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www.pwc.de/de/privateequity Pushing further in search of return: The new private equity model As acquisition prices continue to rise, private equity funds have to work harder and longer to secure a viable return from their investment. How are the talent, operational improvement and exit strategies adapting to the new market realities? Pushing further in search of return: The new private equity model As acquisition prices continue to rise, private equity funds have to work harder and longer to secure a viable return from their investment. How are the talent, operational improvement and exit strategies adapting to the new market realities? Pushing further in search of return: The new private equity model Published by PricewaterhouseCoopers Aktiengesellschaft Wirtschaftsprüfungsgesellschaft By Steve Roberts August 2015, 40 pages, 23 figures, softcover All rights reserved. This material may not be reproduced in any form, copied onto microfilm or saved and edited in any digital medium without the explicit permission of the editor. This publication is intended to be a resource for our clients, and the information therein was correct to the best of the authors’ knowledge at the time of publication. Before making any decision or taking any action, you should consult the sources or contacts listed here. The opinions reflected are those of the authors. The graphics may contain rounding differences. © August 2015 PricewaterhouseCoopers Aktiengesellschaft Wirtschaftsprüfungsgesellschaft. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers Aktiengesellschaft Wirtschaftsprüfungsgesellschaft, which is a member firm of PricewaterhouseCoopers International Limited (PwCIL). Each member firm of PwCIL is a separate and independent legal entity. Preface Preface Welcome to Pushing further in search of return: The new private equity model. Private equity funds have record levels of dry powder and easy access to debt finance, a picture that harks back to the boom years of 2004–2007. But this is a very different marketplace. With the supply of quality assets failing to match demand, buyers are paying premium prices to acquire target companies. This requires them to generate more value from the asset to meet their return objectives, which takes longer – holding periods have increased – and demands more investment in efficiency, channel effectiveness and other forms of operational improvement. In this paper, we look at how funding, value generation and exit strategies, which are the three sides of the new value triangle, are being reshaped by these new market realities. We also look at the emerging challenges ahead and the likely drivers for success. The report draws on a survey of 100 private equity executives from across Europe, who offer their perspectives on how operational improvement fits into their overall strategy and equity story, and what they see as the key value drivers in this area. We would like to thank all of the survey participants for sharing their valuable time and insight. We hope that you find the paper useful and informative. If you have any queries or would like to discuss any of the issues in more detail, please speak to your usual PwC representative or one of the authors listed on page 36. Steve Roberts Partner, Private Equity Leader at PwC in Germany “Our firm’s operating models have changed in the past ten years; we have widened our approach more with respect to the highly volatile and diverse market, and we now gauge businesses uniquely and check all possible options for improvement.” Managing Director, Germany Pushing further in search of return: The new private equity model 5 Table of contents Table of contents Table of figures.........................................................................................................7 AIntroduction..................................................................................................... 10 B Debt: How long will the good times last?..........................................................13 COperational improvement: The key to delivering a return................................22 DExit: Making the most of all the available options.............................................29 EConclusion: Pressure for return........................................................................34 Contacts..................................................................................................................36 6 Pushing further in search of return: The new private equity model Table of figures Table of figures Fig. 1European Private Equity Fund Level Return – Allocation IRR drivers...... 11 Fig. 2 How do private equity funds rank the three value drivers?......................12 Fig. 3European Leveraged Finance Issuance.................................................... 14 Fig. 4 European Cov-Lite Volume...................................................................... 14 Fig. 5 Loan Overviews-Leverage Ratios............................................................15 Fig. 6 European Sub-Investment Grade Ratings Distribution............................ 16 Fig. 7Bond Spreads Investment Grade & Subprime Lending/ Sponsored & Non-Sponsored Transactions.............................................. 17 Fig. 8 Credit Margins for Leveraged Loans in Europe Sponsored Deals............. 17 Fig. 9 Private Equity Dry Powder......................................................................18 Fig. 10 General Purpose Diversification for LBOs over Time...............................19 Fig. 11 European Equity Contributions in LBOs..................................................20 Fig. 12 European Institutional Repricing Volume rolling 3 months.....................21 Fig. 13What is your predominant portfolio strategy, which you pursue in new investments? (Please select only one option)...............................25 Fig. 14 Which levers are most important?...........................................................26 Fig. 15In which form does your company apply the operating model on portfolio companies? (Please select the most important)....................27 Fig. 16 Holding Period of PE Portfolio Companies in Europe..............................28 Fig. 17 European Buyout Volume: Where Does PE Invest?..................................30 Fig. 18 Number of Secondary Buyout Exits in Europe.........................................30 Fig. 19 Number of Secondary Buyout Exits in Germany......................................31 Fig. 20 Purchase Price Multiples: Sponsor to Sponsor Transactions....................31 Fig. 21 Number of Trade Sale Exits in Europe.....................................................32 Fig. 22 Purchase Price Multiples: Sale to Corporate............................................32 Fig. 23 Number of IPO Exits in Europe................................................................33 Pushing further in search of return: The new private equity model 7 Einleitung: Relevanz gesunden, nachhaltigen Unternehmenswachstums “The private equity model has fundamentally changed over the past 10 years.” The changing dynamics: Interview with Steve Roberts, Private Equity Leader at PwC Germany The outlook for private equity funds remains promising. But as Steve Roberts explains, new strategies have been required to secure expected return levels. A lot of people were predicting an acquisition surge in 2015. Is this being borne out? Looking at Germany in particular, where are the opportunities likely to emerge from? Private equity funds certainly have the finance and the appetite to step up acquisition levels. Globally, the dry powder available for investment stood at a record $1.24 trillion at the end of March 20151. In Europe, the available funds have risen beyond $300 billion, with more than half yet to be invested. There is a lot of pressure to put this dry powder to work. But here in Germany and in Europe as a whole, the limited number of quality assets coming up for sale means that actual deal volumes in 2015 have been steady rather than surging. The main focus will continue to be mid-sized industrial companies. Much of the mittelstand is of course familyowned. We know that some of the founders’ grandchildren and great grandchildren are keen to sell. But not at any price and not to anyone. With the German economy continuing to perform strongly and demand for acquisition outstripping supply, they know that they can command premium prices. They are also mindful of their social responsibilities and family legacy, and are therefore only going to sell to buyers they can trust. It’s therefore important to approach targets with a strong story for future investment and growth, as well as strong financial offers. Funds may also need to look at a broader range of opportunities, be this countries or industries that haven’t previously been part of the core focus. They may even need to look at lower quality or more complex targets, which would be cheaper but take more time, work and investment to deliver an eventual return. Why are acquisition targets in such short supply and what is the impact on prices? Most corporations have healthy balance sheets and a lot of money sitting in the bank. There is therefore less pressure to divest. With few quality assets coming up for sale, prices continue to rise. While average price/earnings ratios of ten or more might have looked like an aberration two years ago, they are now becoming the market norm. 1 Preqin Quarterly Update, Q1 2015. 8 Pushing further in search of return: The new private equity model The changing dynamics: Interview with Steve Roberts, Private Equity Leader at PwC Germany What is the impact of higher acquisition costs on the market? How is this new market dynamic influencing exit strategies? These high and rising multiples are transforming the value strategies and equity stories that surround them. There may be a lot of dry powder around and leverage is readily available, but more of these funds are being committed to acquisition. The more private equity funds pay, the more they have to do to secure the right return. Where before it might have been enough to carve out and package up the asset for resale to deliver a return on investment, buyers now have to look more closely at opportunities for operational improvement. Our survey found that the most important drivers of value are improved efficiency, sales and channel effectiveness and working capital optimisation, though investment in R&D and entry into new markets also rate highly. Certain exit routes are now more prevalent than at any time since the financial crisis. While the main route used to be selling on to another private equity buyer, the options now include IPO and corporate sale. The stock market surge also means that the price/ earnings ratios for exit sales are also back up to where they were in 2007 and 2008, though these are also the multiples they are paying for their next acquisitions, so the bar for value generation and return keeps rising. These operational improvement strategies clearly take time to bear fruit, which is lengthening the time funds have to hold companies before they are ready for resale. Average hold periods were less than four years in 2008, now they are edging up towards six years. The make-up of a typical private equity firm is also changing. Where the workforce may have been primarily focused on deals, we’re now seeing a reasonably even split between operational and financial specialists. 82% of the private equity executives taking part in our survey say that the potential for operational improvement is the cornerstone of their investment decision. Pushing further in search of return: The new private equity model 9 Introduction AIntroduction 10 Pushing further in search of return: The new private equity model Introduction Following a classic text book approach private equity funds create value thru three pillars (1) use of leverage (i.e. high debt burden and as little equity as needed), (2) multiple arbitrage (‘buy cheap/sell high’) and (3) operational improvement (value generation based on a clear cut investment and value generation strategy – the so called ‘Alpha’ factor). Historically, leverage and multiple arbitrage have been the main drivers of success measured by the internal rate of return (IRR). Combined the two factors have accounted for around 70% of the realised average IRR of 19.61% (see Figure 1). Fig. 1European Private Equity Fund Level Return – Allocation IRR drivers Based on 20 Private Equity Buyout Funds – Investment focus Europe – Funds volume €300 million–€3 billion – Vintage Years 1995–2000 (i.e. all funds were invested). Share of avrg. IRR 7% 39% 31% 23% avrg. IRR 4.47% 19.61% PE Alpha 2 Total PE Return 6.01% 7.71% 1.42% Passive Return 1 2 Leverage Multiple (industry Matched PME1) Unlevered industry matched Public Market Equivalent. Value add through Private Equity Ownership (e.g. Corporate Governance, Selection Management Team, Operational Influencers). Source: London Business School, HEC Paris – sponsored by Pantheon Private Equity & BVCA. Pushing further in search of return: The new private equity model 11 Introduction Besides being benchmarked against an IRR level of 20%, going forward private equity funds face the challenge of how to accomplish a more balanced outcome amongst the main three IRR drivers. As a result, operational improvement capabilities have become, and will continue to be, far more important for a private equity fund’s success. This view is shared by an overwhelming majority of the private equity executives taking part in our survey (see Figure 2). Fig. 2 How do private equity funds rank the three value drivers? 34% 45% 21% 41% 39% 20% 16% 46% Operational improvements Multiple arbitrage 38% Financial Leverage Ranked most important driver Ranked important driver Ranked less important driver Source: Survey of 100 private equity executives carried out by PwC in June 2015. In this study we have looked at all three success factors and how the dynamics are evolving. 12 Pushing further in search of return: The new private equity model Debt: How long will the good times last? B Debt: How long will the good times last? Pushing further in search of return: The new private equity model 13 Debt: How long will the good times last? Funding, including leveraged finance, is reaching record levels, enabling private equity funds to refinance on highly favourable terms and build up plenty of ammunition for acquisition. But the easy access to leverage has to be offset against higher purchase price multiples, which are requiring funds to commit more of their own equity. And it also remains to be seen how long these exceptionally favourable debt market conditions would last once interest rates begin to normalise or the economy heads towards a renewed downturn. This is a good time to be seeking finance. The favourable terms are reflected in the continuing rise in leveraged finance issuance (see Figure 3) and increasing availability of covenant-lite loans (see Figure 4). Fig. 3European Leveraged Finance Issuance in € bn 24.3 22.7 70.1 165.5 2.6 131.3 53.6 44.4 24.5 15.4 2006 2007 2008 Loans Bonds 2009 35.3 42.3 42.7 2010 2011 36.4 67.4 71.7 78.4 27.1 28.7 2012 20.3 2013 2014 1Q 2015 Source: S&P Capital IQ LCD. Fig. 4 European Cov-Lite Volume in € bn 42% 35% 33% 29% 28% 29% 2.09 0.67 9% 3.14 3% 0.12 1.25 0% 0% 1.50 1.27 1Q 2012 2Q 2012 3Q 2012 4Q 2012 1Q 2013 2Q 2013 Domestic 1.03 1.31 19% Cross-border 40% 37% 1.76 3Q 2013 % of total inst. volume Source: S&P Capital IQ LCD. 14 Pushing further in search of return: The new private equity model 4Q 2013 4.64 2.57 3.47 2.03 4.04 0.95 1Q 2014 2Q 2014 3Q 2014 4Q 2014 1Q 2015 Debt: How long will the good times last? Yet, as leverage ratios edge towards pre-crisis levels (see Figure 5), people are inevitably asking whether we’re heading towards a new bubble. At the other end of the spectrum, others see today’s easy access to finance as a relatively short-lived high point, with a lot of the transient new capital likely to switch once interest rates rise or tougher economic conditions spur a move towards more cautious investment strategies. So what is driving change in today’s market, how durable is it and what are the risks? Fig. 5 Loan Overviews-Leverage Ratios Leverage Ratios in Europe 5.0x 5.3x 5.6x 6.0x 5.2x 3.8x 2004 2005 2006 2007 2008 2009 4.3x 2010 4.5x 4.4x 2011 2012 4.7x 2013 4.9x 5.0x 2014 1Q 2014 4.8x 1Q 2015 Leverage Ratios in Germany 5.7x 5.0x 5.0x 5.1x 5.0x 4.7x 3.8x 2004 2005 2006 2007 2008 2009 4.0x 2010 5.2x 5.1x 2013 2014 5.4x 5.7x 3.8x 2011 2012 1Q 2014 1Q 2015 Source: S&P Capital IQ LCD. Pushing further in search of return: The new private equity model 15 Debt: How long will the good times last? Favoured options Coming out of the crisis, bond-for-loan structures dominated the lending landscape, allowing sponsors and some leveraged corporates to use the bond market to replace ageing, and sometimes tight-to-test, loan financings. The popularity of such structures and the arrival of new institutional players in the market underline what many see as a move towards a US-style corporate financing model across Europe. Over the last 18 months, institutional investors’ search for yield in a market where demand of high return investment opportunities outstrips supply of promising assets has encouraged investors to look further afield for openings. As a result, investors have increased their appetite for riskier assets (see Figure 6). Fig. 6 European Sub-Investment Grade Ratings Distribution No. of entities 20 54 24 39 16 14 6 16 30 31 27 27 3 22 34 37 35 29 25 4 17 35 37 36 28 24 12 15 25 32 26 18 30 17 19 38 19 25 31 2005 2006 2007 2008 2009 48 BB+ BB BB– B+ 16 B B– 27 36 11 28 38 55 58 29 23 39 2010 141 87 55 65 181 107 88 60 34 31 29 31 41 43 50 51 40 35 41 2011 2012 2013 2014 CCC/CC Source: S&P. This has been accelerated by the European Central Bank’s quantitative easing measures to provide sufficient liquidity to markets. A combination of quantitative easing and competition among institutional investors to put their funds to work has resulted in generally favourable terms for borrowers (see Figures 7 and 8) and encouraged further development in the ‘cov-lite’ European Term Loan B market, which merges – from a borrower’s point of view – the best from both US Leveraged Loan and US High Yield Bonds. 16 Pushing further in search of return: The new private equity model Debt: How long will the good times last? Fig. 7 Bond Spreads Investment Grade & Subprime Lending/Sponsored & Non-Sponsored Transactions 1,400 1,200 1,000 800 600 487 400 245 200 1 0 Mar. May July Sep. Nov. Jan. Mar. May July Sep. Nov. Jan Mar. May July Sep. Nov. Jan. Mar. May July Sep. Nov. Jan. Mar. '11 '11 '11 '11 '11 '12 '12 '12 '12 '12 '12 '13 '13 '13 '13 '13 '13 '14 '14 '14 '14 '14 '14 '15 '15 BBB Rated BB Rated B Rated Source: S&P Capital IQ LCD. Fig. 8 Credit Margins for Leveraged Loans in Europe Sponsored Deals 550 500 446 450 400 350 358 300 Mar. May July Sep. Nov. Jan. Mar. May July Sep. Nov. Jan Mar. May July Sep. Nov. Jan. Mar. May July Sep. Nov. Jan. Mar. '11 '11 '11 '11 '11 '12 '12 '12 '12 '12 '12 '13 '13 '13 '13 '13 '13 '14 '14 '14 '14 '14 '14 '15 '15 RC/Tla TLb/TLc Source: S&P Capital IQ LCD. Yet it’s still too early to say whether this US-style corporate finance model will prevail in the long-term in Europe. The new inter-creditor relationships being forged between bondholders and loan providers have yet to go through a full cycle. Documentation of new financing structures is only emerging and largely untested. We would certainly need to see how these developments stand up to tougher economic conditions before we view this as a permanent shift. Along this would need to go both a deepening of the European institutional investor base for speculative credits and a continuous development of the restructuring standards and insolvency standards across Europe. Pushing further in search of return: The new private equity model 17 Debt: How long will the good times last? Where the money goes As Figure 9 highlights, funds in Europe are sitting on more dry powder than ever before. However, generally healthy corporate cash reserves and strong balance sheets means there is less pressure on companies to sell or divest. The resulting paucity of quality targets coming to market is reflected in the fluctuation in LBO and M&A levels (see Figure 10). The surge in M&A in Germany in the first quarter of 2015 is especially noticeable, so is the amount of re-financing and recaps. As obvious sponsors are clearly trying to harvest and take advantage of the current financial climate. Fig. 9 Private Equity Dry Powder in € bn Dec 2003 75.7 84.7 Dec 2004 85.0 93.4 Dec 2005 129.6 146.0 Dec 2006 183.2 197.0 Dec 2007 241.2 248.8 Dec 2008 246.8 270.7 Dec 2009 242.2 272.6 Dec 2010 211.5 235.1 Dec 2011 228.7 245.3 Dec 2012 195.2 221.4 Dec 2013 245.7 263.8 Dec 2014 236.3 263.1 May 2015 273.9 PE headquartered in Europe Source: Preqin. 18 Pushing further in search of return: The new private equity model PE worldwide with focus on Europe 307.5 Debt: How long will the good times last? Fig. 10 General Purpose Diversification for LBOs over Time in % Europe 22.4 5.5 7.1 64.3 2004 26.9 13.1 5.5 11.7 12.4 56.1 2005 68.0 2006 17.6 27.7 9.4 8.8 5.3 67.5 2007 18.1 8.3 2008 86.1 2009 13.8 29.5 32.0 23.1 13.4 71.8 5.3 6.9 2.1 12.9 70.5 2010 56.3 48.1 2012 2013 25.1 21.0 14.1 20.5 33.3 18.6 5.3 32.6 36.3 5.9 42.5 2011 27.6 2014 15.4 48.6 1Q 2014 1Q 2015 Germany 5.7 23.3 28.5 6.9 40.7 6.1 23.9 18.7 11.4 17.2 58.8 38.8 18.5 37.5 9.4 82.9 30.6 27.8 29.0 7.4 8.0 6.2 19.0 63.2 48.0 70.7 40.6 84.0 55.2 33.5 17.5 90.4 72.0 9.1 6.9 44.7 61.6 21.8 2004 LBO 2005 2006 M&A 2007 Refinancing 2008 2009 2010 Recapitalizations 2011 2012 2013 2014 1Q 2014 1Q 2015 Other Source: S&P Capital IQ LCD. Pushing further in search of return: The new private equity model 19 Debt: How long will the good times last? And when the right target does become available, private equity now has to be prepared to pay premium prices to secure the deal. As Figure 11 highlights, the equity contribution to LBOs is still much higher as a proportion of the overall transaction than in 2004–2007. Putting nowadays dry powder to work is hence more costly despite the renewed availability of leverage. And as the purchase price multiples that are being paid continue to rise, the equity contribution is much higher in absolute terms. Fig. 11 European Equity Contributions in LBOs 2004 33.2% 2005 32.7% 2006 32.9% 2007 32.5% 2008 2009 42.1% 45.4% 46.9% 2010 2011 44.2% 47.7% 2012 2013 42.4% 2014 41.2% 1Q15 41.1% Source: S&P Capital IQ LCD. 20 Pushing further in search of return: The new private equity model Debt: How long will the good times last? The volume of loans being repriced in Europe has been subdued in recent months, but is now starting to pick up (see Figure 12). The majority of margin reduction requests in Europe in 2015 have been seen on cross-border deals. Fig. 12 European Institutional Repricing Volume rolling 3 months in € bn 4.9 4.4 3.3 3.8 3.5 2.5 2.8 2.5 4.0 3.4 2.7 3.7 3.1 3.0 3.0 3.4 3.3 2.1 2.8 2.0 2.0 1.5 1.4 0.7 0.4 Apr. May Jun. July Aug. Sep. Okt. Nov. Dec. Jan. Feb. Mar. Apr. May Jun. July Aug. Sep. Okt. Nov. Dec. Jan. Feb. Mar. Apr. '13 '13 '13 '13 '13 '13 '13 '13 '13 '14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '14 '15 '15 '15 '15 Source: S&P Capital IQ LCD. Prospects ahead Key developments that are set to shape the price, terms and sustainability of finance include the higher capital charges under Basel III and the impact of the Alternative Investment Fund Managers Directive (AIFMD) and Germany’s new capital investment code (Kapitalanlagegesetzbuch) on ‘alternative’ lending. Looking ahead, there will eventually be a normalisation of interest rates and unwinding of monetary stimulus. Moreover, lenders might decide against financing corporate takeovers which are perceived not to be in line with new regulatory guidelines. US banks are being encouraged by the Federal Reserve to avoid financing takeover with leverage of more than six times EBITDA. The new regulatory intervention could result in more expensive transactions for private equity firms, as bank lending still plays an important role in financing a deal. Therefore, while there are bound to be comparisons with 2004–2007, the dynamics of this market are very different. Finance may be plentiful but even putting it to work let alone delivering returns is a challenge. We may also be coming to the high watermark of funding. Indeed, rather than looking for precedents from the past, the real challenge is how to develop winning strategies in a sector that is being turned on its head. Pushing further in search of return: The new private equity model 21 Operational improvement: The key to delivering a return COperational improvement: The key to delivering a return 22 Pushing further in search of return: The new private equity model Operational improvement: The key to delivering a return Investment in improving efficiency, performance and market reach have always been important elements of private equity firms’ investment and return strategies. But as it gets harder to deliver a return on acquired assets, the operational focus is now central to the private equity business model. How is this new model changing strategies, investment priorities and organisational design? What we mean by operational improvement Our definition of operational improvement looks beyond the common focus on efficiency savings towards procurement, working capital management, commercial optimisation, R&D effectiveness, global footprint design, leaner back-offices and sales and channel effectiveness, as well as the business transformations taking place within the ‘Industry 4.0’ world. At the height of the pre-crisis boom, a private equity firm could expect to carve out an asset and prepare it for profitable sale relatively quickly. Buoyant economic conditions meant limited operational uplift would be needed to secure a return. Cut to 2015 and private equity firms need to make more money to offset the higher acquisition costs in an economic environment in which returns are exceptionally hard won. Some have also had to diversify or lower the quality thresholds for the assets they acquire, presenting them with greater challenges in generating value. 78% of the private equity executives taking part in our survey say that the importance of operational improvement will increase further over the next five years. Pushing further in search of return: The new private equity model 23 Operational improvement: The key to delivering a return Inevitably, this changing dynamic is reshaping the models within private equity firms. More than 90% of the 100 private equity executives taking part in our survey say the way their operating model is being applied has changed over the past ten years. “In the past ten years, we have focused completely on learning and adapting new methodologies and universally proven strategies for portfolio improvements, so I would say we have positively changed.” Managing Director, Germany Operational value creation is at the forefront of this new model. More than a third of the executives we spoke to say that it is their predominant portfolio strategy (see Figure 13). More than 80% of participants say that the potential for operational improvement and synergies is an important or very important factor in their investment decision. More than three quarters believe that the contribution of operational improvement to return on investment has increased and even more believe that it will grow still further over the next five years. “In the next five years, our commitment towards the portfolio businesses will increase and we will actively look at options to improve the processes and the productivity. The competition is getting more intense and we have to increase our strategies to keep up the profitability of our portfolio companies,” says a chief operating officer from Sweden. “Determining feasible exit strategies and making operational improvements in the business can help in gaining an appreciated value, but the debt crisis in the past has impacted the appetite of the buyers. Getting a good value is a complex aspect and so over the years the importance of this has strongly increased,” says a managing director from Germany. “Operational improvements tend to have a long lasting positive impact on the business and also give investors a positive impression which can be very encouraging and can attract them to invest more which is being seen as an advantage” Managing Partner, Spain 24 Pushing further in search of return: The new private equity model Operational improvement: The key to delivering a return Fig. 13What is your predominant portfolio strategy, which you pursue in new investments? (Please select only one option) Percentage of Respondents Multiple Arbitrage 8% Operational Value Creation Organic Expansion (geographic/product) 36% 24% Buy and Build 32% Source: Survey of 100 private equity executives carried out by PwC in June 2015. By contrast, multiple arbitrage appears to have fallen by the wayside, the victim of high acquisition prices and a more challenging economic environment. Taking the business forward While operational improvement is often seen as being synonymous with cost cutting, the priorities are much broader (see Figure 14). Our survey found that the most important drivers of value are operational cost reduction, working capital management, sales and channel effectiveness and working capital optimisation. “Boosting the sales force effectiveness and commercial optimisation is the most important value driver, as it accelerates the internal efficiencies and opens up immense value. Sales force effectiveness and new channels can help the business in entering new customer groups,” says a managing partner in Germany. Investment in R&D and entry into new markets also rate highly. “By getting access to firms that have operations in other locations and by acquiring the majority equity stake in them, we aim at having a global footprint in global markets especially as we have the finances to initiate and execute these business plans completely,” said a partner in Denmark. Pushing further in search of return: The new private equity model 25 Operational improvement: The key to delivering a return Fig. 14 Which levers are most important? Operational cost reduction 9 Working capital management 8 Sales and channel effectiveness 7 Leaner backoffice 6 Commercial oeprations 5 Global footprint design 4 Strategic sourcing 3 R&D effectiveness 2 Others 1 Source: Survey of 100 private equity executives carried out by PwC in June 2015. Some participants go further by arguing that the hard work on operational efficiency has, or at least should, already have been achieved and therefore deeper business transformation is needed to generate value. “Over the next five years, business transformational activities will become the main focus and operational improvements will already be an important internal business factor. It will become necessary to not only look at the operational aspects but also external aspects and opportunities,” says a managing director in Germany. Shaping the equity story As investors press for more clarity and insight on how funds are spent, more than 80% of the executives we spoke to believe that the importance of operational improvement within their equity story has increased. “We check how the investment fits in and how we will able to manage along with management of other investments. I feel it is necessary to balance out transactions so that none of the investments lack attention which could later cause a deficit in expectations,” says a chief executive from the UK. 26 Pushing further in search of return: The new private equity model Operational improvement: The key to delivering a return New demands, new people So how is this model reshaping private equity firms themselves? One of the most striking effects of this shift is the impact on the make-up of the typical private equity firm. Where most of the team would have been made up of financial and transaction teams, there are now as many operating specialists employed in-house or through a network – Figure 15 outlines their role in applying the model. “We have created an operating partners network to widen our approach and understanding about the target or the portfolio companies’ performances; this has greatly helped us in achieving our desired results,” says a partner from Germany. “Our industry has faced enormous pressure to drive operational value from investments and with the help of operating partners, we are able to get in-depth information on changes that should be brought about to create more assertiveness within the business. This has helped us manage our core business investments and portfolio investments tactfully to achieve value as expected,” says a managing partner in the UK. Fig. 15In which form does your company apply the operating model on portfolio companies? (Please select the most important) Percentage of Respondents 35% Operating partners network 32% Target management team In-house operating partners/ consultants External consultants 24% 9% Working alongside operating partners, company management is critical to the delivery of the operational improvements strategy. They have the technical knowhow that is so vital within Germany’s many specialist engineering companies and many private equity funds are offering high performance incentives. A strong role for the existing management and possibly selling family during transition can also help to assure customers, communities and local authorities about the future prospects of the company. Breaking the family link can appear like a loss. But private equity funds can inject investment, management techniques and access to new markets that the previous owners couldn’t. Pushing further in search of return: The new private equity model 27 Operational improvement: The key to delivering a return And as operational improvement becomes more important and, in many cases, more far-reaching, the time to execute strategies ready for sale is increasing (see Figure 16). Fig. 16 Holding Period of PE Portfolio Companies in Europe in years Ø Ø 4,7 3.9 2004 4.2 4.3 2005 2006 4.0 2007 3.8 2008 4.2 2009 4.7 2010 5.0 2011 5.3 2012 5.5 5.6 5.5 2013 2014 1Q 2015 Prospects ahead It is clear that both the breadth and importance of operational improvement strategies will continue to increase in the coming years. Costs are only one part of the equation. Companies looking to compete in markets being transformed by technology won’t survive or thrive without R&D effectiveness, for example. And this isn’t just the innovative ideas coming from a few creative personnel, but speed of decision making, speed to market and willingness to embrace change in the organisation as a whole. The capabilities needed for this operational engineering are now as important as financial engineering. 28 Pushing further in search of return: The new private equity model Exit: Making the most of all the available options DExit: Making the most of all the available options Pushing further in search of return: The new private equity model 29 Exit: Making the most of all the available options Recent surges in stock market prices have enabled private equity firms to raise sales price expectations and helped to broaden the range of exit options. With all the dry powder at private equity funds disposal (Figure 9), they are under pressure from investors to deploy the funds and deliver high yield exits so they can raise funds in the future. The prospects for a successful return have been boosted by the re-emergence of IPOs and trade sales as an exit option (see Figure 17). Fig. 17 European Buyout Volume: Where Does PE Invest? in % 5 7 18 28 27 7 20 27 45 2005 2006 Secondary 38 2007 P2P 22 20 10 4 31 37 2008 2009 Corporate 65 16 37 64 62 43 2010 2011 13 24 5 8 44 4 47 5 13 18 47 30 20 12 4 7 2012 2013 9 38 12 54 49 2014 1Q 2015 Family/Other Secondary buyouts With quality assets in short supply, many funds are pleased to be able to put their dry powder to work through secondary market acquisition. Secondary exits in 2014 exceeded 2007 (see Figure 18), though Germany has been more restrained (see Figure 19). In turn, sellers are keen to take advantage of sponsor-to-sponsor prices that are close to pre-crisis levels (see Figure 20). Fig. 18 Number of Secondary Buyout Exits in Europe 224 202 196 183 154 153 126 125 112 77 48 2004 2005 2006 2007 2008 Source: Preqin. 30 Pushing further in search of return: The new private equity model 2009 48 2010 2011 2012 2013 2014 1Q 2015 Exit: Making the most of all the available options Fig. 19 Number of Secondary Buyout Exits in Germany 26 21 24 21 20 20 22 15 14 10 4 2004 2005 2006 2007 2008 2009 2 2010 2011 2012 2013 2014 1Q 2015 Source: Preqin. Fig. 20 Purchase Price Multiples: Sponsor to Sponsor Transactions 10.4x 8.6x 7.0x 6.7x 9.9x 9.7x 8.8x 8.8x 9.4x 9.0x 9.8x 9.0x 7.3x NA 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1Q 2015 Source: S&P Capital IQ LCD. Yet with purchase price multiples at a peak, some funds are focusing on restructuring and exiting their current portfolio, rather than new acquisition. Pushing further in search of return: The new private equity model 31 Exit: Making the most of all the available options Trade sale Trade sale volumes and prices have bounced back from the crisis lows to provide renewed opportunities for exit (see Figures 21 and 22). Fig. 21 Number of Trade Sale Exits in Europe 238 231 236 208 205 224 179 174 152 99 93 2004 2005 2006 2007 2008 2009 79 2010 2011 2012 2013 2014 1Q 2015 Source: Preqin Fig. 22 Purchase Price Multiples: Sale to Corporate 7.2x 7.2x 7.5x 7.7x 8.2x 9.0x 9.0x 9.9x 8.6x 8.7x 7.4x 9.3x 8.0x NA 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1Q 2015 Source: S&P Capital IQ LCD. It is important to gear operational improvement to the demands of potential trade buyers as they look to boost growth and position themselves for the future. This might be enabling them to extend their geographical footprint or acquire new sources of innovation. 32 Pushing further in search of return: The new private equity model Exit: Making the most of all the available options IPO Many funds looking to exit are running dual-track sale and public placement strategies. Stock market gains in 2014 have helped to make IPO a potentially lucrative option. A further attraction of IPO is that it can boost a private equity firm’s reputation. In 2014, European IPO exits reached a high of 52 compared to a pre-crisis peak of 45 in 2006 (see Figure 23). As long as stock markets remain stable in the face of mounting regional and global uncertainty, we’re likely to see continuing interest in IPO and follow-on offerings. Fig. 23 Number of IPO Exits in Europe 52 45 37 40 30 27 24 14 12 2004 2005 2006 2007 1 2 2008 2009 3 2010 2011 2012 2013 2014 1Q 2015 Source: Preqin Recapitalisation In Europe, recapitalisation as a share of total exits reached a high of 28% in 2014 (see Figure 10). Recapitalisation allows funds to return money to investors by taking advantage of current financing conditions, with firms extracting around €4.6bn in 2014 and €6.1bn in 2013 through this option. The big question is how well they can operationally govern portfolio companies whose dividend recapitalisations have already provided good returns. Pushing further in search of return: The new private equity model 33 Conclusion: Pressure for return EConclusion: Pressure for return 34 Pushing further in search of return: The new private equity model Conclusion: Pressure for return Private equity funds face a classic quandary. The increase in exit options and prices should enable them to deliver a highly favourable rate of return. But they also have to pay more to acquire the assets in the first place. “There have been constant changes in the regulatory environment and market dynamics which have made situations more complex today and increased risks for private equity businesses. These changes have in turn pushed us to accept change and have promoted flexibility in the investment environment.” CFO Netherlands Multiple arbitrage simply isn’t an option when asset prices are so high. Funds therefore see more active operational improvement strategies as the primary way to square this circle and boost IRRs up to the targets needed to attract further investment. But the ability to realise the necessary operational gains remains unproven. With many portfolio companies having already undergone several rounds of efficiency savings during the economic downturn, broader and more innovative strategies are likely to be needed. This operational engineering is likely to focus as much on R&D effectiveness and technological investment as streamlining operations or optimising capital, though the latter would need to be in place before anything else can be achieved. This changing model demands new strategies and new people. Funds are also likely to face increased investor and regulatory scrutiny as they navigate through this new and unfamiliar landscape. There could be as many losers as winners as firms change tack, reshape their capabilities and vie for renewed investment. What’s certain is that the typical private equity firm will look very different from the precrisis vintage. Pushing further in search of return: The new private equity model 35 Contacts Contacts Steve Roberts Private Equity Leader Tel: +49 69 9585-1950 [email protected] Daniel Judenhahn Private Equity Partner: Debt Advice Tel: +49 69 9585-6976 [email protected] Alexander Griesmeier Private Equity Partner: Operational Improvement Tel: +49 89 5790-5278 [email protected] Elena Naydenova Private Equity Business Development Manager Tel: +49 69 9585-6731 [email protected] André Lerchenmüller Private Equity Manager Tel: +49 69 9585-3185 [email protected] Marcel Reiher Private Equity Senior Consultant Tel: +49 69 9585-3979 [email protected] About us Our clients face diverse challenges, strive to put new ideas into practice and seek expert advice. They turn to us for comprehensive support and practical solutions that deliver maximum value. 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