Time to go for Europe's middle markets
In recent months, a view has generally taken hold among European investors in private equity about market conditions for large corporate buyouts – that is, transactions with a value greater than $750m (e808m) or so – in Europe versus the US. Broadly speaking, investors seem to have concluded that conditions in Europe are far more favourable for such transactions than they are across the Atlantic, and are likely to remain so in the near-to-medium term.
This apparent consensus has been reflected in divergent European investor support of late for US versus European mega buyout funds. About half of the top 10 US buyout houses are or have recently been seeking to raise multi-billion-dollar funds. Generally, it appears that their offerings are meeting with resistance among Europeans, despite the lengthy and profitable track records of these firms, and their proven skill in managing capital pools.
By contrast, recently many of Europe’s premier firms have raised the largest funds in their corporate histories. BC Partners, Industri Kapital and Schroders, for example, have all closed funds ranging from €2bn–4bn in size. These new funds are considerably larger than the predecessor ones that generated the track records these firms used in raising new capital, and a substantial share of their commitments came from European investors.
The arguments favouring ever-larger European mega-buyout funds are familiar – for example, increasing economic integration allows more scope for pan-European consolidation strategies, and shareholder value imperatives are forcing corporate rationalisation. Conversely, it is widely held that there is too much money chasing too few deals in the US, and that corporate restructurings, potentially a fertile source of buyout transactions, were a phenomenon of the last two decades but will not feature so prominently in America during the next one.
A question for European investors arises, however: is there a contrarian position to take, one that challenges this settled thinking and might generate higher relative returns in the future? In other words, is there a case to be made that favours large buyout exposure in the US in the current markets versus that of Europe?
Certainly the statistical evidence, imperfect as it is in a world of privately-held firms and varying methods of data assembly, indicates that Europe offers a more compelling opportunity than the US. ‘Penetration rates’, measuring gross private equity investments versus GDP, remain far lower in most European countries than the US level. In addition, over the past three years, funds deployed in Europe have largely matched funds raised; in other words, the European private equity markets, buyout-dominated by volume, have absorbed the capital available to invest in them.
Conversely, in the US, the pace and volume of conventional buyout transactions appear not to have kept pace with the funds raised to focus on them. Thus there the theoretical ‘overhang’ of uninvested capital targeted for buyouts in the US significantly exceeds that in Europe. In addition, the past few years have seen almost all of the large US buyout firms deploy capital in situations outside their traditional areas of focus.
Yet before the contrarian position is dismissed on the grounds of imperfect statistical information, perhaps anecdotal evidence from private equity practitioners operating at the large end of both the American and European markets should be considered. To assemble this evidence, the author spoke to several senior professionals at private equity houses on both sides of the Atlantic; the interviewees were offered anonymity in exchange for candour. Their observations suggest that even if a fully contrarian, pro-US buyout position is not justified, neither can a one-dimensional, Europe-above-all decision be easily embraced.
For example, a senior partner at a top American house considered the set of opportunities presented now by publicly-quoted, ‘old economy’, traditional manufacturing and industrial companies to offer the ‘best relative value’ seen in buyout markets since the early 1990s, when the Drexel junk bond machine collapsed. Prospective purchase prices on a multiple of cash flow basis are lower, and in theory more readily financeable, than they have been since that era of market lows. Given the size of the American economy, and the depth of its capital markets, there are also dozens of substantial, billion-dollar target companies where public-to-private transactions could conceivably absorb hundreds of millions of dollars in buyout funds’ equity capital.
Yet however tempting the targets, a junior partner at the same firm cautioned that two primary obstacles stand in the way of completing these transactions. First, the leveraged financing markets, whether the public high yield ones or those supplied by banks, are effectively closed in the US: he said bluntly that “subordinated debt is impossible to raise”. While the US markets have a history of shifting sentiments rapidly, for now they act as a brake, rather than a spur, to capturing old economy values. Second, “coming off the tail end of the bull market,” public shareholders’ expectations are “slow to change and memories are long” of 52- week, or more distant, share price highs. Boards are reluctant to recommend offers where shareholders “will be sitting on losses at the buyout price”, according to this practitioner. In order for this more psychological obstacle to be cleared, he concluded that “it has to get worse here” – either through a recession or even more persistently depressed prices – before “reality” leads to “fantastic conditions” for traditional buyouts.
If more ‘macro’ factors like overall market or economic performance may then dictate how propitious US market conditions are for large buyouts, more ‘micro’ ones like competition among well-funded firms or cultural factors may have a disproportionate effect on the outlook for big European buyouts. By a number of accounts, the intensity of competition in Europe for $750m–1bn-plus deals is even greater than in the US. One participant described it as “pretty frightening”, and another said “anybody who is anybody is stepping up” to this level, “where it is a different world” than the one where many firms learned their trade. Many houses, both locals and American transplants, have in the past two to three years staked their claim to this mega-deal territory, and need to justify their participation in it. Meanwhile, there have been only 10–15 deals of this size annually on which to focus in Europe. Typically, these few transactions are, in the words of one practitioner, “so professionally sold that the only thing that wins is price”. In an environment of such fully-priced entry costs, in-house restructuring or add-on acquisition skills are now essential: generating long-term gains, one player observed, requires changing the asset rather than riding the market.
Clearly much of the pressure would be diminished at the top level if more than 10–15 deals were on offer every year, and in this respect under-penetrated Germany, nexus of cross-shareholdings to unwind and middle-sized private companies to purchase, continues to cause private equity operators to salivate at its wealth of opportunities. For many years, however, promise has not been met by performance in Germany, at least in terms of completed deals. Changes to the tax system in 2002 may contribute materially to improved, high quality deal flow, but cultural obstacles remain, some less obvious than others. In particular, one UK-based buyout player reported that “the quality of financial information” at German companies generally is surprisingly inadequate, with accounts either prepared inadequately or published infrequently, or both. Not only does this information gap make it hard for equity players to assess value, it undermines the confidence of providers of leveraged financing. As this problem will not be solved quickly, this practitioner expected Germany eventually to be a vibrant private equity market, but not soon enough to meet the requirements of many current funds’ investment periods.
Perhaps the answer for investors is to treat the large buyout market on both sides of the Atlantic with some caution in the near term, investing only with those firms that have demonstrated the ability to deploy substantial amounts of capital successfully throughout the economic cycle. Indeed, a better focus may be the middle market, an area that has been unfashionable for many years. Arguably, it is the middle market that will benefit most as European conglomerates are dismantled. Also, in the US as in Europe, the smaller fees available to intermediaries in the medium-sized sector mean less interest from investment banks in auctioning companies and driving up purchase pricing.
John Barber is a director of Helix Associates in London. Sebastian Klinder assisted with research for this article