Rising Above The Foam In A Frothy Sourcing Environment
The most significant challenge facing private equity firms in 2016 has been and will continue to be the sourcing and winning of quality investment opportunities. The tremendous amount of institutional capital that has been raised over the past 24 months has led to a capital overhang that dwarfs the number of available opportunities for investment. Fierce competition among private equity firms has caused valuations to balloon which many believe will eliminate or dramatically reduce the “multiple expansion” that some funds have relied upon as a safety net or to bolster their overall performance. Strategic buyers are at a clear advantage in this market because their substantial cash reserves and unique perspective on target company valuations put them in the driver’s seat during negotiations. Their ability to rationalize these overpriced assets only serves to pressure these pricing trends to the dizzying heights that we are seeing today – 15x EBITDA and higher in some instances. According to Preqin, According to Preqin, dry powder rose steadily in 2015 to $1.34tn. Therefore, the likelihood of these valuations persisting over the mid-term is quite high.
The response to the frothiness of the private equity markets has taken on different forms on both the GP and LP side. GPs have focused their efforts on subsectors and niche opportunities that are most relevant to their areas of expertise. This narrowed sourcing focus has three important advantages to private equity funds in this overbought environment: (1) the GP’s network, relationships and knowledge have a greater likelihood of yielding deals outside of a process (“proprietary”); (2) the ability to win these transactions by convincing management of the deep sector expertise is greatly increased; and (3) the ability for the GP to deliver on their value-added strategy and thereby compensate for a sellers’ market price is enhanced. Of course more focused strategies and niche opportunities mean one thing to LPs: smaller funds. LPs are encouraging fund managers to specialize in areas where their core expertise is a differentiating factor and to take on less capital given the competitive market and in many cases they are also endorsing a trend for these funds to go down market in search of less efficient processes where less competition can improve pricing dynamics.
GPs that have distinct sourcing models or value-add models are faring much better in standing out from the robust competitive set. In respect to sourcing there is no substitute for time, experience and the relationships that result from the consistently executing transactions within subsectors over different cycles. These industry networks can take on different forms, but the longevity and proven utility of these relationships is common to all the most successful groups. The models for adding value to portfolio companies have even greater diversity among private equity firms – technology specialization, in-house operating groups, human resource specialists, overseas supply chain partnerships – are winning the sourcing battle in this environment by demonstrating these material advantages to management teams who rely on these resources to generate value. LPs are recognizing groups that have spent the time developing these skill-sets directed toward providing a full suite of services designed specifically to transform these privately-owned companies.
Next on 60 Seconds with Sixpoint: Expanding options available to GPs for managing end-of-life portfolios