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Travers Smith’s Dolman: The mother of invention – why necessity and high prices will push private equity to new heights

2014 was a year that saw the number and value of private equity (PE)-backed exits reach unparalleled highs globally. More benevolent economic and market conditions, including an increase in global M&A activity, created renewed confidence in the industry.

With a mountain of dry powder to deploy – that’s unused equity in the industry slang – and more debt funding available than has been the case for years (and on more favourable terms), PE firms have been very busy looking for new investment opportunities. This has resulted in fierce competition for any high-quality assets that come to market. Coupled with the continued high valuations of comparable companies on the public markets and near-zero interest rates, this has inflated valuations and resulted in the purchase-price multiples for leveraged buyouts in Europe reaching an average of ten times EBITDA – highs not seen since the peak of the last cycle.

In such an environment it has clearly never been better to be a seller, while becoming markedly more challenging to be a buyer. Warren Buffett’s mantra of ‘it’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price’ is getting hard to put into practice in today’s climate where all the choice assets are being traded at increasingly racy multiples.

The abundance of available capital in the European PE market and the forces driving up valuations show no signs of changing in 2015. Indeed they look set to be compounded by the results of another strong year of fundraising for many houses in 2014 and the emergence of new players (such as America’s houses and Canadian pension funds) to the European market.

So how is this likely to affect the industry in the short term? Putting to one side the UK and European PE industry’s immediate prospects being at the mercy of the upcoming election, the ongoing instability in the eurozone and other geopolitical risk, I anticipate three knock-on effects.

First, the average holding period of investments will likely continue to lengthen, with sponsors feeling the pressure from investors to deliver convincing returns on assets acquired at the higher multiples of recent years. We are therefore unlikely to see the average holding period return to a three-year average, with five-plus becoming the norm in order to allow assets time to make the requisite two to three times return and an internal rate of return (IRR) in the low teens.

Buffett’s mantra of ‘it’s better to buy a wonderful company at a fair price, than a fair company at a wonderful price’ is getting hard to put into practice.

Second, I firmly believe that PE houses will continue to surprise the market with their creativity. No one can doubt how resilient the PE market has proven to be; the industry’s comeback after 2009 being a case in point. With the limited supply of assets and the amount of money chasing them, I anticipate that many funds will show an increased appetite to purchase minority stakes in high class assets. Houses are also likely to demonstrate new resourcefulness by focusing on unlocking unrealised potential in their existing portfolios by adopting a more hands-on approach and pursuing buy-and-build strategies. As a firm we have already begun to see evidence of this behaviour in the last 12 months.

Third, the proven performance of PE investments as an asset class has led to some institutional investors wanting a bigger piece of the action. Such investors have begun looking for new ways to participate in PE deals beyond the conventional constraints of being passive partners in PE funds. The so-called ‘shadow capital’ provided by them (often in the form of co-investments) is not a new concept – limited partners (LPs) have been passively co-investing alongside general partners (GPs) in deals for years. But I predict, particularly given the increased sophistication of LPs and their ability to effectively manage a co-investment programme, an increase in quantum and in the variety of ways shadow capital will be put to work.

This can offer a series of benefits to both LPs and GPs. For LPs it has the potential to improve their returns yet further and at a lower cost, and for sponsors it can provide them access to larger deals while maintaining an appropriate level of diversification and a way to enhance their relationship with investors. However, the injection of more funds in the form of shadow capital into a market already saturated will increase competition further, with some even going so far as to suggest shadow capital may end up chipping away at the PE industry’s economic margins. How that dynamic plays out remains to be seen…

Paul Dolman (pictured) is head of private equity at Travers Smith