April 17, 2017
Interviewed by: Privcap
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Dealmaker Roundup Q1 2017

Three veterans of the middle-market deal market compare notes on deal activity in the first quarter of 2017, including the dearth of large transactions, the scarcity of public-to-privates, and a dip in private equity-backed exit activity.

Three veterans of the middle-market deal market compare notes on deal activity in the first quarter of 2017, including the dearth of large transactions, the scarcity of public-to-privates, and a dip in private equity-backed exit activity.

Dealmaker Roundup Q1 2017

David Snow, Privcap:
Today we’re joined by Leo Peavy of Preqin, Mike Fanelli of RSM and Jeff Bistrong of Harris Williams. Gentlemen, welcome to Privcap today. Thanks for being here.

Unison: Thank you, David.

Snow: We’re talking all about private equity-backed deal activity in the first quarter of 2017. We’re also going to talk about some really important long-term trends in the private equity deal market, so I’m glad you’re all here. We’d love to have your insights. Why don’t we start with an observation that, as far as deal value goes, the first quarter of 2017 was a bit sleepy? There’s quite a number of deals, many of them in the middle market, but as far as mega-deals or larger deals getting done, there just weren’t that many. Starting with Jeff, what is going on in the market?

Jeff Bistrong, Harris Williams & Co.:
I would attribute it to, we’ve been on a sustained, robust M&A market. And after every year, probably starting in 2015, the market’s taken a pause and said, “Can we have another year that looks like this?” after they’ve had very successful exits, which tend to aggregate in the fourth quarter. I think we experienced that this quarter as well—Q1.

Snow: Yes. Leo, it’s worth noting that Q1 tends to be a slower quarter as far as deal activity goes, right?

Leopold Peavy, Preqin:
Yes, absolutely. Pretty much in deal activity both announced and completed, we’re mirroring Q1 2016. A lot of GPs we’ve spoken to have stated that they’re looking to ramp up their activity throughout the next subsequent quarters as they have to, considering the record levels of dry powder and fundraising competition.

Snow: Yes, we’re going to talk about dry powder in a bit. Mike, what was your Q1 like as far as participating in the deal activity?

Michael Fanelli, RSM:
It was a little slower than we wanted it to be, I think. Again, to your point, typically Q1 is a bit of a slower time period. People [are] coming back into the new year with a smaller pipeline than typically for the rest of the year. But there’s still the desire out there to do deals, both on the large scale and the smaller scale. It’s just really a matter of finding the right deal still, which has been the flight to quality and the issue with finding quality companies to make those acquisitions for.

Bistrong: I’d just add that, as an M&A advisor, we see the deals before they hit the market. In the second half of Q1, we saw significant ramp-up in activity.

Snow: Leo, your company Preqin counts deals that close. That’s what goes into the statistics.

Peavy: Sure.

Snow: But how about deals announced? What does that indicate about what might be down the pipeline from there?

Peavy: It’s actually quite interesting. In terms of deals closed, we saw on average about $135 million per deal. In terms of deals announced, we saw almost $550 million on average per deal. So, down the pipeline in terms of both average size and number of deals announced, it significantly has trumped the number of deals that were completed in Q1.

Snow: It’s worth noting that the largest 10 announced deals of 2017 have a value of roughly $25 billion and that’s just 10 deals.

Snow: Certainly, larger deals should materialize down the road or these large private equity firms are going to have some “‘splainin’” to do. As we speak, private equity is hauling in a record amount of capital in private equity funds. And, in fact, the first quarter of 2017 was actually the biggest first quarter ever for private equity fundraising, correct?

Peavy: For North America, yes.

Snow: For North America, which is primarily where the capital is being raised these days.

Peavy: The same thing goes for the deal market as well. North America really brought up Europe, which had both lackluster fundraising and deal Q1 in 2017.

Snow: Right, so you have huge amounts of capital being raised. Right now, the largest private equity fund possibly ever raised—Apollo’s roughly $20-billion fund—is being raised. That capital is going to have to be put to work, and it can’t be put to work in a lot of lower middle-market deals. It has to be put to work in pretty substantial deals. So, are these GPs confident that they’re going to be able to find the deals that match the size of their funds?

Bistrong: Yes. I think there’s two elements. We’ll talk later about private transactions and certainly there are a number of public companies that are better served in the private market. At the same time, in the private sector, there are still plenty of attractive assets. Either they are privately-held businesses still looking for liquidity (and it was effectively a bull market for M&A) or it’s private equity portfolio companies that will get exited sooner than they might otherwise.

Fanelli: I think the competition is going to be fierce. It’s probably going to keep the multiples relatively high. [That’s] just another reason why values—from an overall valuation perspective and EBIDTA multiple perspective—probably will remain high simply because of that. Because there’s so much money chasing these companies.

Peavy: Agreed.

Bistrong: Yes.

Snow: You mentioned public-to-private deals. Let’s talk about those for a bit. Historically, public-to-private deals have been a very important type of private equity transaction; they’ve tended to be the larger deals to get done and are often sponsored by the larger private equity firms. There haven’t been as many recently and, as a percentage of deals getting done, they don’t rank very highly. What is going on in the public-to-private opportunity set? Why are there not more of these deals getting done?

Bistrong: In my estimation, it is as attractive as it ever has been, but much of the low-hanging fruit has been picked in a sustained growth market. Obviously, the public equity valuations have moved higher over recent years. At the same time, the ones that clearly were not being valued by the market were taken private. And that will just be more selective until we see the next cycle.

Fanelli: The interesting thing about that, to your point about the good ones being taken already, is [that] there’s a significant amount still out there that need to be taken out of the public markets because they’re just not working right now. The challenge is, it’s a lot like the retail industry. There’s a lot of these multi-location, multi-billion-dollar company retailers that would probably benefit from being taken private so they can transform themselves outside of the public eye. But the difficulty is, there’s a huge amount of execution risk with doing that because a lot of these businesses have been declining for a couple of years now and they need almost a full transformation to be able to be profitable. So, there’s a significant amount of work the private equity firms are going to have to do once they take these companies private.

Snow: Let’s talk about another observation from the first quarter, which is that private equity-backed exits have actually been pretty weak. This comes after a fairly sustained period of GPs returning record amounts of capital to their own investors. Really robust exit activity. Yet, in the last quarter and certainly in the last few quarters, it’s been a bit slower. Leo, can you put that in context for us?

Peavy: Yes, absolutely. I think it absolutely has been slower. Like I said, the biggest issue for both LPs and GPs is the valuations. We’ve conducted multiple surveys where 50% of respondents mention that that’s the key issue. And that’s where we do see the slowdown in this area completely.

Bistrong: I’d just add for exits, given that generally this is a robust market for exiting a portfolio company, it’s not a question of desire. And it’s not a question of failed processes. It’s really that, over the last several years, they’ve exited a lot of their portfolio, so they’ve got a selective group of assets they’ve held for duration that they can bring to market. So, we have just a natural shift given the rapid pace of deals over the last several years.

Fanelli: Yes. And, just in terms of PE exits, Q1 numbers (from my perspective) seem to be more of a blip than anything, as opposed to something interesting from a trend perspective. Also, when I talk to my private equity firm clients, right now is a good time to sell. It still remains a good time to sell, right? The key is, they also aren’t bringing companies to market until they’ve executed on their strategy that they set out when they acquired the company.

So, even if they’ve owned the company for two years or eight years, but they haven’t finalized the execution of the strategy of where they want to get to, most of the time they’re not bringing it to the market just to be able to sell it in a relatively good sales process market. They want to get to the point where we have these strategic initiatives. We’ve done three out of the five of them. We still want to do the next two because we think we’ll get even higher value, even if it’s a year or two from now, once we finish these strategic initiatives.

Bistrong: I think we will see a pick-up throughout the year in terms of deal pace, partly because the market is accepting of shorter hold periods. And you’re seeing these companies cycle through the private equity portfolios more rapidly than we’ve seen in the past.

Peavy: It is interesting, though, that you have to go back to Q1 2010—seven full years—to view this level of aggregate deal exit value, which is actually very surprising considering how robust the exit environment currently is. Almost a decade. We do expect the numbers to increase about 5% to 10%, but it’s still incredibly low.

Snow: Do you get a sense that the private equity firms that held on to these assets all through the great recession and leading up through this great exit boom that we had—that they sold their better companies first and now they’re holding on to some of the stragglers that maybe aren’t as attractive to buyers?

Bistrong: There’s certainly an element of that. But what’s also happened is at the beginning of the boom, they invested in companies that are very good, have grown through the boom and will be attractive exit candidates.

Snow: One of the most important exit routes, or the most important exit route, for private equity firms is the sale to a strategic buyer—a corporate buyer. Anecdotally, what are hearing from those types of buyers? Do they still have the same type of appetite to grow through acquisition?

Bistrong: Our 10-year track record for tech deals—where I focus—is 70% goes strategic. In the last 18 to 24 months, the private equity guys have become highly competitive. They’ve been willing to pay higher multiples for highly recurring revenue business models. The strategics have had to re-look at that, but they remain as competitive as ever. They’ve got now a very good acquisition currency if they’re a public company given valuations and I expect to see balance restored there.

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