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2014 Private Equity Market Outlook
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©2014 TorreyCove Capital Partners
Table of Contents
3
A Macroeconomic Overview
15 Tactical Summary
Buyouts 16 North America Buyouts 22 Europe Large Buyouts
Special Situations 28 Distressed Debt 35 Mezzanine 38 Secondaries
43 Venture Capital
This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from TorreyCove Capital Partners. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding whether any investment is appropriate, nor a solicitation of any type. The general information contained herein should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Generally, alternative investments involve a high degree of risk, including potential loss of principal, can be highly illiquid and can charge higher fees than other investments. Private equity investments are generally not subject to the same regulatory requirements as registered investment options. Past performance may not be indicative of future results.
2014 Outlook
A Macroeconomic Overview Domestic economic news was dominated in 2013 by the seemingly inexorable rise of the U.S. stock market. While equities moved relative to market sentiment rather than fundamental valuations, debt markets produced disappointing returns and have left investors on a multi-year search for yield. Meanwhile, the United States’ trade and budget deficits came in lower than in 2012, even as federal debt ballooned by over $600 billion. The prospects for a continued improving trend in Europe and the United States remain under stress, particularly in the labor markets, where unemployment and underemployment remained high. In emerging markets, growth continued to decelerate in 2013 amid economic and political instability, leading to heavy pressure on the government budgets and currencies of the most profligate, as well as some dubious policy choices by some countries that have put a damper on foreign investor confidence. All eyes are now on the new Federal Reserve Chairman, Janet Yellen, wondering how much she will turn down the dial on quantitative easing in 2014. So far, she appears set to stay the course, originally set by Bernanke, to gradually wean the markets off of easy money.
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A Macroeconomic Overview 2014 Outlook
Economic Growth U.S. real GDP increased at an annual rate of 4.1% during the third quarter of 2013 compared to 2.5% during the previous quarter, according to the Bureau of Economic Analysis (“BEA”). The BEA attributes this growth to increases in private inventory investment, personal consumption expenditures, residential and nonresidential fixed investment, and state and local spending, which were partially offset by negative federal government spending and imports. House prices in the U.S. have risen in line with last year’s expectations, as the average home price rose in 88% of U.S. cities, according to Bloomberg, thanks to limited inventories and fewer foreclosures. At year end, markets continued to be wary of the unsolved U.S. budget stalemate, which effectively shut down the U.S. government in 2013, with the hope that Washington would come to a consensus to avoid more such disruption in 2014. That hope appears to have been answered, at least in part, with the recently reached bipartisan debt ceiling deal, which looks to have effectively pushed that issue off the table for the year. For Europe, Eurostat estimates that 2013 yielded zero growth for the 28 European Union countries. Of the largest European economies, Bulgaria posted a growth rate of 0.5%, while Germany trailed slightly with 0.4%.
GDP Growth 20%
China
United States
European Union
15% 10% 5% 0% -5% -10% 2001 Source: IMF
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011 ©
2012
2013
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A Macroeconomic Overview 2014 Outlook
Smaller countries on the periphery demonstrated the strongest growth, with Latvia, Lithuania and Estonia showing 4.0%, 3.4%, and 1.3% GDP growth, respectively, since 2012. Notably, Cyprus (-8.7%), Greece (-4.0%), and Slovenia (-2.7%) contracted the most. Lackluster growth inspired some creative fiscal strategies from government entities in Europe. Last year France enacted its most aggressive “wealth tax” on its citizenry (which contributed to an estimated 77% decline in foreign direct investment), portions of Cypriot bank deposits were confiscated by the ECB and IMF, and the Greek Troika was criticized for allowing unelected officials to determine massive austerity measures that many claim only further hampered the Greek economy. These are among the major challenges to the restoration of business confidence and resumed economic expansion on the Continent. In Asia, China’s GDP grew 2.2% during the third quarter of 2013 according to Trading Economics. And as predicted last year, growth continued to mellow from its reported 10% growth in 20102012 and is likely to stabilize around 7.5% to 8.0% going into 2014 and beyond. It is important to note that 2013 was a year of policy shift in China, as it begins a very slow evolution to a more liberalized economy. The specter of a major liquidity crunch continues to lurk, as the central government attempts to discourage high borrowing rates among municipalities, as well as the ubiquitous “shadow banking” system that serves them and other credit-starved sectors of the economy. Notably, China’s trade surplus began to narrow toward the end of 2013 (though it more recently saw a considerable expansion), as exports slowed in the face of global currency devaluation, which served to drive up the price of Chinese goods. Japan’s growth must be considered in the context of the aggressive quantitative and qualitative easing program implemented in 2013. The Japanese government and the central bank formed an unprecedented agreement to target 2% inflation through asset purchases during 2013 in order to mitigate deflation, amounting to purchases between $574 billion and $671 billion annually for the next two years. The effect, so far, has been a mild increase in GDP growth throughout 2013 (estimated at 1.6%) and an increase of more than 50% in the Nikkei 225 index. The Bank of Japan has announced it intends to maintain this asset purchase program indefinitely until the desired inflation levels are achieved.
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A Macroeconomic Overview 2014 Outlook
Unemployment Always a major concern for citizens, U.S. unemployment decreased from 7.9% to 6.7% between December 2012 and 2013, according to the Bureau of Labor Statistics (“BLS”). Unemployed civilians decreased by 1.9 million persons to 10.4 million. The number of workers unemployed for 27 weeks or more remained steady at 3.9 million, or 37.7% of the unemployed. In spite of what looks to be an improving trend, the unemployment picture is not as positive as the headline numbers would suggest. For one thing, there is the problem of the chronically “underemployed,” meaning those who work less than full-time (who are still counted as employed). The BLS estimates nearly 7.8 million Americans are such involuntary part-time workers, meaning those who would like more work but cannot find it. Additionally, 2.4 million Americans were defined as “marginally attached to the labor force” (those who had looked for a job within the last 12 months, but were not counted as unemployed because they had not searched for work in the four weeks preceding the survey). Further, more and more Americans are leaving the workforce as discouraged workers, indicated by another year-on-year decline in the labor force participation rate, which dropped to 62.8% in December from over 63% at the beginning of the year. Long-term unemployment, under-employment and variations in those only marginally attached to the labor force are among the factors that will have to be overcome to put the economy on a more solid footing. Unemployment Rates
U.S. Unemployment Rate 12%
25%
10%
20%
8%
15%
6%
10%
4%
5%
2%
0%
0% Greece Spain South Africa Nigeria Iraq Portugal Egypt Poland Italy Ireland Euro Area France Iran Turkey Austria Belgium Colombia Netherlands Finland Czech Republic
30%
Source: Trading Economics
Source: Bureau of Labor Statistics
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A Macroeconomic Overview 2014 Outlook
The Euro area reported an unemployment rate of 12.1% during November 2013, up from the prior year’s 11.8%, representing an increase of approximately 450,000 unemployed civilians on a year-over-year basis. Among the member states, the lowest rates were in Austria (4.8%), Germany (5.2%), and Luxembourg (6.1%). The highest unemployment rates persisted in Spain (26.7%) and Greece (27.4%). Notably, youth unemployment in Spain and Greece reached an unprecedented 57.7% and 54.8%, respectively. Such high unemployment rates among youths are of particular concern, as they may serve as a catalyst for social and political unrest, with potentially destabilizing consequences for the larger EU.
Asia continued to exhibit low unemployment rates. The South Korean and Vietnamese unemployment rates were among the lowest at 2.9%, followed by China, which reported 3.0%. Japan reported a 3.9% unemployment rate as of June 2013.
Inflation U.S. inflation remained in check, in spite of the aggressive expansionist policies of the Fed over the past several years. Indeed, deflation has been the primary concern of Chairman Bernanke over that period of time, and the effects of his policies will undoubtedly be of primary concern to Yellen as she navigates heretofore uncharted waters. Inflation in the United States rose slightly in 2013, with the annual change in the consumer price index gaining 1.2% through November 2013. Food prices increased 1.2% while the energy index declined 2.4% during the year. The EU annual inflation rate was 1.0% in December 2013, down from the prior year’s 2.3%. The highest annual rates were recorded in alcohol & tobacco (3.6%), housing (3.4%), and food and education (both 3.0%), while the lowest inflation rates were for communications (-3.8%), household equipment (1.0%), and recreation & culture (1.2%). Geographically, the lowest inflation rates were observed in Greece (0.3%), Sweden (1.1%), and France (1.5%), and the highest in Hungary (5.1%), Romania (4.6%), and Estonia (3.6%).
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A Macroeconomic Overview 2014 Outlook
China’s annualized inflation rate was 2.5% in December 2013, near the 10-year average of 2.6%, essentially unchanged from 2012. Food prices increased 4.1%. Costs of consumer goods increased 2.2% and service prices increased 3.3%. Many major Asian countries saw wages grow at a faster pace than their economies, sometimes nearly doubling, and thereby putting pressure on manufacturers, according to the International Labour Organization in Geneva. Intended as a political solution to help narrow the widening wealth gap, wage inflation is increasing costs for Asian manufacturers and spurring potential labor substitution to lower cost markets in Africa and Latin America, as well as some talk of “in-sourcing” in developed economies.
While the EU and U.S. work to achieve more inflation, most emerging markets are attempting to dampen it. In Argentina, inflation continues to be a major problem for the economy. While the government reports inflation of 10.5%, the black market exchanges and the Foundation of Latin American Economic Research both suggest it is closer to 26.4%. In fact, the IMF has drawn attention to this discrepancy, recently voting to censure the country over its lack of transparent statistics. Along with the capital controls implemented in 2011, the reactionary economic policies of Cristina de Kirchner should be followed closely in 2014, as further economic erosion could lead to greater social unrest and capital flight.
Global Inflation Rates 10% U.S. European Union China
8% 6% 4% 2% 0% -2% -4% 2003
2004
2005
Source: Eurostat, National Bureau of Statistics China
2006
2007
2008
2009
2010
2011
2012 ©
2013
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A Macroeconomic Overview 2014 Outlook
Sovereign Banks 2013 was a landmark year for central bank activism, as many of these institutions flexed their muscles in an attempt to bolster growth. The Federal Reserve’s balance sheet broke through $3.7 trillion for the first time in history in December 2013, and has more than quadrupled since early 2008, due to the Fed’s effort to keep rates low and stimulate a weak economy. At year end, the balance sheet showed a staggering $4.0 trillion in liabilities. Any whisper of discontinued quantitative easing (“QE”) put both domestic and foreign public markets on edge in 2013, so reductions in QE will be moderate throughout 2014. Importantly, Chairman Ben Bernanke stepped down as the head of the Federal Reserve and was replaced by Janet Yellen in January 2014. Many expect her to continue to relax the Fed’s monthly debt purchases and to focus on unemployment in 2014. In Europe, Cyprus and Greece were among the countries requiring further bailout cash in 2013, though those packages are increasingly offered with strings attached. In Cyprus’s case, the IMF and ECB demanded a 9.9% wealth tax on all bank accounts over €100,000 and imposed capital controls in order to provide the bailout cash. This drew criticism from Russia in particular. More developed markets also grumbled when the IMF proposed a EU-wide “capital levy” in their October 2013 Fiscal Monitor report. The report argued in favor of a one-off, 10% wealth tax on all households with positive net wealth in order to help bring government debt levels down to their 2007 levels. Central Bank Rates 12% 10% 8% 6%
2011
2012
2013
4% 2% 0%
Source: Trading Economics
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A Macroeconomic Overview 2014 Outlook
While this was largely an academic argument, it served to demonstrate the rather fluid mindset that prevails in the search for solutions to the European financial crisis. As banks shed toxic assets and continue to make progress recapitalizing, there is still a large capital gap that must be addressed to meet Basel III requirements. The solvency and liquidity issues of European banks have to date been ameliorated primarily by the ECB backstop , and to a much smaller degree by U.S. Federal Reserve programs like the Dollar Liquidity Swaps, which have been permanently instated as standing agreements instead of temporary relief programs. However, the prospects for the return of robust lending and the velocity of money within the Eurozone, which are critically needed for the overall economic recovery, are not likely to rebound sufficiently until the banking system recapitalizes in a more aggressive manner. The People’s Bank of China (“PBOC”) recently unveiled bold economic reforms meant to begin a transition to a freer exchange of some goods and services, a very tall order indeed. Among the changes, there was a slight migration toward the typical tools used by other major central banks. Last year, the PBOC cut reserve ratios in February and May, and lowered benchmark interest rates in June and July. This year the PBOC will most likely rely more on open market operations. Meanwhile, an audit of local governments exposed an increased reliance on shadow banking, promoting concerns that large amounts of poor quality debt continue to be created, as well as concerns that the effectiveness of central government and PBOC policies is being thwarted by such informal credit channels. This has in turn led to periodic government hiking of interbank lending rates in an attempt to slow down the borrowing spree. As the Chinese economy shifts (presumably) to a more liberalized market, the chances of disruption in the financial system and the real economy grow significantly greater.
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A Macroeconomic Overview 2014 Outlook
Public Markets Despite anemic economic growth in many developed markets and slowed growth in emerging markets, the equity markets did very well in 2013. The S&P 500 and Russell 3000®1 returned 32.4% and 33.6%, respectively, marking a solid year that outpaced the German DAX Index (up 25.5% for the year). Compared to last year, volatility measured by the VIX Index decreased. In Asia, the Japanese Nikkei 225 Index was up over 50% and the Hong Kong Hang Seng Index ended the year about even after recovering from a precipitous summer drop of 13% through June.
Much of the growth in public markets is attributable to aggressive monetary policy, rather than fundamental strength in public companies. The number of successful initial public offerings increased greatly in 2013 in the U.S., with 222 new issuers coming to market during the year. Though still far short of the record of 406 IPOs set in 2000 during the dot-com bubble, 2013 still represented a sevenfold increase from 2008, according to Renaissance Capital. Twitter, Rocket Fuel, Inc., and Sprouts Farmers Market were among the new issuers. After a rash of frenzied IPO offerings in China, regulators closed the IPO markets there in October. As of January 2014, they had not been re-opened.
VIX Index
Public Markets Returns S&P 500
DAX 30
MSCI Emerging Mkt
FTSE 100
Russell 3000 ® 1
300 250
300 250 200
200
150
150 100
100
50
50 0
0 2011
Source: Bloomberg 1
Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Russell Investment Group.
2012
2013
Source: Bloomberg ©
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A Macroeconomic Overview 2014 Outlook
The Outlook for 2014 World output is projected to increase to 3.6% in 2014 from 2.9% in 2013, according to the IMF. Advanced economies are expected to grow 2%, including U.S. growth of 2.6%. U.S. inflation has remained mild and is expected to decrease further in 2014 before reverting closer to its 10 year mean just above 2%. Business investment is expected to increase only slightly in 2014, with many CEOs keeping a wary eye on a polarized Congress that has effectively caused gridlock on the national level, as well as on myriad uncertainties in the regulatory, public policy, and central bank policy fronts. Thus, a continuing cautious approach is expected from the corporate sector, even as the economic fundamentals pick up. With interest rates still very low and increased risk appetite on the part of investors hunting for yield, the high yield market continues to show substantial strength. Corporations like ExxonMobil, Canadian National Railways, and Apple were able to issue record amounts of debt as investors looked for safe fixed income alternatives outside of U.S. Treasuries. We would expect this trend to continue into 2014. The residential sector in the U.S. should continue to recover, in spite of the effect of somewhat higher interest rates. Europe’s economy is expected to modestly recover, with growth for 2014 forecasted to reach 1%, per the International Monetary Fund. Many believe most of the recessionary pains have passed, but record unemployment remains a major concern. More developed nations are expected to drive growth, as emerging economies will likely have to contend with inflation (hence higher input costs) and shifting political climes at home. Despite some increased economic activity in Japan as an effect of the so called “Abenomics,” the expected unwinding of fiscal stimulus and reconstruction spending together with consumption tax hikes will lower growth from about 1.6% in 2013 to approximately 1.25% in 2014 (IMF estimate). In China, growth is projected to decelerate slightly from 7.5% in 2013 to 7.25% in 2014. Policymakers claim to have refrained from stimulating activity amid concerns for financial stability and the need to support a more balanced and sustainable growth path.
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A Macroeconomic Overview 2014 Outlook
Within the larger investment universe, private equity continues to command high interest on the part of limited partners, due to its positive return dynamics. On a relative basis, diversified private equity portfolios continue to compare favorably in terms of performance with other major asset classes, including equities and fixed income. To be sure, the past year’s stellar equity markets took the spotlight, but investors continue to be attracted to the asset class due to its long term track record, which held up decently even through the boom year vintages, as well as due to its ability to generate alpha (especially with regard to strategies that operate in less efficient markets). Interestingly, the strength of the equity markets may serve as a slight impetus to boost deployments to private equity strategies, by removing the denominator effect as a major concern. In the larger sense, private equity continues to deal with the same fundamental issue as all other financial assets in today’s investment milieu – enormous quantities of investment capital seeking high yield in what is still a relatively low yield world (the major exception being the equity markets in 2013). This translates into more or less full pricing of private equity assets across the board, meaning it is difficult in today’s environment to achieve highly favorable entry pricing for investments. This is certainly the case with respect to buyouts in both North America and Europe, as well as such special situation strategies as secondaries and mezzanine. Distressed strategies, on the other hand, are suffering from a severe shortage of deal flow, a result in large part of the massive central bank easing that has been in place since the financial crisis broke. Within the buyout category, we see the most attractive opportunities in the smaller end of the North American market, due to marginally better deal pricing; as well as value plays in Europe when they can be found. Intense competition within the mezzanine space (from high yield bonds and other sources) and secondaries strategies (from new entrants and large amounts of dry powder) make these strategies relatively less attractive going into 2014. Despite its deal flow difficulties, we think distressed strategies are coming more into favor over the next few years, as Fed tightening and the buildup of large quantities of debt set the stage for an eventual shakeout
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A Macroeconomic Overview 2014 Outlook
in credit markets (though perhaps not in the next year or two). After some time of relatively uninspiring overall performance, venture capital/growth strategies turned in a solid performance last year, due to the strong exit environment provided by resurgent equity markets. Going into 2014, we expect another positive year from the venture capital/growth sector. On a geographic basis, we see growth momentum returning to North America, favoring buyout and venture strategies for the next year or two. Europe will remain stable, but growth will be tough to find as many countries continue to consolidate at the public level and as banking sector deleveraging persists, putting credit strategies and value investors in favor within the region. Many major emerging markets within Asia and Latin America are undergoing considerable strain at present, in terms of slowing growth, deleveraging, currency issues relating to the Fed tapering, and political instability. While it makes for difficult visibility in the near term, these markets may offer attractive value plays to the extent entry prices for private equity investments adjust to reflect these challenges and appropriately account for the risk that has always been inherent in these markets. This could very well occur in the next couple of years, making an opportunistic mindset regarding major emerging market economies appropriate.
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Tactical Summary
Ratings are tactical recommendations and assume a portfolio with a stable strategic allocation
North America Buyouts > page 16 SMALL ($500 Million and Below) and MIDDLE MARKET ($500 Million to $5 Billion)
Relatively stable fundraising, investment, and exit activity; modestly lower leverage and pricing; improving economic backdrop
12- to 18-month commitment outlook >
MODERATE OVERWEIGHT
LARGE ($5 Billion and Over)
Expected strengthening deal flow and investment activity within North America; strong exit markets; aggressive pricing; increasing leverage
NEUTRAL
Europe Large Buyouts > page 22 Stabilized euro and sovereign debt scenarios; modestly improving economic outlook but poor growth prospects for EU; credit availability not broadly based; continuing high purchase multiples
NEUTRAL
Special Situations Distressed Debt, Mezzanine, Secondaries > page 28 DISTRESSED DEBT > page 28
Historically low default rates make deal flow scarce; credit markets robust; Fed pullback from quantitative easing indicates higher future interest rates and better distressed investing environment (probably three to five years out) MEZZANINE > page 35
Improving deal flow prospects in large buyout space; future rising interest rate environment; highly competitive debt capital markets and other sources of supply SECONDARIES > page 38
Strong deal flow likely to persist into 2014, driven by regulatory dynamics; large quantity of dry powder with large funds; competitive pricing environment ; well-managed smaller, niche funds should have more pricing power and outperform
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
Venture Capital > page 43 Active exit markets likely to maintain in 2014; steady deployment of capital; more aggressive pricing; good opportunity for investors who can access top quality managers
MODERATE OVERWEIGHT
It should be noted that TorreyCove’s private equity portfolio management methodology emphasizes the equal or greater importance of manager selection in relation to other elements of the portfolio management process, such as regional or sector weightings. For this reason, a client may pursue an investment with a top-performing investment manager even when a region, sector, or strategy is deemed less attractive on a relative basis. These are guidelines; an institution’s weightings may differ based on their current portfolio composition and overall goals, objectives, and risk tolerance. © 2014 TorreyCove Capital Partners | 15
Buyouts > North America
In 2012, the North American buyout space stabilized, posting much stronger numbers in most major activity categories, or at least breaking a losing streak (as occurred with fundraising, when a three year decline was ended). Last year, North American buyout managers consolidated and extended these gains. Overall, North American buyout deals’ aggregate value came in at $171 billion in 2013, close to a 10% improvement over the 2012 number (itself a major improvement over 2011). The number of North American buyout transactions was nearly double that of Europe once again this year, which demonstrated that animal spirits are once again beginning to stir on the North American continent, at least in comparison to other developed markets. Not surprisingly, this renewed confidence has translated in part into high purchase price multiples, not only for mega- and large- deals, but down into the middle market ranks as well. To be fair, purchase price multiples have been high on a relatively consistent basis for most of the post-crisis era, with the exception of a short-lived jog downward in 2009.
Fundraising Mega-funds reasserted their dominance in 2013. After staging an impressive resurgence in 2012, the past year has seen major improvements in the performance of such funds, thanks in part to a strong IPO market that facilitated some impressive exits. Encouraged by meaningful distributions from their existing portfolios and newfound flexibility in terms of allocation (due to public market performance and below average commitments to private equity in the immediate post-crisis years), limited partners returned to the buyout asset class with gusto in 2013. The North American buyout sector (all size ranges) was able to raise $103 billion over 86 funds, up more than double from 2012, which paled in comparison at $47 billion. Average Debt Multiples of Large Corporate LBO Loans Sub Debt/EBITDA SLD/EBITDA
8x 7x 6x 5x 4x
Other Sr Debt/EBITDA FLD/EBITDA
6.2 5.4
4.9
4.7
5.2
5.3
5.4
6.0
Purchase Price Multiples Others
10x
Equity/EBITDA
9.7x 8.4x
Sub Debt/EBITDA
9.1x 7.7x
Sr Debt/EBITDA
8.5x 8.8x 8.7x 8.8x
9.7x
4.0 5x
3x 2x 1x
0x
0x 2006 2007 2008 2009 2010 2011 2012 2013 4Q13 Source: S&P
2006 2007 2008 2009 2010 2011 2012 2013 Source: S&P LCD
4Q 2013 © 2014 TorreyCove Capital Partners | 16
Buyouts > North America
Investment Activity While taking in the best haul in years on the fundraising trail, North American buyout shops got busy putting money out the door as well in 2013. Deals greater than $1 billion in value represented more than 50% of the total dollars spent in the global buyout sector. However, 75% of the deals were less than $250 million in size. But a closer look indicates that this picture of health for large- and mega-cap deals is not entirely accurate. To wit, the most notable transactions were the Dell and Heinz deals, together commanding over $50 billion in total deal value. Excluding these two transactions, deal flow does not appear to have rebounded in 2013 from 2012 levels, and might even be a bit disappointing. This is somewhat curious, in light of the large amount of buyout capital awaiting deployment, suggesting that most managers maintained discipline in spite of the pressure created by large piles of dry powder and upcoming investment period expirations. Whether the big numbers for the mega buyout sector (over $5 billion) extend into 2014 is therefore an open question. However, the strength of the public markets, returning investor confidence, and the growing supply of dry powder from newly realized funds would indicate that the coming year should be a good one for deals on the larger end of the buyout scale.
U.S. LBO Disclosed Deal Value As of December 10, 2013 | $ Billion $700 $600
4Q
3Q
2Q
1Q
$500 $400 $300 $200 $100 $0 2006
2007
2008
2009
2010
2011
2012
2013*
Source: Thomson, Reuters, Buyouts Magazine Note: Q4 2013 numbers through December 10, 2013
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Buyouts > North America
There was an estimated increase of over 15% in aggregate value for U.S. buyout-backed deals (which accounts for the lion’s share of deals in North America) year over year. Dry powder levels remain high in spite of the roll-off of investment periods for 2007 and 2008 vintage year funds, due to the large amount of fresh capital raised throughout 2013, which contributes to the elevated prices seen at auctions in that year. As of the end of 2013, purchase multiples for all deal size ranges remained at or near the peaks of the past several years. However, there was the usual variance, depending on the size of transaction. For deals over $500 million, multiples came in just under 9x EBITDA . Deals between $250 million and $499 million came in slightly under that (around 8x to 8.5x EBITDA), while smaller deals of $250 million or less indicated somewhat lower multiples (though the data is less robust). This demonstrates the somewhat more favorable pricing dynamics within the North American buyout sector as deal size declines. Much the same dynamic prevailed on the leverage side, with overall high multiples (currently averaging about four times EBITDA or higher for first lien debt), declining somewhat for smaller deal sizes.
Investments flowed strongly into IT (20% of total investment dollars), food & agriculture (16%), and consumer and retail (16%), while materials deals attracted a mere 1% of buyout-backed deals.
Exits The performance of buyout funds improved throughout 2013, both in terms of distributions and net asset valuations. Over the course of 2013, U.S. buyout fund portfolios appreciated markedly due to strong exits achieved through both a vibrant secondary and IPO market, as well as the ever-present trade sale route. There were 52 exits via IPO in 2013 versus 37 in 2012. Meanwhile, trade sales declined from 365 to 308 over the year. For 2013, 744 exits achieved an aggregate value of nearly $173 billion, one of the best years since 2006, and markedly better than the lows of 2009 ($30 billion).
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Buyouts > North America Buyouts > North America Small and Middle Market 12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Buyouts > North America Large 12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Outlook Last year we expected that purchase multiples would remain high throughout 2013, underpinned by increasing competition amongst buyout investors, steady interest from strategic players, and abundant financing activity. This proved to be generally true, and most surprises were further to the upside as outperforming public equity markets boosted market confidence, capital inflows, and performance metrics, all of which translated into a very competitive deal environment. For the next 12 – 18 months, this trend is very likely to continue. The continuing supply-demand imbalance in the North American buyout sphere should test the pricing discipline of buyout fund managers and favor those who can provide a demonstrable advantage in terms of postinvestment value-add capability. We also expected that secondary buyouts would prove resilient through 2013. Again, this was true, as large and middle market firms scrambled to deploy the last of their capital commitments before expiration. Secondary sales should continue to be a meaningful exit route for North American buyout deals in 2014; however, there was already a noticeable moderation in the use of this route in 2013, due to the strength of the more attractive routes, especially the IPO market. This trend should persist into 2014, and we expect secondary sales to remain static or cool further from 2013 levels (at least on a percentage basis). At least part of the recent strength to the secondary exit route appears to be attributable to a longer-term trend in the buyout exit markets, as both fund managers and limited partners become more comfortable with such transactions, particularly in the case of transactions involving sales from smaller to larger funds.
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Buyouts > North America
The IPO market entered 2014 with strong momentum and – in spite of recent market wobbling – should provide fund managers an attractive means to exit positions and generate sizable distributions to limited partners during the year. Leverage will play an even larger role in the buyout sphere, as cheap credit abounds (in spite of tapering by the Fed) and competition for deal flow encourages higher prices. Mega- and large- buyout funds will see continued demand as their institutional clients have increased allocations of their total portfolios to private equity and will be looking to deploy larger dollar amounts. In the same vein, we are likely to see continuing consolidation in the industry, as underperforming managers and less established funds lose favor to their larger, more proven counterparts. Thanks to this strong performance and demand, limited partners have lost some of their bargaining power vis-a-vis general partners, the best of which can now resist some demands of even highly-desired limited partners. Increased competition for deal flow, which was already building throughout 2013, will place a premium on funds that can employ “proprietary” sourcing (or less competitive sourcing due to reputation, network, and expertise) or a demonstrable “edge” with respect to sector expertise, and the ability to translate that into measurable alpha. Funds without such an advantage will find it difficult to purchase companies at reasonable prices in today’s environment.
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Buyouts >North America
Our tactical rating for the large buyout sector remains at “Neutral.” The major new positive factor is the gradually improving North American economic environment. Important concerns include near-peak purchase price multiples, high leverage levels, and a substantial quantity of dry powder. Our tactical rating for the small and middle market buyout sectors remains “Moderate Overweight.” This is based on a somewhat less heated purchase price environment and slightly lower deal leverage, both primarily with respect to the lower end of the market. An upward trend for both segments is expected for 2014 in regards to investment, valuation, and exits. As always, a great deal of importance must be attached to manager selection, with those who have demonstrated pricing discipline and/or a differentiated deal sourcing strategy expected to outperform in the 2014 vintage.
Secondary Sales Trends | $ Billion $120
Deal Value ($BB)
400
No. of Deals
$100 300 $80 $60
200
$40 100 $20 $0
0 2006
Source: Thomson Reuters
2007
2008
2009
2010
2011
2012 ©
2013 2014 TorreyCove Capital Partners | 21
Buyouts > Europe
The European buyout space rebounded well on the fundraising front in 2013, while investment and exit activity essentially held steady from 2012 levels. The focus of attention in Europe shifted from the potentially catastrophic – a meltdown of the Euro or breakup of the European Union – to the more commonplace, but still troubling, concerns regarding growth within the Eurozone countries. With several important countries on a diet of public sector austerity and banks still holding the purse strings tightly, GDP growth and unemployment continue to confront major headwinds within the region.
Continuing Economic Woes For the year, EU unemployment steadied, but remained at double-digit levels. High youth unemployment is exceptionally worrisome, exceeding 25% in some countries. This has clear implications for not only those directly affected, but also the investment community, since the specters of social unrest, political disruption, and economic stagnation all beset the EU as it strives to return to anything close to its pre-crisis growth trajectory. While the Eurozone appears to have staved off a breakup of the Union, growth - though improving - remains anemic. The January 2014 IMF World Economic Outlook projects GDP growth at 1.0% in 2014, increasing to 1.4% in 2015. Inflation remained tame at approximately 0.8% in the Euro Area, spurring deflation concerns (much as in the United States in the immediate post-crisis years) and supporting the thesis that the European Central Bank (“ECB”) will continue its accommodative monetary policy and backstop role for the foreseeable future. Considering Europe’s continued economic malaise, the return of investor interest in the region and stabilization of private equity fundraising, investment, and exits within the past 12 months have exceeded the expectations we formed in the darker days of 2012. That being said, the prospects for growth plays in the EU are still opaque, meaning that we expect credit niche opportunities and value-oriented investments will continue to rule the day throughout 2014.
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Buyouts > Europe
Fundraising 2013 showed dramatic improvement in European buyout fundraising. Nearly €57 billion was raised, making 2013 the best year since 2008; however, the market has not fully rebounded to its heyday prior to the financial crisis. For perspective, 2013 raised approximately 80% of 2008’s record high of €72 billion. Given that the 2008 amount was raised, in part, in an extremely heated environment and that the EU has only recently emerged from an existential crisis, the 2013 fundraising total should be viewed as a highly favorable vote of confidence in the viability of the European buyout sector, and the EU as a whole. Notably, of the €57 billion total raised, CVC Capital Partners was responsible for €10.9 billion (raised in connection with its sixth fund), indicating that the upswing in popularity of the established mega-fund, with its perceived safety, is not simply a U.S. phenomenon.
Investment Activity In terms of capital deployment, 2013 was a stable year, as funds invested €55 billion into private equity deals over the year, a modest rise of over 7% from 2012’s €51 billion (per Preqin). Assuming the EU economies continue to find their way toward meaningful growth, there is likely to be a significant increase in investment over 2014, though nowhere near the chart-busting year of 2007, when nearly €138 billion was deployed. Purchase price multiples are still high at 8.7x for deals over €500 million, but this does represent a slight decline year-over-year. This unexpected decline may show that, though market sentiment is improving, investors are still wary of instabilities among periphery countries. More likely, this marginal decline is a result of still-stingy bank financing of some transactions. Notable European buyout deals in 2013 include Joh. A. Benckiser purchasing D.E. Master Blenders for €7.1 billion and BC Partners purchasing Springer Science + Media from EQT and Singapore’s sovereign wealth fund for €3.2 billion.
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Buyouts > Europe
Exits Private equity-backed exits for 2013 came in slightly above 2012, both just under €70 billion, as some traces of a reversal in the downward trend following the high of 2011 (€107 billion) were seen. Exits in the industrials/chemicals and the consumer sectors, traditionally the most actively exited by value, fell to their lowest levels since 2009, according to MergerMarket. Meanwhile, exits in business services more than doubled from the first half of 2012 to the first half of 2013, using the most recently available numbers, from €3 billion over 27 deals to €7 billion over 36 deals. Overall, exit routes improved, as capital markets strengthened and merger and acquisition deal flow increased from 2012 to 2013. The secondary market for private equity transactions — typically a popular form of private equity exit in Europe — remained strong, as managers hastened to deploy expiring capital; however, there was a marginal decline in the number of transactions over the year.
Outlook In 2013, economic doom and gloom still permeated the headlines across Europe, but there may be signs of Spring. Unfortunately, the cautiously optimistic expectations across the Eurozone for 2014 do not apply to the Continent’s jobless, who are likely going to be unable to find work in what appears to be the dismal “New Normal” for the European job market. Many observers expect wages to continue to fall, as the fixed currency across the Eurozone means external devaluation is not possible; therefore, internal devaluation will likely have to fill its place as nations struggle to build competitive advantages.
Volume and Value of European Private Equity-backed Buyouts Volume
Value (€bn)
160 140 120 100 80 60 40 20 0
30 25 20 15 10 5 0 Q3 2011
Q4 2011
Q1 2012
Source: Q3 2013 unquote” Private Equity Barometer
Q2 2012
Q3 2012
Q4 2012
Q1 2013
Q2 2013
Q3 2013 ©
Q4 2013
2014 TorreyCove Capital Partners | 24
Buyouts > Europe
12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
The depressive effect of these structural changes, without the usual amelioration via government spending, sets up a vicious circle (lower growth, less tax receipts, more austerity, less employment and growth) and means that the EU appears to be staring at years of sub-par growth and persistent unemployment unless major structural reform is pursued by both the EU and its member countries. The ECB will continue providing easy liquidity to the European banking sector in an effort to further the twin goals of inducing more bank lending and avoiding another sovereign crisis. The IMF and EU will continue to provide aid on an ad hoc basis to member states that run aground in terms of solvency. European banks will continue to slowly shed toxic assets and build reserve levels, but probably not fast enough to loosen lending sufficiently for the health of the European business sector. One thing that became abundantly clear in 2013 is that fiscal austerity will not long remain a viable path forward for the EU. Such austerity in Italy and Greece is now being blamed for worsening their respective crises, rather than alleviating pain. France has implemented aggressive wealth tax schemes which have dramatically discouraged both investment from businesses and spurred tax avoidance by both businesses and individuals; as a result, capital flight is in full swing. European Area GDP Growth Expectations 4%
3.0%
3%
2.0%
2%
1.7%
1.6%
1.1%
0.4%
1% 0% -1%
-0.7%
-0.4%
-2% -3% -4.4%
-4% -5% 2007 Source: Eurostat
2008
2009
2010
2011
2012
2013
2014* ©
2015*
2014 TorreyCove Capital Partners | 25
Buyouts > Europe
In Cyprus, an unprecedented bank deposit levy and capital controls led the island nation into a damaging GDP collapse of nearly 6%, with more contraction expected into 2014. Continued tight budgets in Spain appear to have eased the fiscal pressures on that country’s public sector debt load, but have done little or nothing to restore the robust GDP growth (a loss for 2013 and projected at around 1% for 2014) that is sorely needed in order to put its people back to work in meaningful numbers. Last year the state of the European financial system pointed to a continued credit shortfall, as banks struggle to repair their balance sheets and improve capital ratios. Though senior credit provision in 2013 was up meaningfully from 2012 levels (see nearby graphic), credit conditions are expected to remain relatively tight within the region, meaning smaller, higher-growth (and perhaps less creditworthy) businesses may have difficulty obtaining adequate financing. This of course will put a damper on already weak economic activity throughout the EU. Cash will be king for another year in Europe, as credit channels will only loosen significantly after the banking sector gets its house in order, which does not look to be a short term proposition.
Annual Senior Loan Volume | € Billion DEAL COUNT
€ Billion
140
1Q
2Q
3Q
320
4Q
120
280
100
240 200
80
160
60
120
40
80
20
40
0
0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: S&P M&A Stats
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2014 TorreyCove Capital Partners | 26
Buyouts > Europe
Last year, our Outlook anticipated the UK would lead the way in private equity deals, as their unbound currency allowed them some shelter from the greater Eurozone financial crisis. This region was indeed strong in terms of private equity activity in 2013, and there appears to be nothing in the offing that would stand in the way of a repeat in 2014. As the distance from the euro and sovereign crises (as well as the global financial crisis) extends, the boldness of private equity investors appears to be growing, as evidenced by high purchase price multiples. This more aggressive attitude, combined with companies in need of capital for growth, bodes well for increased deployment activity within the EU in 2014.
Our tactical ranking for the European buyout sector for 2014 is “Neutral,” an improvement from last year’s “Moderate Underweight.” Though the prospects for an economic rebound appear to be on more solid footing, the Union still has many potential stumbling blocks en route to recovery. However, investor confidence in the EU is returning rather strongly, as evidenced by the solid fundraising year for the region. In terms of private equity investment, the key positives are: 1) the lack of existential threats visible in the near term relating to the euro or EU cohesion and 2) the continuing need for capital in the region, due to the poor condition of the important Continental banking sector. On the negative side are a relatively weak macroeconomic growth picture and a persistently high-priced deal environment.
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2014 TorreyCove Capital Partners | 27
Special Situations > Distressed Debt
Distressed strategies have had a tough run since 2009, thanks in no small part to the extraordinary efforts (largely successful, at least as of 2013) of the Fed to prop up financial asset values and keep the cost of debt at or near historical lows. With all of this easy liquidity sloshing around, investors looking for yield, and lenders that would rather push the day of reckoning for highly-levered borrowers out to a presumably better future environment, default rates have stayed quite low, borrowers have been able to refinance, and the credit markets have shifted into a very accommodating stance. Needless to say, this has made life difficult for distressed investors. The prospect for this situation changing appreciably in 2014 would have to be assigned a relatively low probability. However, with the buildup of high yield assets continuing apace over the past couple of years, indications of Fed tightening (albeit very modest and in some ambiguous future), and growing risk appetite on the part of investors in debt, it is simply a matter of time when there will be a shakeout. The question – which is unanswerable – is when that time will come. Probably not this year, and perhaps not next, but sometime within the next four or five seems more likely. Then distressed investors will have their long-awaited opportunity to perform.
Fundraising In spite of record, or near-record, low default rates over the past few years, distress-related strategies continued to demonstrate reasonable fundraising success. Given the current market conditions relating to distressed investments, this should probably not be taken as any kind of meaningful indication that investors are betting on a near-term resurgence in distressed opportunities. More likely, it should be seen as another sign of the continued maturation of the distressed investing space, as institutional investors now allocate capital to such strategies on a long term, strategic basis rather than strictly as opportunity arises. Last year, 43 distressed funds
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Special Situations > Distressed Debt
raised a respectable $33 billion in fresh commitments, about 15% off from 2012 levels ($39B), but still more capital than in seven of the past ten years (2007 and 2008 being major exceptions, as they raised over $50B each). With respect to the geographic breakdown of distressed fundraising, the center of gravity shifted strongly back to its traditional North American focus, with funds dedicated to that region amassing $26 billion, besting the prior year by around 20% and turning in the best fundraising year since the surge in 2008. Meanwhile, with the immediate heat off of Europe (partly as a result of the actions of the ECB) and opportunities not materializing as anticipated, investor interest in distressed plays in that territory appears to have cooled, as reflected in the steep drop in fundraising in 2013, when just under $3 billion was gathered by funds focused on the region - a decline of over 70% from the peak crisis year of 2012, when approximately $10 billion was raised.
Annual Distressed Private Equity Fundraising | 2006-2013 60 No. of Funds
50
Aggregate Capital Raised (bn USD)
40 30 20 10 0 2006 Source: Preqin
2007
2008
2009
2010
2011
2012 ©
2013 2014 TorreyCove Capital Partners | 29
Special Situations > Distressed Debt
Investment Activity Attractive deal flow within the distressed space remained relatively scarce in 2013, as default rates maintained at benign levels throughout the year. Part of the explanation for this state of affairs relates to factors that have been in place for years since the crisis – a highly accommodative policy by the Fed in terms of interest rates and market liquidity provision, strong credit markets (for the past couple of years), and solid corporate balance sheets with substantial cash as a result of years of reducing costs. Add in the modest resumption of U.S. GDP growth that appeared to take hold in the second half of 2013, and the recipe for continued low default rates is complete. Through the first three quarters of 2013, less than one percent of the high yield bond universe went into default (0.84%). Barring a larger-than-expected default occurrence for the fourth quarter, this indicates that the annual default figure for the year will come in well below 2012 (1.62%), or any year since 2007. According to Altman & Kuehne, just ten high yield issuers defaulted in the third quarter of 2013, with the most significant being Cengage Learning ($1.9 billion), Energy Future Holdings ($1.4 billion), and Urbi Desarrolos Urbanos ($950 million).
Historical Default Rates – Straight Bonds Only | 1998-3Q 2013 14% 12% 10% 8% 6% 4% 2% 0% 1998
1999
2000
2001
2002
2003
2004
Source: Professors Edward I. Altman and Brenda J. Kuehne (NYU Salomon Center)
2005
2006
2007
2008
2009
2010 ©
2011
2012 3Q13
2014 TorreyCove Capital Partners | 30
Special Situations > Distressed Debt
12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Outlook 2013 turned out to be another difficult year for distressed investors with respect to deploying capital – and this on top of a quiescent 2012 on that front. Based on the state of the markets as we begin 2014, there appears to be little in the way of hope that this situation will change appreciably over the course of the year. Most of the indicators of distress are flashing green at the present time and with U.S. macroeconomic growth picking up,
the pressure on highly-levered companies – never too great anyway since the beginning of the Fed’s aggressive easing program - is lessening (at least in some respects). However, one important bullish indicator moved in favor of distressed investment funds in late 2013 – the initiation of explicit tapering of quantitative easing support by the Fed.
Percentage of New High-Yield Issuance Rated B- or Below | Based on the Amount of Issuance 60% 50% 40% 30% 20% 10% 0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 3Q 2013 Source: S&P’s Global Fixed Income Research
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Special Situations > Distressed Debt
With respect to the credit markets more specifically, there are several current indicators that point in the direction of the continuance of a low pressure environment rather than increasing stress - for even the most suspect debt issuers. Some notable metrics are as follows:
• The size of the U.S. high yield bond market stood at approximately $1.4 trillion as of the end of September 2013, or about 6% higher than where it stood at the end of 2012. New high yield issuance was a healthy $85 billion during the third quarter of 2013, more or less in line with issuance for the prior quarter of 2013, but over 10% off the third quarter of 2012. Of note, upgrades out of the high yield category ($76 billion) more than doubled downgrades into the high yield category ($34 billion), pointing to some improvement in credit quality during the first three quarters of 2013.
• The face value of defaulted and distressed debt was approximately $1 trillion as of the third quarter, indicating that 2013 appears set to log the second straight year of decline in this metric, which stood at around $1.2 trillion as of the end of 2012 and nearly $1.5 trillion outstanding as of December 2011. Moreover, defaulted and distressed debt as a percentage of high yield and defaulted debt outstanding is also falling, coming in at 20% as of September 2013, compared to 24% at year end 2012. If this holds up through the year end, it will make 2013 the best post crisis year with regard to this measure. High Yield Default Rate
High Yield Issuance (bn USD) 400
18
350
16
300
14 12
250
10
200
8
150
6
100
4
50
2
0
0 2002
Source: Fitch Ratings
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012 ©
2013
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Special Situations > Distressed Debt
• After peaking in 2011, the distress ratio (the percentage of high yield bonds trading to yield 1,000 basis points or higher over comparable U.S. Treasury securities) continued to fall throughout 2013, ending the third quarter at 5% ($88 billion in face amount), a steep drop of 37% from the 2012 third quarter.
• 2013 became the second-best year ever for U.S. high yield issuance, with its $324 billion flotation modestly undershooting the peak year of 2012, when $344 billion of new issues were sold into the market. Interestingly however, there is not yet an indication that credit quality has slipped substantially, at least not to the levels seen in the lead-up years to the global financial crisis. Through the third quarter of 2013, about 27% of new high yield issuance was rated B- or lower, compared to about 30% for the prior year. By comparison, the years 2004 through 2006 never saw less than 33% of issues at B- or lower, and 2007 blew this type of issuance out to 51%.
• In December, Fitch Ratings reported an estimated 2013 high yield default rate of 1.5% and predicted that the 2014 default rate would come in somewhere between 1.5% and 2% (Altman & Kuehne are more pessimistic with their prediction of 2.65%). Also, high yield bond spreads narrowed in 2013, and are currently trading around 400 basis points, not record low numbers, but certainly entering territory last seen in the few years leading up to the global financial crisis.
It may sound redundant, but the tune for distressed investing strategies in 2014 is nearly copied from the 2013 songbook. And why shouldn’t it be that way? After all, most of the elements that made 2013 a tough year for the strategy remain in place. Even though it has finally begun to scale back quantitative easing, the Fed’s monetary stance remains highly accommodative for the foreseeable future. Also, as illustrated by nearly all of the measures discussed above, the credit markets are generally seeing nothing much to worry about – default rates remain very low and are not expected to bump up too much in 2014, the percentage of distressed/defaulted debt in the high yield category has declined, and new issuance at the lower end of the quality scale is very much in line with the average (excepting 2007) over the past several years. Further, strong
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Special Situations > Distressed Debt
high yield markets make it easier for highly-levered companies to refinance their way out of any near term trouble. Yield-chasing investors have made all of this liquidity possible, and the tightening of high yield spreads indicates increasing investor comfort with holding riskier debt issues. Finally, one of the only important things to change over the past year – the pace of growth of the U.S. economy - provides no comfort to the distressed investor. With all of these factors in place, it is difficult to predict a robust distressed investing environment in 2014 or even 2015. Reviewing our thoughts from 2013, we suggested that the credit cycle was in the middle innings and that the large amount of high yield issuance put in place before 2013 would serve as fuel for the eventual fire that was likely three to four years away. That assessment still seems correct today, though the fuse has shortened and an additional year of fuel has accumulated. Of course it is impossible to predict massive market dislocations, and there is never a shortage of triggering events that could spark an opportunity for distressed debt investment. However, given the state of the credit markets, the accommodative policy of the important central banks, and the slow but steady recovery in the U.S., our best guess is that investing in distress will not be “in favor” over the next 12 to 18 months. In spite of this currently forgiving market environment, the attractiveness of distressed investment strategies has improved somewhat since last year. In large part this is due to the Fed’s very gradual pullback from quantitative easing. While highly unlikely to have a major impact on distress in 2014, the markets are aware that interest rates are on an uptrend, which will eventually put pressure on highly-levered companies. This raises the probability of a major distressed opportunity occurring sometime within the next three to five years. Given the continued buildup of debt and apparent market complacency, the next cycle promises to be a “good one” for distressed investors. Therefore, our tactical rating will move from “Neutral” to “Moderate Overweight.”
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2014 TorreyCove Capital Partners | 34
Special Situations > Mezzanine
After several lackluster years since the crisis, mezzanine funds may finally be able to shine a bit in 2014. For most mezzanine providers (at least the larger funds), the life blood of their business is the symbiotic relationships they maintain with their larger equity sponsor brethren. So, as deal flow goes with the sponsor community, likewise it goes with the mezzanine providers. And deal flow has not been very copious in the post crisis years, a situation especially acute with regard to the larger sponsors which account for a major portion of mezzanine deal flow. Add to this the high equity contributions for LBO deals that lenders have required in the post crisis years, large amounts of dry powder at buyout shops, and burgeoning sources of competition (BDCs, high yield, etc) for mezzanine providers, and you have a challenging environment indeed for the mezzanine asset class. While most of these elements remain in place, two factors have shifted in favor of the strategy recently. One involves the improving U.S. economy (and resurgent exit markets), which can be expected to impart some energy into the buyout sector on the acquisition side over the next few years (barring another downturn), which should provide for a more friendly mezzanine deal flow environment. The other involves the long-awaited beginning of the pullback of quantitative easing by the Fed, which will eventually lead to higher interest rates (though the Fed is moving very gingerly, so material rate increases are probably a year or two away). A higher interest rate environment, to the extent it raises the “price” of competing forms
of credit, will make mezzanine debt more attractive on the margin, while at the same time increasing the negotiating leverage (and potential profitability) of mezzanine funds. On the downside, holding mezzanine securities may be somewhat less attractive to investors in a rising rate environment, due to their quasi-fixed income nature.
Fundraising Mezzanine has seen a constant increase in committed capital since the 2009 lull, and 2013 was no exception. Certainly, it was still nowhere near the credit-fuelled record year 2008 (admittedly an outlier), when a whopping $31.1 billion was raised; nevertheless, fundraising of $15.8 billion for 2013 has put it into a league with 2007, when $16.4 billion was gathered for the strategy.
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2014 TorreyCove Capital Partners | 35
Special Situations > Mezzanine
Thomson One states that 51 funds were raised in 2013, the lowest figure in the last five vintage years. This is not to suggest that there is less capital flowing into mezzanine. On the contrary, more capital is flowing, albeit into fewer vehicles, suggesting that the consolidation trend evident across the private equity investment spectrum is also alive and well in the mezzanine space.
Investment Activity Just as the number of funds is dwindling, so too are the number of companies in which the funds invest. Deals are getting more sizable, as the space becomes dominated by the handful of established players that are in a position to raise larger funds. These funds tend to have close relationships with several key large and mega buyout firms, and so their deal flow will of necessity be on the larger side. While mezzanine managers have experienced a reasonably favorable fundraising trend over the past few years, they have struggled to put money to work in deals in each of the past two years. Both 2012 and 2013 appear to have been relatively subdued years in terms of capital deployment. According to Thomson Reuters, deals completed for those years came in well below half of the deals completed for the prior two (2010 and 2011), as the difficulties of buyout funds regarding the deployment of capital reduced potential deal flow. Further, equity levels of buyout transactions remain decently high and the availability of alternative sources of debt capital appear to have contributed mightily to the difficulties faced by mezzanine players on the investment side of the business. Annual Mezzanine Fundraising 2003-2013 | $ Billion
35 30 25 20 15 10 5 0 2003 Source: Preqin
2004
2005
2006
2007
2008
2009
2010
2011
2012 ©
2013
2014 TorreyCove Capital Partners | 36
Special Situations
12- to 18-month commitment outlook >
> Mezzanine
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Outlook Intelligence gathered from mezzanine market participants points to a continuing weak bargaining position of mezzanine providers in relation to key sponsors and investee companies. As they have been for the past few years at least, mezzanine fund managers are effectively in the position of being “price takers” due in large part to the strength of the high yield markets and other sources of inexpensive capital. This continues to put pressure on current income (interest) as well as the amount of equity exposure (“kickers”) that may be obtained. Unsurprisingly, deal terms – debt covenants, negative protections, call provisions, yield maintenance - are also less than favorable to the mezzanine lender in today’s market. Of course a rising interest rate environment will shift the balance of power somewhat in favor of mezzanine providers, but with the Fed taper more or less just begun late in 2013, those days appear a long way off yet. Looking to 2014, a benign credit environment, continued loose money fostered by the Fed, and stiff competition from alternative sources of debt are expected to keep a lid on mezzanine funds’ profitability and significantly reduce their ability to negotiate favorable terms. We expect that more creative management teams will be able to provide customized solutions that may afford them somewhat better pricing. Further, established funds that enjoy good reputations for speed, flexibility, and credibility with important sponsors should find some pricing power on the margin. Finally, smaller funds that operate in inefficient market spaces should continue to find consistent and adequate deal flow that hits their expected return targets. We look for fundraising to increase over the next year, as investors anticipate a resurgent North American buyout sector in 2014. Based on the same expectation, we expect that capital deployment for mezzanine funds will be significantly higher over the coming year than it has been for the past two. Our tactical weighting for mezzanine strategies will remain at “Neutral.” On the positive side for the strategy is a strengthening North American buyout sector in 2014, which should provide a substantially improved environment for capital deployment. Also, the Fed’s decision to taper – while not having a dramatic impact within the U.S. so far, at least signals that rates will rise over the next few years, which may make mezzanine marginally more attractive, on a relative basis, in comparison to some of its lower cost competitors. On the negative side: continued strong competition from alternative debt providers and a tight mezzanine deal flow market, leading to low levels of pricing power. ©
2014 TorreyCove Capital Partners | 37
Special Situations > Secondaries
The secondary market had a record setting year in terms of deal flow and fundraising, thanks in part to new regulations across the U.S. and Europe and the rebalancing of portfolios on the part of large institutional investors. Real estate and infrastructure deals, historically underrepresented in secondary markets, gained the most market share and there appears to be little on the horizon to buck this trend. While the strategy has enjoyed considerable success over the past few years in raising and deploying capital, the pricing environment has remained consistently firm nearly every year since the crisis (with the exception of 2009, when fewer major deals were done due to the huge bid-ask spread existing at that time). Secondary players continue to put capital to work, often finding creative structures and using leverage in an attempt to maintain attractive returns while bidding for deals in a very competitive environment.
Fundraising As liquidity has increased over the last year, volumes and pricing have remained strong. The increase in sell-side activity was nearly matched by the increase in committed capital from fund of funds, pension funds, institutional buyers, and committed secondary funds all looking to get money to work, which propelled the secondary market to another strong year. Secondary funds raised nearly $14.3 billion in 2013, down about one-third from 2012’s $20.6 billion, but still a respectable showing for the year. Annual Secondary Fundraising |$ Billion 25
Aggregate Capital Raised (bn USD)
No. of Funds
20
15
10
5
0 2006 Source: Preqin
2007
2008
2009
2010
2011
2012 ©
2013
2014 TorreyCove Capital Partners | 38
Special Situations > Secondaries
As is the case in the primary sector, consolidation looks to be the order of the day, as large, established secondary managers, raising ever-greater funds, gained market share at the expense of their smaller rivals. The market appears to be bifurcating into two camps: “mega” funds that possess high credibility and capability in terms of closing large institutional deals and smaller “niche” funds that focus on smaller bite size deals and are able to operate effectively in less efficient market spaces (which offer potentially higher returns).
Investment Activity According to Cogent, over $27.5 billion of transaction value in secondary investments was generated in 2013, more than double 2009’s total, further solidifying the trend of the past few years. In terms of deal flow, the market has come a long way since the first $1 billion secondary deal was done in 2000. Setter Capital suggests that the average deal size was approximately $25 million during the year. The U.S. and Europe have been, as usual, the most active markets for sourcing. Today more managers are expanding to Asia in anticipation of increased deal flow that has yet to develop there. Much of the activity in 2012 and 2013 was undertaken to provide liquidity to investors, to reallocate more capital to primary or existing investments, or to restructure portfolios.
Secondary Deal Volumes |$ Billion 30
27.5 25
25
2011
2012
25 21 20 16
15
15
12.5
11 10 5
7.5 1.5
2.5
3
2.5
3
1999
2000
2001
2002
9
8.5
2004
2005
0 1998
Source: Cogent Partners
2003
2006
2007
2008
2009
2010 ©
2013
2014 TorreyCove Capital Partners | 39
Special Situations > Secondaries
12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Outlook The secondary market appears to have finally arrived as a sustainable force, as limited partners continue to evolve the composition of their portfolios. According to a recent Coller Capital survey, 42% of LPs intend to sell assets in the secondaries market within the next two years. While it is unlikely that this seemingly aggressive percentage is realized, as a statement of intent it serves as evidence of the continuing institutionalization of the secondary markets. According to the survey, reasons for the sales are decidedly split across the Atlantic. Most North American would-be sellers plan to repurpose their sale proceeds into their best performing managers. For Europeans, only one quarter of limited partners intend to consolidate their funds among fewer managers.
Actively Trading Primaries |$B
Average Trailing 3-7 Year Primaries |$B
Forecasted Deal Volume 5-10% Turnover | $B
$30
Aggregate Capital Raised (bn USD) $243 $362
$179
$314
24.3 20.8 18.0
$20 $15
$211 $160 $121
$25
$208
$389
$143
$161
$189
$10
12.1
10.4
$5
8.9
$0 2004 2005 2006 2007 2008 2009 2010 2011 2012
2014
2015
2016
2014E
2015E
2016E
Source: Preqin, TorreyCove Research
©
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Special Situations > Secondaries
Cogent Partners predicts the supply of secondary market deal flow will grow by 10% in 2014, in large part as a result of demand side factors, including the approximately $52 billion in dry powder currently held by secondary funds, as well as the additional capital brought to the table by new market entrants (ie, institutional primary investors). The supply side should be active as well, with limited partners having to pare portfolios in response to regulatory requirements, or simply to optimize their portfolios. Infrastructure and real estate, previously underrepresented, may begin to garner an increasing share of the investment attention into 2014 and beyond. While eyes are beginning to turn to Asia as well, Europe and American institutions will continue to represent the lion’s share of deal flow for 2014. Deal flow should remain ample, as new regulations (Basel III, Solvency II, and provisions of the Dodd-Frank Act) force banks and large financial institutions to continue to shed some or all of their private equity holdings. The Volcker Rule has yet to be formally enforced and some exemptions may yet be named, but many expect it to be finally implemented in 2014. A major part of the increased activity observable in the secondary markets over the past five years can be traced back to these regulatory pressures. Several factors should conspire to keep secondary market pricing strong. On the buy-side, some of the largest secondary funds in history, a few exceeding $8 billion, are currently being raised. With all of this dry powder available, the pressure on the large funds to deploy capital will be high. Recent Regulations Changing the Secondary Market Oct 2010: Banks begin to unwind proprietary trading operations to comply
Sept 2008: Lehman Brothers Declares Bankruptcy
June 2010: U.S. Congress names the Volcker Rule
Jan 2013: Basel III heightened capital requirements implemented in Europe
May 2012: London Whale scandal hits the newswire
Jan 2014: Solvency II implemented
Dec 2013: Volcker Rule approved
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Special Situations > Secondaries
In recent years, large institutions have started entering the secondary markets directly. With substantially lower actuarial return targets (and no carried interest hurdles), these players are likely to pose stiff competition to incumbent secondary fund managers, thereby cutting bid margins for large secondary transactions even thinner. Finally, the increasing use of debt by traditional and non-traditional buyers to finance secondary deals has already led to more aggressive pricing of secondary assets, and should continue to do so as long as the low interest rate environment persists. In recent years the “denominator effect” has pressured limited partners, in particular large institutions, into reducing private equity exposure to maintain their mandated allocation levels as other portfolio components (primarily public equities) remained at depressed values (in comparison to the period prior to the financial crisis). This shedding of assets has been a primary boost to secondary deal flow since 2010. 2013 saw a reversal of this trend. As general partners returned large amounts of capital to limited partners and public equity markets boomed, the denominator effect on illiquid private equity assets was significantly diminished. For 2014, the pressure is off to reduce private equity exposure as a way to ameliorate the “denominator effect” or shift to a more liquid portfolio stance, which may dampen a source of deal flow into the secondary markets. Also, the roll-off of the 2007 and 2008 primary vintages will result in lower organic deal flow in the years after 2014 (as indicated in the preceding graphics on page 40). Here though, we harken back to the undercapitalized European banks (and financial institutions more generally), which we believe will provide a constant flow of secondary deals that will likely outpace any reduction from slower portfolio management and rebalancing activities by large institutional investors. Our rating for secondary strategies will move from “Neutral” to “Moderate Underweight”, primarily based on the continuing high pricing environment within the secondary space, as well as increasing competitive pressures. All in all, little in terms of the structure of the market, supply/demand dynamics, or pricing have changed from the past year. The trend is currently against secondary funds, as intensifying competition, savvier sellers, and more pricing transparency (in short, more efficient markets) will take their toll on the returns that can be offered by secondary funds investing in the present vintage (without using leverage).
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Venture Capital
After years of relatively humdrum results, the venture capital space looked to have finally broken its bounds in 2013, as a solid equity bull market opened the door to one of the most attractive exit environments for venture-backed companies since the end of the post-crisis recession. Taking advantage of the opportunity, venture funds teed up over 80 companies for the public markets during the year, and stand ready to chase that number in 2014. Strong exit valuations in the IPO market raised the value of financing rounds, and hence venture funds’ portfolio company valuations. All in all, it was quite a good year for the asset class. And 2014 should be another good one, barring a significant deterioration in equity markets. Capital deployment and exits should rival or exceed 2013 levels, and fundraising should tick upward as investors pay more attention to a venture capital space that finally seems to have a good deal of energy and momentum behind it.
Fundraising 2013 was a moderate year for venture capital fundraising. Breaking a three year uptrend, commitments came in at just under $17 billion, which was off about 15% from the 2012 figure. It was also just a little over half of the amount raised in the better years of 2005 through 2007. The sorting of the venture capital ranks into “haves” and “have nots” continues apace; in fact, the venture capital universe has probably gone farther and faster down this road than most.
U.S. Venture Capital Fundraising Activity | $ Billion 35.0 30.0 25.0 20.0 15.0 10.0 5.0 2007 Source: Preqin
2008
2009
2010
2011
2012 ©
2013
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Venture Capital
Last year, nearly 43% of U.S.-focused funds were able to exceed their target fundraising amounts and only 30% of funds were unable to reach their target amounts - one of the lowest rates of the last decade. However, it does not appear that the reason has to do with a lack of selectivity on the part of investors, as few green managers were able to gain traction. Most managers were well-seasoned, having invested at least two funds. This hint at an industry in consolidation may mean that large institutional investors will have even fewer avenues through which to deploy meaningful cash over the coming years.
Investment Activity 2013 saw a reasonably steady pace of investment by venture capitalists, as approximately $29 billion in capital was deployed, a modest increase of about 7% over the prior year, and more or less even with 2011, which was the best year since 2008. There was a trend of increasing deal values over the course of 2013, which is anything but surprising considering the strength of the IPO exit route that is of such vital importance to venture capitalists. Accordingly, the demand for more developed, later stage deals increased substantially. To this point, on a global basis, late stage (Series D or later) deals garnered the most investment dollars in 2013, followed by the growth/expansion category (source: Preqin). This increased demand was an important factor in driving up prices in those segments. For instance, Series D rounds and later showed an impressive 23% rise in value in 2013, on a year over year basis (source: Preqin, global venture capital). U.S. Venture Capital Investment Activity | $ Billion NUMBER OF DEALS (000s)
AMOUNT INVESTED
Q4
$50
Q3
Q2
Q1
6 5
$40
4
$30
3 $20
2
$10
1
$-
0 2007
2008
Source: National Venture Capital Association, Thomson Reuters
2009
2010
2011
2012 ©
2013
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Venture Capital
Of the ten largest deals, five were Internet companies, including 360Buy, Spotify and Pinterest. Cleantech deals, specifically, attracted far less dollars from venture capital firms, making 2013 one of the slowest years for the sector since 2007.
Exits The strong public markets breathed life into what had, over the past few years (oddly), been a rather boring asset class, with the occasional high profile IPO (Facebook, Groupon, Twitter) to liven things up for a time. But 2013 had the look of a breakout year, at least on the allimportant exit front. The number of venture-backed IPOs was up over 60% from 2012, with 82 companies going public, the highest amount since 2007. By total amount raised, 2013 was a solid year, with a total take of over $11 billion, edging out 2011 and easily besting 2009 and 2010. Of course, 2012 was the best year since the financial crisis for venture-backed IPOs ($21 billion of proceeds), but was heavily skewed by Facebook’s gargantuan IPO. Taking Facebook out of the picture, 2013 had a much better IPO year, and since it was more broadly based, it is a better indicator of the overall trend.
Number of U.S. Based IPOs | $ Billion
Number of U.S.-Based M&A | $ Billion
100
600
Venture-backed
Buyout-backed
Venture-backed
Buyout-backed
500 75 400 50
300 200
25 100 0
0 2007
2008
2009
2010
2011
2012 2013*
2007
2008
2009
2010
2011
Source: Thomson Reuters & National Venture Capital Association
Source: Thomson Reuters & National Venture Capital Association
*Buyout backed as of 12/13/2013
*Buyout backed as of 12/13/2013 ©
2012
2013*
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Venture Capital
12- to 18-month commitment outlook >
STRONG OVERWEIGHT
MODERATE OVERWEIGHT
NEUTRAL
MODERATE UNDERWEIGHT
STRONG UNDERWEIGHT
Conversely, the other major exit route, M&A sales, logged its slowest year since 2009 for venture-backed exits. On a year over year basis, M&A exits for venture-backed companies were off by about 31% and 35%, by number and total proceeds, respectively. This is not an unusual result, given the high valuations achieved for public companies on Wall Street during the past year, making trade sales far from the preferred exit option for the most attractive venturebacked companies. The venture deal that gained the most media coverage was far and away the successful IPO of Twitter, with private equity firm Rizvi Traverse backing the transaction, which secured nearly $2.2 billion in proceeds. Interesting to note, Twitter has never turned a profit and makes most of its cash from advertising revenue, reminding some market participants of an IPO from the Internet Bubble days. In keeping with that profile, the company saw a 73% price jump on its first day of trading. Nevertheless, we are nowhere near the euphoria that abounded in the “Bubble” days, and it remains an open question whether the run of exit success seen by the venture capital sector is sustainable.
Outlook Last year, we suggested that fundraising and investment flows in the venture capital space would remain relatively steady in relation to the numbers posted in 2012, with fundraising for 2013 in the range of $20 billion to $25 billion and investment of around $25 billion. As it turns out, the fundraising figures undershot this estimate by a considerable margin, while the investment dollars overshot significantly ($29 billion). For 2014, we expect a significant increase in fundraising, as investors – seeing the solid exit performance of the asset class from 2011 through 2013 – find some renewed interest in committing to the venture space. While equity markets have shown considerable volatility in the opening days of 2014, amid worries about emerging market growth and the sustainability of the U.S. recovery, investor sentiment remains generally confident, which bodes well for momentum in 2014. So long as the IPO market is open, venture-backed companies should continue to be in high demand, especially given the strong post-IPO performance of most of last year’s crop of newly-minted public companies. ©
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Venture Capital
Last year we expected exit momentum to persist throughout 2013. We also expected exit strength to be more broadly based. Both of these expectations turned out to be substantially correct. What was not entirely on the mark was our assessment of the M&A markets, which we expected to be stable year to year. As noted earlier, 2013 saw a meaningful decline in companies exiting via the trade sale route. While any prediction is almost certain to be wrong, we expect exit markets for VC-backed companies to be reasonably solid, especially if the Fed stays the course of taking away the monetary punchbowl in slow, methodical steps. There is certainly a substantial pipeline of companies eager to take advantage of what has been (and they hope will continue to be) a buoyant equity market. That being said, we do not expect 2014 exits to outperform 2013, at least on the IPO side. For the last several years, capital supply and demand dynamics have been reasonably well balanced within the venture capital sector. Nothing seen in 2013 seems to indicate that that status will change appreciably. In fact, the past few years have seen capital deployment exceed fundraising by meaningful amounts, indicating that – if anything – there are marginally fewer dollars chasing deals than there were several years ago. Any effect on deal pricing will most likely be short-lived, as investors - drawn by attractive recent exits - seek to put more capital into venture funds. Further, it is the nature of the business for venture capitalists to be relatively insensitive to price when confronted with what they perceive to be a leading, high growth IPO candidate. On the margin, deal pricing does not appear out of hand, but the pressure is certainly toward higher prices when exit markets are strong. Therefore, we expect pricing to increase across most funding stages. Likewise, we expect to see increased investment of venture dollars across stages, with seed and early stage deals leading the way in terms of percentage gains, as VCs replenish their pipelines in the wake of substantial exit activity over the past two years (and likely in 2014 as well). An indicator of this can be seen in the level of first-time financings (first institutional money invested in a company) from 2013. Such deployments totaled $5 billion in 2013, a 14% increase (in dollars) from the prior year.
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Venture Capital
The consolidation trend with respect to venture capital funds, begun in earnest a few years after the crash of the Internet Bubble, continues to roll forward unabated. In 2013, 53 new funds (those raised by a new venture capital firm) were raised. This represented a 25% reduction from 2012 (11% in dollar terms), which illustrates the trend of fewer “first-time” funds successfully raising capital. Limited partners continue to value established names quite highly and continue to concentrate bets with a select list of such managers. Conversely, they show little inclination for taking on more risky managers in the hopes of identifying the next top tier investor, especially within the venture capital asset class.
Our tactical rating for venture capital strategies will move from “Neutral” to “Moderate Overweight.” We anticipate that the venture capital space will have another solid year on the exit front, which should in turn encourage another year of substantial capital deployment at or above 2013 levels. The performance of the industry in 2013, in terms of exits, distributions, and portfolio valuations should build fundraising momentum going into next year. The primary concern relates to the possibility of aggressive pricing in later stage deals taking hold as venture capital managers scramble to access one of the best exit markets in years. For the large institutional investor, accessing early stage funds, especially those of the most successful managers, is structurally difficult. Therefore, deploying capital into high quality growth capital funds will remain the most opportune way to gain exposure to what looks to be a favorable vintage year for venture capital in 2014.
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