At the start of 2016 there was little in the tea leaves to foretell of imminent global political upheaval. The private equity outlook was, for many, ‘business as usual’. The previous year’s shocks had been mostly limited to the Syriza Party’s electoral victory in Greece and a Chinese renminbi devaluation. Fast forward to the end of 2016 and we’ve already seen President-elect Donald Trump, Brexit, and the resignation of Italian premier, Matteo Renzi.
With several rate hikes expected by the US Federal Reserve next year, forthcoming European elections, and escalating global tensions with Russia it’s more important than ever that private equity limited partners (LPs) understand the risks in their portfolios and how best to position their 2017 allocations to maximise future returns.
Brexit is here to stay and will continue to influence market sentiment, particularly relating to sterling.
Brexit is here to stay and will continue to influence market sentiment, particularly relating to sterling. UK businesses with complex European sales and/or purchasing relationships will likely face continued ambiguity on pricing power. This is creating some widening of spreads in the secondary fund market but in equal measure, good opportunities for buyers who can form a clear view on underlying portfolio risks.
In the primary fund space, lower mid-market, single European country funds offer attractive prospects, with general partners (GPs) able to source local opportunities at competitive valuations, and can add value by, for example, taking businesses out of complicated family ownership. Investors will always be attracted to these teams who have clear long-term value creation strategies at the heart of their investment decisions and can therefore weather shorter-term dislocations more effectively.
European investors will also need to keep focused on events in the US, in particular, how Donald Trump will fill his remaining key advisor positions. This will help shape how the new US administration will engage on domestic and global issues, including trade with the EU. With Republican control of both House and Senate, the new President will have greater scope to enact policy priorities than his predecessor – indeed, his well-publicised rhetoric on de-globalisation could lead to a more pro-domestic corporate stance. There are likely to be some implications for European businesses with a bias towards US exports, particularly with any prolonged freezing of the planned Trans-Atlantic Trade and Investment Partnership.
The Fed’s recent December forward guidance on rate rises should be closely monitored. Higher rates will have some impact on returns for larger European businesses with exposure to dollar-denominated debt. However, European debt financing remains extremely attractive, which should result in a vibrant European deal market through 2017, albeit with a quiet start to the year, as is normal in Europe.
GPs’ pricing and capital deployment discipline will continue to be a focus for investors, as well as how portfolios are constructed against the current risk backdrop. Smarter use of co-investment to manage portfolio sizing is something that good GPs understand well, but that is by no means a universal approach.
We are entering 2017 against a backdrop of ever increasing global dry powder from previous vintages. This will test GPs’ discipline on pricing for larger deals in an environment where purchase multiples continue to rise. With elevated dry powder levels it is inevitable that pricing has trended higher. Holding periods for private equity owned assets are likely to lengthen. Given that, we should expect returns to start trending towards longer-term averages, largely based on the inability for deal pricing to keep going upwards.
Successful GPs will demonstrate an understanding of how rapidly changing technologies could dislocate established portfolio companies.
Successful GPs will demonstrate an understanding of how rapidly changing technologies could dislocate established portfolio companies. We regularly review Gartner’s Hype Cycle and can see how quickly that the time taken between the innovation and commercial reality stages of new technology has narrowed. Marrying this to rapidly changing consumer tastes and different demographics groups’ spending patterns (‘millennials’ for example) means neither LPs nor GPs should take the efficacy and sustainability of existing technologies and processes for granted. All private equity investors will have to work harder to understand these implications in 2017 and beyond.
Significant opportunities will exist for nimble European private equity investors that understand the implications of political and economic change. Those with a clear plan for value creation, allied to an understanding of how corporate and consumer habits will evolve will likely reap strong returns.
The article above by Alex Barr, Senior Investment Manager, previously appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 25th January 2017