February 15, 2017
Interviewed by: David Snow
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Dealmaker Roundup – Private Equity 2016 Review & Outlook

What drove private equity deal activity in 2016 and what are the top predictions for deals in 2017? A panel of experts from RSM, Preqin and Harris Williams discuss the reasons behind drop in overall deal value last year, the boom in add-ons, how 2016 compares to boom-year 2006, and why 2017 may be another huge year for private equity deals.

What drove private equity deal activity in 2016 and what are the top predictions for deals in 2017? A panel of experts from RSM, Preqin and Harris Williams discuss the reasons behind drop in overall deal value last year, the boom in add-ons, how 2016 compares to boom-year 2006, and why 2017 may be another huge year for private equity deals.

Dealmaker Roundup
Private Equity | 2016 Review & Outlook

David Snow, Privcap:
Hello and welcome to Dealmaker Roundup. I’m David Snow, co-founder and CEO of Privcap. Today, we’re joined by Giles Tucker of Harris Williams, Leopold Peavy of Preqin and Michael Fanelli of RSM. Gentlemen, welcome to Privcap today. Thanks for being here.

Michael Fanelli, RSM US LLP:
Thanks for having us.

Leopold Peavy, Preqin:
Thanks, David.

Snow: We’re talking about the deals that happened in 2016. 2016 was a big year for private equity-backed deals and yet it could have been bigger, based on what history tells us. Let’s first take a look at the numbers. If you look at the number of deals completed, it was a very big year. But the value of the deals done has actually dropped on an overall basis, so that’s an interesting trend. Giles, from your perch as a senior partner at a major middle-market investment bank, what did you see in 2016 by way of deals done?

Giles Tucker, Harris Williams & Co.:
David, I think you hit the nail on the head. It was a great year by all accounts and I wouldn’t read too much into the volume number in any given year. The volume number, as we know, can change pretty dramatically if two or three or four notable deals don’t get done. And we saw a bunch of notable public deals that didn’t get done. So, if you think about that backdrop, 2016 was a great year in terms of number of deals getting done. I suspect that this year—and we’ll talk about 2017 later—you’ll see a nice rebound on the volume front.

Peavy: Looking back, we saw about 87 of these deals over $1 billion and that’s certainly high. Looking back at 2006—10 years prior—there were about 127 deals over $1 billion as well. We’re not near those pre-crisis levels just yet, but I think we’re certainly rebounding.

Fanelli: The thing we’re seeing, too, especially in the middle market, is middle-market private equity firms acquiring platform companies and really having this rollup strategy of doing a significant line of add-on acquisitions. You can get a significant number of deals getting done with that strategy. They’re saying, “From an inorganic growth perspective, we have an add-on strategy in a fragmented industry with also getting multiple arbitrage.” So, a lot of times—and I think we saw it in 2016—you see the higher number and volume of deals going up.

Peavy: Add-ons have actually doubled from 18% in 2006 to about 35.5% in 2016, year-end. Certainly, we have seen a large growth there—double the growth, actually—in those types of investments.

Snow: What’s been remarkable is that the past three or four years, as far as number of deals done, have been remarkably consistent. Is that what you’ve seen in your shop as well?

Tucker: We have. The last three years, across the board, have been almost equal in terms of number of transactions we’ve worked on. We had good growth in 2016. 2015 was a bit better than 2014, but overall, our level of activity across all 10 industry groups has been very consistent. I think it matches up well with the data. The one thing I would say about the large-deal market is that it’s just a much thinner market than the middle market, to your point. There are just not as many good quality assets out there for the big funds to chase.

Fanelli: At RSM, we focus 100% in the middle market, so we’re not seeing as much of the five, 10 or even more so on the billion-dollar deals getting done. But we are seeing those larger private equity firms who are typically going after those larger deal value-type assets—they’re coming down a little bit. Not always, but they’re coming down on occasion to go to the upper middle market or even core middle market to do deals or finding that one asset they feel comfortable with.

Snow: Another notable observation from 2016 is the dry powder that has accumulated. It is now at record levels. That capital has to be put to work or the managers have to give it back. This is going to drive deal activity significantly. I’d like to go back 10 years and look at another notable year in private equity deal-making: 2006. If we think we are in the midst of a deal boom, it doesn’t even compare to what took place in 2006, so I’d like to compare the two markets to get a better understanding of what’s likely to happen next.

Tucker: 2006 was one of the best markets we’ve ever seen. You can describe it, but if you look at the things that were driving that market, everything was hitting on all cylinders. You had plenty of confidence out there in boards and management teams. You had plenty of liquidity. The banks were doing some pretty incredible things on the leverage front. At that time, if you remember, true banks were involved in the marketplace. I think about 60% of the LBO facilities who are out there were actually funded by banks. [It was] very different from today—it’s about 15%, I think. The non-bank banks are doing all the deals today.

Little did anybody know, we were headed in to a pretty difficult period in 2008. A lot of people put money to work during those two years into various companies, proven out by the level of transactions. And there are some people who had a tough stretch from 2008 to 2009 into 2010.

Snow: Yes. If you look at the statistics comparing 2006 with 2016, there were roughly the same number of deals done, but the value was double essentially. Leo, when you look at those numbers, how do you compare the two years?

Peavy: When you look at 2006, 77% of deals done were over $1 billion when you look at the aggregate universe. Today, you’re looking at 63% over $1 billion in terms of aggregate deal activity globally. So, you see about a 15-point drop off there alone. When we look at 2006, 41% of aggregate deals were over $5-billion deals across the globe. Today, it’s just 13%. That’s almost a one-third difference, which is a tremendous change within a decade of an entire industry.

Fanelli: A lot of things are different now. The regulatory environment is different. The lending environment is different. Then, a lot of larger buyers were kind of scared straight, as I would say, because of some of the deals.

Snow: A number of the very large deals done in the heaviest days of 2006, at heavy multiples and with large amounts of leverage, are still on the books of the private equity backers and have not yet been exited to the chagrin of their investors. They haven’t been exited partially or, in many cases, because they haven’t performed as people had hoped. So, you’re saying there’s that sense of “We’d better not repeat this exuberance” in today’s market.

Fanelli: 2017 could be an interesting time to start thinking about how we can maybe divest those assets that we’ve had on our books for 10 years. The overall economy is a bit better. We’ve seen some growth in some other—

Tucker: If you look at where purchase multiples are today on average versus 2006, they’re very close to the top. Debt multiples are sniffing the high points of 2006. One thing that has changed since 2006 is that the average equity contribution going into a traditional buyout has gone from roughly 35% back then to 45% to even 50% today.

Snow: What are your predictions for 2017 as a deal market? How much bigger? How much more active could it become?

Tucker: As long as we don’t have some type of regulatory surprise coming out of Washington, whether it’s tax policy or something with the fed—something to really stir up the market—2017 could be a terrific year.

I think confidence is such a huge factor in the M&A market. If boards, management teams and private equity group professionals are feeling confident about the deal market in 2017 and are sitting on a company that’s performed reasonably well, you have to think they’re having discussions with their advisors and internally about taking those businesses out.

Fanelli: I totally agree with your sentiment in terms of—I think 2017 is going to be a very good year for overall M&A. The interesting thing, too, to bring it to the next level is that there are some industries maybe that haven’t been very active in the last two years that could be like energy and infrastructure.

Snow: With multiples has high as they are, how are private equity buyers getting comfortable with deploying capital when it’s clear to everyone that multiples are on the higher end of the spectrum?

Fanelli: The private equity clients we speak to really think about it from the perspective that our limited partners invest in us and they expect us to invest throughout the 10-year cycle of the fund and into the next 10-year cycle in Fund 2 and so forth. They’re not trying to pick when multiples are at the peak versus the trough. They’re just saying that, in the current environment we’re in, where can we add the most value and increase the rate of return within my fund to the highest extent possible?

Tucker: We hear frustration from a lot of different middle-market private equity groups about going far in processes—sometimes two or three or four—to the finish, completing all their due diligence and not prevailing. That clearly is frustrating to them to some degree. But, to Mike’s point, they are in the business of putting money to work.

On a relative basis, private equity looks pretty good to the bond market. It looks pretty good to the public market. The spread is still there, so they fully expect the groups they’re investing in to deploy capital through all the cycles.

Fanelli: In the near term, I don’t think it’s going to impact it really at all. I mean near-term in terms of 6 to 12 months; 12 to 24 is an interesting story because we think there’s going to be three or so rate hikes in the next year. Once you start getting past that, it gets into the thought process of, “The amount that I’m paying on interest now due to the higher rate might make me pay one turn less on the asset class.” If that gets into the market in totality, maybe instead of 10 times or nine times (or whatever the current average is today), that nine goes to eight.

Tucker: If there’s tax reform and they start poking it—tax deductibility of interest on debt, for instance—that could have an impact.

Snow: Walk us through how that would change the economics of the buyout deal.

Tucker: We currently model a transaction interest rate on the debt that you have on your balance sheet as deductible. If they start messing with that deductibility, it will naturally change the return profile of a particular deal however you model it out. What you hope will happen is that they convert, at the same time, lower overall rates that will offset the impact of losing that deduction.

Snow: It’s now time for a highlight of an interview with Stewart Kohl, co-CEO of The Riverside Company. In this clip, Kohl explains why Riverside exclusively targets lower middle-market businesses.

Don Lipari, RSM US LLP:
In 1995, you closed your first fund—$34 million—with a thesis of lower middle market. And that is the investment strategy to this day—lower middle market. What about the lower middle market does Riverside find so appealing?

Stewart Kohl, The Riverside Group:
What’s wonderful about where we play—these businesses that have less than $35 or $40 million of EBITDA and, in most cases, much less; in some cases, virtually zero—is that, number one, there are so many ways to make them more valuable. We’re not buying flawed companies. We’re not doing true turnarounds. In fact, we’re buying what I would describe as beautiful little businesses, but there are so many ways we can add value to these companies.

We can professionalize the business by improving the management team and management information systems, writing the first written strategic plan, creating the first real board of directors with outside experts, using our toolkit to improve things, like pricing at the business—all these ways to create value. That’s one of the reasons we feel the opportunities for an outsized outcome are better when you start where we do.

Secondly, it’s more fun.

Snow: All right. I learned a lot about what happened in 2016 in the private equity deal market and I’m very interested to see what’s going to happen now in 2017. I really appreciate the insights that you gentlemen brought to the conversation. Thank you very much.

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