as investors seek to monetise their investments.
Research indicates that US PE fundraising will reach an all-time high of $330 billion in 2021, with a continued concentration in the tech sphere. While economic uncertainty continues, however, limited partners are focusing their attention on management teams and targeted deal making. In fact, many PE investors have attributed portfolio success during COVID-19 to management team success, primarily through agile decision making and the ability to respond rapidly and proactively.
Throughout the post-March 2020 recovery, price multiples in both public and private markets have risen to significant levels, with the S&P Shiller PE ratio (cyclically adjusted price-to-earnings ratio) reaching 35 in March of 2021, thanks to many factors including monetary easing, as seen in the surging value of central banks’ balance sheets, and a generally increasing appetite for risk.
Most importantly, nearly 90% of private equity investors have indicated their most important goal for the year to come is the deployment of capital, a sharp increase relative to previous years, which is highlighted in the aggregate deal value returning to pre-pandemic levels in Q4 of 2020.
Considering the vast array of large public companies which have been struggling throughout the pandemic, the economic uncertainty has resulted in many companies turning to capital markets for additional liquidity. As their leverage has increased, many firms have been forced to turn to private markets in order to sell non-core assets, such as to avoid over-indebtedness. On the flip-side, PE firms have globally been raising significant capital, and are estimated to be sitting on approximately $2.9 trillion in dry powder. Although LBO activity declined significantly in the first semester of 2020, fundraising has remained extremely healthy, indicating that a positive turn in the pandemic will likely result in a large increase in deal-making.
Deal multiples in the US and Europe are at or near record levels, putting added pressure on general partners to produce growth:
A Balancing Act
Valuations across Europe have been soaring to record levels despite the pandemic. As a result, the pathway for acquisitions by PE firms is not without challenges. Indeed, total purchase price multiples reached a record high in 2020, partly linked to dry powder standing at extremely high levels. Private equity firms will now need to determine if higher multiples are simply the new normal, and will have to be mindful of the need to deploy their deep reserves. Some sources make clear that high valuations are a notable hurdle, but there does equally appear to be a thawing in the reticence to buy at high valuations. After all, the dry powder needs to be put to work in order for private equity firms to make the returns promised to limited partners. Many sponsors agree that currently, a 20x acquisition in a tech company is rather standard, and that 30x valuations will come in the near future.
Debt markets, on the other hand, continue to be supportive in terms of both leverage and financing costs. Indeed, leverage levels have crept up over the past year, with the average total debt-to-EBITDA multiple for European private equity sponsored deals now standing at 5.8, and cost of financing remains at a historic low thanks to the monetary policies of central banks that aim to boost the economy in a post-pandemic economy.
All in all, we can define this situation as a balancing act between finding attractive investments, adapting to a high multiple environment, and taking advantage of the beneficial debt markets in order to put at a profitable use the high volumes of dry powder.
Publicly traded PE firms took a valuation hit in Q1 of 2020, but have more than bounced back since, highlighting the positive market perception at present.
The Growing Case for Specialisation and ESG
As funds are looking to commit capital, and put their money to work, the trend for 2021 appears to be favourable to specialisation. Classic buyout funds may have a harder time attracting capital than previously, especially as general partners begin to value adaptability. In fact, classic buyout funds held 62% of global private equity AUM in 2010, down to 41% in 2020. When it comes to sector focus, those industries that have best weathered the pandemic will likely be favoured in 2021, namely technology, healthcare, industrial goods, and financial services, which represented approximately 75% of the global deal volume last year.
Limited partners are now looking to fulfil their alternative asset allocations or address specific requirements (such as sustainability standards) from their stakeholders. As a result, general partners that provide higher performance, or a specific focus, have been able to attract more capital globally. In addition, the last five years have shown unprecedented growth in AUM, as well as fierce competition for assets and continually high price multiples. These factors have made it ever more important for PE firms to find deeper insights, showing a growing preference for specialisation. In fact, limited partners have been investing heavily into growth equity funds, tactical opportunity funds, long-hold funds, and ESG-focused and impact funds. Overall, the market is craving new ways to find and create value, as seen in the massive growth in SPACs.
Various other factors, such as customer and employee expectations, point to ESG guidelines being a pivotal factor in 2021, and the years to come. As the pandemic continues, market demand for sustainable and socially responsible corporate behaviour has perdured. According to the 2020 Edelman Trust Barometer Special Report, close to 90% of limited partners use ESG indicators when making investment decisions.
Green behaviour is a key strategy in maintaining investor attractiveness, and can also be monetized, as PE firms such as EQT benefit from reaching ESG indicators, through their ESG-linked subscription credit facilities (lowered interest rates when meeting targets).
Although susceptible to greenwashing, and with differing practices around the world, economic forces at large indicate that ESG is here to stay and will play a decisive role in the competitiveness of PE firms globally.
Despite the Covid-19 pandemic, as well as many political tensions globally, private equity came out of 2020 nearly unscathed. Although the end of the first quarter, and beginning of the second quarter of 2020 presented many challenges, and a heavily reduced deal volume, overall deal count only fell 2.4% for the year.
Strong global activity in early 2021 appears to be a result of accumulated demand in the second semester of 2020, and will likely have a strong positive influence on this year’s deal volume. The accumulated dry powder also highlights private equity’s resilience to periods of economic disruption relative to other asset classes.
Although today’s high multiples leave little room for error, deep sector and sub-sector expertise have shown tremendous development, and combined with the flourishing ESG tactics, and the development of vaccines across the world, we expect 2021 to show accelerated growth in deal volume, and potentially an IRR well above the asset class’ 16% historical average.
Authors: Joana Przadka, Calum Welstead and Eugenio Molinatti