VC's Drive Up Tech-Valuations

Tech-Valuations Jump Published: April 10, 2013 in Knowledge@Wharton         

Venerable retailer J.C. Penney opened its doors more than a century ago and boasts annual revenues of nearly $13 billion from its 1,100 stores. Yet a three-year-old website with an untested business model and little discernible revenue is closing in on the department store chain's $3 billion market cap: 

Pinterest.

The online scrapbooking site recently raised $200 million in venture capital funds to bring its implied valuation to $2.5 billion, according to a February 20 story in The Wall Street Journal. Founded by three young entrepreneurs in March 2010, the tech start-up has 48 million users as of December 2012, up from nine million in the prior year, the article noted.

While Pinterest is wildly popular, its business model remains unproven. Users, including businesses, sign up for free accounts. The company is just gearing up to accept paid advertising and recently unveiled a free analytics tool for users with business-related accounts to track what has been pinned from their sites.

Pinterest may be thinking hard about ways to make money, but it remains unclear whether the firm's financial strategies can bring in enough revenue to cover costs and generate a healthy profit, which will be especially important once the company goes public. No matter. Pinterest has garnered the interest of such Silicon Valley blue-chip venture capital firms as Andreessen Horowitz (as in Netscape co-founder Marc Andreessen). For now, Pinterest has money to burn.

The company is one of at least 25 start-ups that command market caps of one billion dollars or more, according to a February 4 story in The New York Times. The billion-dollar start-ups club includes such familiar names as productivity application Evernote, travel rental site Airbnb, online questionnaire software SurveyMonkey and streaming music service Spotify. But such high valuations are bringing back concerns that the market is entering another tech bubble like the dot-com frenzy in the late 1990s that led to scores of Internet companies going belly up and investors losing vast fortunes.

Wharton finance professor Jeremy Siegel, who warned that Internet and other tech stocks were overvalued in 1999 shortly before the dot-com bubble burst, says the sector is not in the same kind of peril today. "It's a world of difference," he notes. Back then, tech companies -- including well-capitalized S&P 500 firms like AOL, Sun Microsystems and EMC -- were trading at sky-high valuations, Siegel says, adding that shell companies without good business ideas also were given similar pricetags simply because they were a "dot-com."

In an April 1999 editorial for the Journal, Siegel warned that tech's high valuations could not be sustained. Back then, Siegel pointed out that AOL was selling at more than 700 times its earnings for the past 12 months, an "unprecedented valuation for a firm with this market value," and one which put it among the country's 10 most highly valued firms. Yet, the Internet service provider came in only 311^th in profits and 415^th in sales against other companies. (AOL has since spun off from Time Warner and currently is valued at $2.8 billion.)

Such inflated valuations are not the norm in the tech sector today. "Big tech companies are [trading at] less than 20 times earnings," he points out, citing as examples the valuations of market leaders Google and Apple. "It's not overvalued."

At $450 a share, Apple is currently trading at about 10 times fiscal 2013 projected earnings per share of $44.19. Google is trading at $815, or 18 times fiscal 2013 projected earnings per share of $45.55. Microsoft is trading at 10 times 2013 earnings and Yahoo is at 21 times this year's profit. These price-to-earnings ratios are hardly inflated vis-a-vis the market: As of March 22, the S&P 500 was trading at 14 times forward earnings, the Nasdaq 100 was at 15 times and the Dow hovered at 13 times. The market is "nowhere near as speculative" today because investors remember the painful lessons of the dot-com crash, Siegel notes. "People have been burned. They're more cautious. Their memories are in place."

But there are several reasons why Pinterest and a select group of start-ups are getting valuations that any brick-and-mortar company would envy.

New Cycle of Growth

Social media is turning out to be a lasting tech trend, thanks largely to the success of Facebook, Twitter and LinkedIn. The exponential growth of users at Pinterest and other billion-dollar start-ups are signals that these companies could be the next tech leaders, and venture capitalists want to get in early to cash out at the time of an IPO or shortly thereafter.

On a macroeconomic level, it also helps that investor sentiment is rising as the U.S. economy recovers, according to Wharton management professor Saikat Chaudhuri. As a new cycle of growth emerges, investors are feeling more bullish. "They're optimistic now about the future and placing bets," he says.

But unlike the last tech bubble, "we're seeing investors being more critical," Chaudhuri adds. So while they are looking to invest, "they have also shown a bit more restraint." He notes that investors today are quick to ask the start-up where it is parking its money and how the business plans to "monetize" -- jargon for a business model that will lead to revenue and profits.

Venture capitalists have also become pickier, especially following a consolidation in the VC industry. The number of VC companies is down by about half from 1,000 companies five years ago, says Doug Collom, vice dean of Wharton's San Francisco campus.

VCs historically make an annual average return of 15% to 20%, but recently that figure has fallen to 6% because finding good bets has been difficult, Collom adds. Start-up investors are not being compensated enough for the level of risk they are shouldering, and there are better places to put their money.

Not only is the number of VC funds shrinking, but so is the fund size, notes Wharton management professor Raffi Amit. "The industry is in a major transition and consolidation." Mitigating the decline somewhat is that 10 to 15 years ago, several million dollars typically was needed to get a company off the ground; today, $50,000 to $100,000 can suffice, he adds.

Still, the remaining VCs are placing their bets more conservatively, watching to see where others are investing. "There is the herd phenomenon. Some sectors are considered hot, and hence a disproportionate amount of capital flows into companies in these hot sectors," Amit says.

If VCs see that other firms with proven track records, such as Kleiner Perkins and Accel Partners, are backing a tech company, they are more likely to jump in as well because the start-up has been "validated," Collom notes. As more big name VCs invest in the same company, it creates a "feeding frenzy dynamic that drives the price up, pushing valuation up beyond rationality," he adds. Hence a $2.5 billion valuation for Pinterest becomes reality as VCs wonder, "Are they the next Google?"

Don't Throw Out DCF with the Bathwater

As one of the hottest social media companies to emerge since Facebook, Pinterest could well be worth a high valuation. But how did VCs arrive at $2.5 billion?

The traditional method of valuing companies is through the discounted cash flow model, or DCF, which projects a company's cash flows out by several years and discounts it to arrive at the present value. But applying the DCF model becomes a challenge when a start-up is not making any money.

"It's difficult to value companies that are very young, that don't have positive cash flows or even revenues," says Wharton finance professor Luke Taylor. Even so, the "discounted cash flow model is simply correct finance."

David Wessels, an adjunct finance professor at Wharton, concurs. In a book he co-authored titled, Valuation: Measuring and Managing the Value of Companies, Wessels suggests that the discounted cash flow model is the best way to value high-growth companies because the core principles of economics and finance apply even in uncharted territory. But instead of using a firm's historical performance in the model, Wessels says, one should start by examining the expected long-term developments of a company's market and work backwards. Given that long-term projections are uncertain, it is critical to develop different financial scenarios.

OpenTable vs. Groupon

Wessels, with co-authors Tim Koller and Marc Goedhart, analyzed the business of OpenTable, a provider of online restaurant reservations.

The company generates revenue by charging business customers $1 for every seated diner who uses the site to make reservations and 25 cents if the customer uses the restaurant's website. There is also a monthly subscription fee of $250 for restaurants to use OpenTable's proprietary computer system that manages reservations and table seating, keeps track of guests and provides e-mail marketing. In addition, there is a one-time installation fee of $800.

From 2004 to 2008, OpenTable's revenue grew from $10 million to $56 million, a compounded annual growth rate of 53%. Subscription fees comprised 54% of its 2008 revenue while reservation fees took up 42% and the rest came from installation fees.

In 2008, OpenTable reported that 34 million diners used its service at 10,335 restaurants. That comes to about 30% of the 30,000 reservation-taking restaurants in the U.S. The authors projected that by 2018, OpenTable will command 60% of the U.S. market and also profit from a continued expansion overseas. They based the 60% prediction on OpenTable's market share in San Francisco in 2008.

If the number of restaurants increased by 2% a year, or twice the rate of population growth in the U.S., there would be 36,500 U.S. restaurants taking reservations by 2018. A 60% share for OpenTable means it would have 21,900 restaurants as clients. As for the firm's foreign operations, the authors assumed the growth would match that of the U.S., delayed by six years. By their calculation, OpenTable could record global revenue of $306.8 million by 2018.

To stress-test their projection, the authors first compared OpenTable's growth path with the first five years of expansion of Internet companies founded in the 1990s that now make more than $10 million in revenue. "Benchmark against other high-growth companies in the past to see if the projection is reasonable," Wessels says.

OpenTable's revenue grew from $10 million to $56 million from 2004 to 2008, which matched the performance of the median Internet company. The book, released in its fifth edition in 2010, forecast that by 2012, OpenTable would book revenue of $141.2 million, a bit higher than the median Internet company but within the bounds of distribution.

The authors also looked at OpenTable's target operating margin of 30% to 35% and compared the forecast to other consumer Internet companies such as Expedia, Priceline, Orbitz and Monster.com. OpenTable's margin range is higher, but the authors predicted that achieving it is feasible because the company is the leader in the online reservations market and has little competition.

Finally, they considered three scenarios for OpenTable: exceeding, meeting or underperforming expectations by 2018. If the company outperforms, its eventual valuation was estimated at $1.14 billion. If it meets forecasts, then $719 million was the calculated value. It was $545 million if OpenTable lags predictions. OpenTable went public in May 2009.

As of March 22, OpenTable had a market cap of $1.4 billion. Last year, it booked revenues of $161.6 million with an operating margin of 23%.

OpenTable exceeded expectations, as Pinterest and other highly valued tech start-ups one day might, but it also could easily have fallen by the wayside, much like what happened to daily deals site Groupon.

Before its IPO in November 2011, Groupon was valued at more than $6 billion. On the stock's first day of trading, Groupon's valuation jumped to $16.6 billion. But later on, accounting problems surfaced, profits stumbled and revenue growth fell below Wall Street's expectations. Last month, the company fired CEO and founder Andrew Mason. Groupon is now valued at $3.8 billion, a loss of $13 billion in market cap in little more than a year.

Going public is a sobering event. After an IPO, the focus of investors shifts from a company's user growth and buzz to its financial performance, testing the start-up's business model. "The real acid test is when they get out into the public market," Collom notes.

Until then, VCs make an educated guess whether these hot start-ups are worth the money -- and the dice keep rolling. Most bets do not pay off. And even among those investments that make it to Pinterest's level of funding, "there's a lot of debate about whether companies can sustain these valuations," Collom says.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

Top 10 Private Equity Tax Breaks

10 Top Private Equity Tax Breaks by Terry Stidham

Victor Fleischer, University Of Colorado Law School Professor, Identified These Top 10 PE Tax Breaks

1. Carried Interest - In exchange for managing an investment fund, managers receive a percentage of the fund’s profits, known as carried interest. The amount of carried interest is typically 20 percent, and in any given year, individual fund managers earn anywhere from nothing to tens of millions of dollars. Under current law, if the fund’s profits are capital gains, the manager’s carried interest is also taxed at capital gains rates.
2. Management Fee Waivers - Fund managers receive a fixed management fee, often 2 percent of capital, for managing the fund. Management fees are normally taxed as ordinary income. To avoid this, the fees can be waived in exchange for an almost-risk-free priority allocation of profits taxed at capital gains rates.
3. The Limited Partner Loophole - As labor income, management fees would normally be subject to the Medicare tax, now 3.8% for high-income individuals. Under current law, even investment income is subject to the 3.8% tax. Through careful structuring, some fund managers take their income through a limited partnership in which they are technically “limited partners” in the management company, even though it is their labor, and not their capital, that generates the fee income. Allocations to limited partners, however, are neither subject to the Medicare tax as self-employment income nor as investment income under section 1411.
4. The S Corp Loophole - This is conceptually the same as the limited partner loophole: wages are paid through an S Corporation avoiding employment taxes.
5. Private Equity Publicly Traded Partnerships - Normally, publicly traded companies are taxed as corporations, which mean that shareholders pay both an entity-level tax and also a shareholder-level tax on dividends or capital gains. But when investment firms go public, they use the favorable tax treatment of carried interest (which is treated as investment income, not labor income) to fit into an exception to the publicly traded partnership rules for “qualifying income,” which includes investment income. This enables publicly traded private equity firms to avoid the corporate tax altogether.
6. Supercharged Public Offerings - Private equity firms that went public structured the initial public offerings to resemble a sale of the firm’s assets to the newly public company, creating for the public company a new, higher “cost basis” in the firm’s assets. The value of those assets attributable to the goodwill of the firm could then be amortized over 15 years, generating new tax deductions at a 35 percent rate. As part of the deals, the newly public companies entered into tax receivable agreements, in which the companies promise to pay 85 percent of the tax benefits back to the selling founders.  The founders pay tax on the sale at low capital gains rate and they get a check each year from the newly public companies.
7. Enterprise Value - If the carried interest legislation were passed, individual managers may cash out by selling their carried interests to a third party and recognizing capital gain. The proposed legislation closes that loophole, but still allows the managers to sell interests in the management company — most of the value of which is attributable to past and future carried interest income and management fees — at capital gains rates.
8. The Angel Investor Loophole - Section 1202 allows investors in “qualified small business stock,” mostly angel investors and venture capitalists, to exclude 100 percent of their capital gains, in most cases up to $10 million.
9. I.R.A. Stuffing - Fund managers sometimes takes risk in partnership interests or shares in underlying portfolio companies and contributes those interests to I.R.A.’s at low valuations. If the interests are inside the I.R.A., appreciation in the value of the investments goes untaxed until distributed.
10. Interest Deductions - Interest deductions from the debt to finance an acquisition in taking a company private shields the portfolio company from tax liability.

Tax Advice Disclaimer

The information on this blog should not be used in any actual transaction without the advice and guidance of a professional Tax Adviser who is familiar with all the relevant facts.

Although the information contained here is presented in good faith and believed to be correct, it is General in nature and is not intended as tax advice. Furthermore, the information contained herein may not be applicable to or suitable for the individuals' specific circumstances or needs and may require consideration of other matters.

Terry Stidham and Target Search Group, LLC assumes no obligation to inform any person of any changes in the tax law or other factors that could affect the information contained  herein.

IRS Circular 230 Disclosure

Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Terry Stidham is the President and founder of Target Search Group. He is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

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PE Assets in Unsold Companies at Record Levels

PE Sets on Record Collection of Unsold Portfolio Co's in the Asset Class. Investors Take Notice.

Arleen Jacobius recently wrote the following post elaborating on several of my recent posts that looks at  the overhang of unsold companies and LP's sentiment. 

The glut is enormous: an estimated 6,500 unsold portfolio companies as of year end, representing 69% of private equity firms' total assets under management as of Sept. 30. That is the highest number of unsold portfolio companies ever recorded by PitchBook Data Inc.  It is estimated to double that of 2006.

Institutional investors are beginning to ask managers about these portfolio companies and the likelihood of achieving exits — before committing capital to new funds. Whether these holdings are sold for sizable profits could affect private equity returns in years to come.

For example, both the $41 billion Los Angeles County Employees' Retirement Association, Pasadena, and the $38 billion Teachers' Retirement System of the State of Illinois, Springfield, tracked Silver Lake Partners' portfolio company exits before making commitments to its latest fund, Silver Lake Partners IV. Each eventually committed $150 million.

Investment Concerns

LACERA's staff named exits of unsold portfolio companies as one of its two “investment concerns” related to investing in Silver Lake's fourth fund, according to a staff memo for the Feb. 13 board of investments meeting. The staff noted Silver Lake has about $7.6 billion invested in 24 still active companies. Some 70% of the capital invested in Silver Lake's second fund, which closed in 2004, and 75% of the capital invested in Silver Lake's third fund, which closed in 2007 is still active.

And it's not just Silver Lake. LACERA staff noted in the memo that a “lingering impact of the financial crisis is the large quantity of unsold portfolio companies building up in large buyout funds.”

Andrew R. Cristinzio, McLean, Va.-based partner in PricewaterhouseCoopers LLP's deals practice, estimated the overhang in assets is double 2006 levels.

“If you look at private-equity-backed portfolio companies back at pre-crisis levels, current private-equity-backed portfolio company overhang at the end of 2012 was somewhere around 6,500, which is estimated to be double that of the pre-2006 period,” said Mr. Cristinzio, citing PitchBook data.

Indeed, of the more than $3.27 trillion in total worldwide private equity assets under management as of Sept. 30, $2.27 trillion is “unrealized portfolio value” or unsold portfolio companies, according to data prepared for Pensions & Investments by Preqin, a London-based alternative investment research firm.

The worst offender in terms of vintage year is 2007 funds, which as a group have the highest unrealized value of portfolio companies — $527 billion — compared with total assets under management of $617 billion, the Preqin data show.

When Preqin compared the proportion of private equity companies invested in each year since 2006 that are still being held by fund managers, 70% of companies invested in throughout 2006 are still being held, said Nicholas Jelfs, Preqin senior analyst and press officer.

The overhang in unsold private equity portfolio companies has never been higher in the history of the asset class, asserted Michael G. Fisch, president and CEO of American Securities LLC, a private equity firm in New York.

“The overhang that is not sufficiently talked about is not the overhang of capital, but the overhang of older portfolio companies and older funds that have not been sold and need to be sold,” Mr. Fisch said.

What ends up happening to this glut of unsold portfolio companies could have a big impact on the private equity industry.

Some firms can't sell some of their portfolio companies because they are worth less than their original investment, Mr. Fisch said.

“What will happen to them? Who will buy them? When will they get sold? What will happen to the returns of the industry when they do get sold?” Mr. Fisch asked.

Every situation will be different, he said. If a manager's relationship with the firm's limited partners is good, investors will give the general partners more time to sell their portfolio companies.

Where the general partner-limited partner relationship is not good, the entire private equity fund might be sold to another general partner, or investors might bring in a new general partner because they have lost faith in the original one, Mr. Fisch said.

New Commitments
Holding onto portfolio companies also can affect investors' ability to make new commitments, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc. That's because exiting companies is a prime source of distributions back to limited partners. “When net asset value is not coming back in distributions, investors find themselves overallocated” to private equity, Mr. Mansukhani said.

Given the lessons of the financial crisis, when overexposure to alternative investments made the entire portfolio less liquid, investors are loath to increase their target allocation in order to commit capital to additional private equity funds, he explained.

Portfolio company refinancing, called recapitalizations, has led to some distributions to limited partners, but most distributions in Towers Watson's portfolio are from portfolio company exits, Mr. Mansukhani said.

This makes it tougher for general partners to raise money, even when their portfolio valuations are rising from the effect of the uptick in the equity markets in the U.S. and the value general partners have added to the portfolio companies, Mr. Mansukhani said.

"Even core investors are giving less money, even for great-performing funds,” he said.

Distributions also are a sign that a private equity firm is a solid performer, noted David Fann, president and CEO of TorreyCove Capital Partners LLC, a San Diego private equity consulting firm.

“Most private equity investors would like to see at least a portion of the prior fund's investments achieve realizations before committing to a new fund,” Mr. Fann said. “Realized investments validate performance and success.”

Damage to Returns
Another aspect of this historic overhang of portfolio companies is the damage it is expected to do to overall private equity returns.

“It's just on the math of the internal rate of returns,” Mr. Mansukhani said.

A longer portfolio company holding period will affect internal rate of return because IRR is time based.

“General partners may gain a little multiple by holding out for a better price, but what it is going to do is dilute the internal rate of return,” he said. “You have to balance those two things.”

It also becomes an issue of capacity, whether a manager with a collection of portfolio companies in older funds and a new fund has enough executives to manage the entire portfolio, Mr. Mansukhani said.

“It's about bandwidth,” Mr. Fann said. “Understanding the capacity of general partners to make new investments is critical. Investors want their GPs to work solely on their behalf. Investors don't want to commit to funds whose general partners are consumed working on the previous fund's investments.”

However, some industry executives are betting the portfolio company overhang might diminish if the economy, at least in the U.S., continues to improve and debt for deals remains available.

“Clearly, there's a general acknowledgement that there's been an increase in the average hold time from investments made in the 2007-2008 time frame,” said PricewaterhouseCoopers' Mr. Cristinzio. “But if the economy continues on the current trend and financing continues being available as it is, we will see an increase in exits.”

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

10 Private Equity Sector Challenges

Top PE Challenges

by Terry Stidham

According to the annual report: Ten Challenges Facing the Private Equity Sector by Altius Associates ("Altius"), the US buyout market faces a challenging environment of rising purchase price multiples for high quality companies while in Europe, GPs have innovatively found sources of capital amongst sovereign wealth funds and public fund managers willing to bridge the pre-IPO gap.

The Report also reveals that private equity flow in China, Peru and Colombia is set to boom while private credit strategies have begun to attract the attention of LPs as funds focused on distressed and primary issuance of debt emerge. 

Altius highlights asset pricing and over ambitious fund managers as key challenges facing the infrastructure market. However Altius believes the secondary market, which is on track to challenge the record fundraising year of 2009, should mature and become more efficient in the future.

Altius provides more detail below on each of the ten challenges:

1.     US Buyouts

Altius believes the US buyout market faces a challenging environment of rising purchase price multiples for high quality companies, which over the last year have hovered at around 9.0x earnings before interest, taxes, depreciation and amortization (EBITDA) and sometimes more.  This is as a result of an increasing number of private equity firms competing for high quality deals, the efficiency of a more intermediated market, and the improvement in accessing debt for leveraged buyouts.

Altius cites improvement in bank financing and capital markets that have allowed debt multiples to increase from an average of 3.0x in 2009 to 5.0x EBITDA thus far.

Brad Young, Executive Director at Altius, said: “Fund managers must be sure their investment thesis is solid as there is less room for mistakes when higher prices are paid.  A good fund manager must be able to make meaningful improvements to portfolio companies and use leverage effectively to balance risk and return. The challenge for limited partners will be identifying those private equity firms that are best poised to outperform in a more expensive and more competitive environment.”

2.     European Buyouts

The challenge for European buyout managers is and will be to find a profitable way to exit the boom year deals.  Altius believes that of the three established exit routes (public markets, trade sales and secondary sales), the IPO market remains largely closed with financing almost certainly not available for financial sponsors to be realistic buyers in a secondary transaction. Indeed a full trade sale of one of these large businesses is theoretically possible but problematic given the current economic environment in Europe and with vendors wanting to receive cash rather than paper.

Charles Magnay, Partner at Altius, commented: “In many cases the clock has reached the five year mark and is very definitely ticking. GPs have been forced to become increasingly innovative in seeking liquidity and, thankfully for the asset class, have been successful in this regard in a number of cases.  They have looked for ready sources of capital and found them amongst sovereign wealth funds and public market fund managers willing to bridge the pre-IPO gap – often corporates from Asia.”

Altius also believes that there are remaining assets which, for a variety of reasons, have either not found the right buyer or are not yet ready to be moved on, perhaps needing more time for further deleveraging.  However the majority of high quality and strategic businesses are saleable even in an environment where the public markets are effectively closed.

Charles Magnay said: “We applaud GPs for their ingenuity in tapping these alternative buyers and believe that, just as the secondary market has improved the exit options for the lower mid-market, so this development will open up a broader range of strategic options at the larger end of the buyout market for years to come.”

3.     Secondary Market

Altius believes the challenge for the secondary market will be to find attractive opportunities in an increasingly transparent and crowded market.  In the first three quarters of 2012, an aggregate of $15.7 billion was raised, which is on track to challenge the record fundraising amount achieved in 2009.  However Altius believes that an inflow of large amounts of capital into a segment can often create issues.

Chason Beggerow, Partner at Altius, said: “The high level of fundraising has been supported by an equally high level of secondary transaction value.  Currently there is a good supply of deals, as European financial institutions have started and are still looking at shedding private assets from their balance sheets due to regulatory concerns and public pension plans are utilizing the secondary market to actively manage their private equity portfolios and exposure.  While the supply has been good, sellers are more strategic and as a result, pricing has remained firm.”

Altius thinks that as the secondary market continues to mature and becomes more efficient, secondary funds/buyers will need to look for ways to differentiate themselves. Indeed these secondary buyers will need to find areas of inefficiency where there is less competition in an effort to generate strong returns consistent with past returns in the secondary market.

4.     Real Assets

Altius cites a number of challenges facing investors today within the infrastructure market. Asset pricing is one issue, especially for core brownfield assets as the asset class is seen as a “safe haven” with the promised yield viewed as an attractive replacement for low-yielding fixed income securities.  As a result, capital is rushing into the space, pushing up asset prices and reducing future returns.

Reyno Norval, Senior Associate at Altius, commented: “Real assets are often exposed to regulatory risk and with lower returns; there is less headroom for maneuvering should there be any adverse regulatory action.”

Another challenge highlighted by Altius is the divergence of returns expectations that core infrastructure will provide to a portfolio.  Altius believes that some managers are unrealistically projecting mid-teen IRRs and yields of 5% or so, while more conservative managers are targeting an 8-10% IRRs with a similar yield.

Reyno Norval concludes: “For investors exploring direct investment into infrastructure assets or projects, a key challenge is acquiring the necessary resources and expertise to properly assess the investment opportunities.  Many investors underestimate the time, cost, and experience required to build the capabilities necessary for successful direct investing.”

5.     Private Credit

Altius believes private credit strategies have attracted the attention of LPs and more broadly, the investor community.

Elvire Perrin, Partner at Altius, said: “Investors are looking at ways to enhance their returns on traditional credit and fixed income portfolios, which have displayed very meager performance over the last couple of years due to the very low interest rate environment in most of Europe and the US.  The market dislocation created by the increasing regulatory pressure on banks has created a space for non-traditional debt providers as well as opportunities for distressed credit sales.  Indeed, the conditions attached to bank rescue packages by the European Competition Entity and the new regulations being implemented are forcing banks to exit or decrease their level of activity in private equity and leveraged lending.”

Altius thinks that with the very uncertain and challenging macro environment, the premium for investing in private credit strategies above public credit strategies is one of the highest in history.

Elvire Perrin continues: “On a segment level, we are seeing the best opportunities in the small and lower-mid market where the issue of refinancing will be the most acute. The market has been quick to spot the opportunity and a plethora of funds focusing on distressed or primary issuance of debt for the private equity industry has emerged.”

Altius thinks that many of these funds focused on distressed or primary issuance of debt have been set up for the first time by ex-investment bankers or hedge fund managers diversifying into private equity type investing or even mezzanine focused funds where risk/return profiles are more attractive than in the traditional mezzanine space.

Elvire Perrin concludes: “Many will not be able to raise the capital they are looking for and therefore will not be viable firms.  When looking into the very specific segment of the market, investors should keep in mind the major risks related to first time funds and adequate experience.”

6.     Emerging Markets

Nearly all emerging markets have a need for healthcare, infrastructure, education and basic technology that facilitate business.  Altius believes that the more attractive regions, such as Southeast Asia, politically stable countries in Latin America such as Peru or Colombia, and the emerging African countries like Kenya or Nigeria have increasingly younger populations with increasing levels of disposable income that will drive consumerism.

Elvire Perrin, Partner at Altius, commented: “Foreign direct investments in emerging markets tend to flow quickly in and out of the regions and it is important for private equity investors to avoid the herd mentality flows of capital.  The one challenge that affects all of these regions, despite the differences in demographics, proximity to developed markets, and an abundance of natural resources, is fundraising.”

Altius believes that the private equity sector benefits from a healthy ecosystem where fundraising is roughly in balance with or less than the opportunity set.  Since fundraising ebbs and flows there will always be regions that are underserved and others that are over capitalized.  In the past few years, Altius thinks that three areas have become over capitalized by private equity: Brazil, Turkey, and Southeast Asia (mainly Indonesia).  In these regions, Altius has seen large funds being raised by global investment firms as well as several regional asset managers and now they are having difficulty deploying this capital.  The funds that raised over USD1.0 billion in Latin America have either been solely dedicated to Brazil or virtually dedicated to Brazil since few other Latin American countries offer large market investment opportunities.

Altius has seen how investors are now turning to countries such as Peru and Colombia, which have been private equity capital starved until the past 12 months, and it appears several funds will be raised at record sizes in those markets in 2012.  Turkey and Indonesia have raised record amounts of capital in the past two years but most of these funds are very young.  On the contrary, countries such as Mexico and virtually all large countries in Africa excluding South Africa have had extreme difficulty raising capital.

7.     Asia Private Equity

Altius believes that as financial markets in China are slowly liberalizing, China has emerged as the largest private equity market in Asia during the last couple of years.  Foreign investors have long had only access to the Chinese market by off-shore constructions, as private equity investment by local investors only became possible in 2005 when new legislation to facilitate this was implemented.

The RMB market includes industries and industry sectors not accessible to foreign investors and offshore funds; conversely for local investors, it is difficult to make commitments to offshore funds.  Private equity has, therefore, become increasingly popular with local fund raisers as well as with local investors, mostly large and cash-rich sovereign funds.

8.     Compliance and Regulation

Compliance with various levels of governmental regulation is an eternal challenge for the industry; but Altius believes that the coming year will be an annus horribilis in this regard with too much regulation happening too fast to be fully digested and absorbed by the industry. Amidst the sea of regulatory proposals facing the industry are: i) Solvency II, a fundamental review of the capital adequacy regime for the European insurance industry; ii) Basel III, a long term package of changes to the original Basel Accord on the strength, soundness and stability of the international banking system; iii) MiFID II, the expected update of the Markets in Financial Instruments Directive (“MiFID”); iv)  consultation on the EU Pensions Fund Directive (“IORPII”) which could have far reaching consequences for both the funding of pension schemes and the way in which they are managed.

Most significant perhaps is the fact that in July 2013 the Alternative Investment Fund Managers Directive (“AIFMD”), the main new piece of regulation affecting the private equity industry, will become effective even though the European Commission only  published its draft implemention measures just before Christmas, leaving most firms little time to prepare for implementation .

In the UK the timing awkwardly overlaps the transformation of the UK Financial Services Authority into two new authorities on 1st April 2013. Altius thinks that the Directive offers little flexibility for member states but some are proposing to introduce additional measures to those required by the EU. Germany, for example, removed the rule that exempted smaller managers, a move that could harm its venture capital market.  For non EU organizations, the directive will still have implications due to the restrictions on being able to market products in the EU. Outside of Europe, the US is still coming to grips with the significant regulatory changes enacted in 2010: the Dodd-Frank Wall Street Reform Act, and the Foreign Account Tax Compliance Act (“FATCA”) designed to combat tax evasion by US persons holding investments in offshore accounts. The impact on PE firms of these continues to be deep and has added to the regulatory burden on the industry at a difficult time.

9.     Client Services/Reporting

Altius believes there is an increasing need for transparency across GPs and private equity advisors. Standardized capital call and distribution templates, which were released by Institutional Limited Partners Association (ILPA) two years ago, are taking root in the industry and several leading GPs have begun to adopt them.  The level of uptake has been promising so far and has been led by several institutional LPs.  There has been a complementary movement on standardization in fund reporting, with an increasing number of GPs either adopting industry body templates, or moving closer towards more investor-friendly forms of reporting with regards to their fund structures and holdings.

Jenny Fenton, Chief Operating Officer at Altius, said: “Standardization and transparency in the industry have been increasing in momentum since the global financial crisis and we expect the trend to continue as LPs are now more conscious of the risk and compliance considerations in their portfolios.  The increasing demand for transparency affects not only the direct GPs, but also advisory firms and intermediaries.  There is more interest from clients on issues ranging from increased compliance at the investment due diligence stage, to management fees and carried interest charges, to performance attributes, though to risks inherent within their underlying portfolio company holdings as well as ESG.”

10.     Investor Relations

Altius believes that a major shift in GP-LP relations in the private equity world is taking place.  Stung by the abrupt valuation shifts and mark-to-market losses through the financial crisis, LPs now demand more information, with greater transparency and on a more regular basis as the price for continuing to support their GPs.

Eric Warner, Executive Director and Head of Investor Relations at Altius, commented: “Most major GPs are now meeting with significant LPS on a quarterly basis, with full portfolio reviews, including all major changes, cash flow statements and details of drawdowns, distributions and any valuation changes.  As a result of this pressure, most PE firms have had to increase their establishment in IR teams significantly; many have doubled their staffing in the last five years, and this trend is set to continue given the rapid change in compliance and regulatory standards across the globe.”

About the author:
Terry Stidham is the founder and senior principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms. 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.

Mid-Market is the Sweet Spot for European M&A

European M&A Goes Big with Mid-Market Deals

The big private equity deals grab the headlines, but the smaller deals in Europe are the ones that are delivering the returns, leaving some investors pondering the wisdom of pouring more cash into the industry's giants.

Mid-market European private equity funds delivered average internal rates of return (IRR) of 17.2 percent in the period 1990-2011 compared with 9.1 percent for all buyout funds, according to research published this week by the European Private Equity and Venture Capital Association (EVCA) using Thomson Reuters data. Similar results are being realized in North America.

"The top performing mid-market managers rely less on leverage and multiple expansion. Instead, performance comes from growth and operational improvement," Craig Donaldson of the EVCA said in the report.

Funds in the mid-market category, defined as those having raised between 250 million euros ($324 million) and 1 billion euros, say that performance is prompting increased interest as investors get more selective about the funds they choose.

"Interest in medium-sized private equity groups is big," Daniel Flaig at Swiss-based medium-sized private equity firm Capvis told Reuters.

"Their targets, medium-sized companies, can be influenced more easily, making it easier to generate good returns. Also, the very large PE transactions from the 2006/07 period have not done so well. Therefore, some investors are not inclined to give them more money for big deals," Flaig said.

The mega buyout groups are still the ones with the most available to invest, with an aggregate $122 billion. Large buyout funds have $96 billion, mid-market $82 billion and small $47 billion, according to Preqin, which provides data and research on private equity and other investments.

Asked what fund type offered the best opportunities in 2013, 39 percent of investors surveyed by Preqin said small to mid-market buyouts, compared to 19 percent who favoured large to mega buyout funds.

Advent International, which targets companies worth between 200 and 2 billion euros, pulled in 8.5 billion euros in November in the biggest private equity fundraising since the financial crisis. This contrasts with rivals more focused on the larger end of the buyout market that have struggled to reach their fundraising targets.

STRETCHED VALUATIONS

Some say the returns on larger deals are lower because competition to win them drives up valuations.

"Investors increasingly doubt that value creation is as big in large buyout funds as in smaller ones. Auctions often create unhealthy price levels while small PE groups can often buy companies directly," Torsten Krumm, partner at medium-sized German private equity group Odewal, told Reuters.

David Zalaznick, founder and CEO of JZ Capital Partners, a listed private equity firm which invests in U.S. and European small companies, said bigger deals tend to go for higher multiples, "so you have to leverage them more which increases the risk, or over-equitize them which reduces the returns".

"We like small and medium-sized companies because you can buy them at lower multiples, they are easier to grow, they are usually private and often you can buy them away from an auction process," he said.

In Europe, almost 40 percent of the capital raised to fund European buyouts flows into the mid-market, with almost a quarter of all deals involving mid-market firms, says the EVCA.

Andrea Bonomi at InvestIndustrial said Europe was the region to target as far as mid-market funds were concerned because of the "attractive valuations that are available and the potential for GPs (general partners) to make a significant difference to their investees' performance by helping them to globalise".

The big buyout funds say that, just because they are big, it does not mean they only do big deals, especially in an environment where the size of a "large" deal is shrinking.

The head of European private equity at Blackstone said at an industry gathering in Berlin last month that the firm was open to doing deals whatever the size.

Investors in private equity firms believe that while some medium sized groups may have performed well over the shorter term, the big players have "justified their position" over a 20 year period, Peter Pereira Gray at The Wellcome Trust said in Berlin.

Another argument in favour of investing in bigger private equity firms is that they offer scale that big institutions are looking for given the size of the funds they need to invest.

"You can't look at the IRR as the only measure. The quantitative dollars that you can deploy in these large funds is a factor that should be considered as well," David Rubenstein of buy-out giant Carlyle told the Berlin conference.

"These larger funds - and they do do smaller deals - they do have the ballast of pretty high qualified people, they're not likely to break apart, they do get the best managers, the best deals from Wall Street, the best financing teams so they do have a lot of advantages." he said.

About the author:

Terry Stidham is the founder and principal of Target Search Group. He is a B2B Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms. 

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.  Mr. Stidham has been instrumental in aiding thousands of business owners prepare their businesses for eventual sale by teaching them how to maximize efficiencies in operations leading to significant increased cash flow.