Private equity firms have more cash than ever before. The success of the asset class over the past five decades and the increasing difficulty of generating impressive returns in the conventional financial markets have led to record amounts of dry powder. Having too much money to spend, however, can be a problem just as large as having too little.
Exacerbating the issue, an excess of funds has heated up the auctions process and driven up valuations into previously rare multiples. A Bain & Co. survey of the industry at the end of 2016 found that the average entry multiple paid by firms was over 10x earnings, more than the record multiples of the mid-2000’s.
These high valuations make it more difficult than ever to generate sufficient returns. The deals that are in the market are few and far between – particularly for large-cap investors searching for deals of sufficient size. This is exacerbated by trade buyers with increasingly deep pockets and a growing experience with the complexities of carrying out M&A deals of size. 86% of LP’s cited rising prices as a primary concern in September 2017.
The situation is particularly acute in the consumer sector. Thinking back across the last two years, it’s difficult to name more than a handful of opportunities in the UK for private equity firms looking to make significant investments apart from Unilever Spreads and The Body Shop (which was ultimately acquired by a trade buyer anyway). High employee numbers, low consumer confidence and uncertainty over the outcome of Brexit have all added up to a febrile atmosphere across the consumer markets.
But scarcity breeds invention and risk creates innovation. Away from the doom and gloom that has characterised much of the coverage of the consumer markets in recent months, private equity houses are getting creative with their strategies to drive growth. In the words of Graham Elton, head of EMEA at Bain “we are seeing private equity firms innovate, experiment and invest at unprecedented levels.”
Platform asset and buy-and-build strategies in particular have become more popular in reaction to market conditions. The strategy revolves around two key pillars. First, it takes advantage of multiple arbitrage – the practice of valuing larger companies at higher multiples on underlying EBITDA than smaller ones. Second, it leverages synergies that can be created between acquired companies as a primary lever of growth.
Beyond this, buy and build and platform asset approaches allow PE firms to access ends of the market that were hitherto outside the investment hypotheses of their existing funds. So much of the consumer space is dynamic, exciting and full of growth, but it tends to be concentrated at the smaller end where agile challenger brands and digital startups are making names for themselves. Take beauty for instance – when Charlotte Tilbury was looking for investment it was too small for many firms. By adopting a platform asset approach, the deal pipeline is expanded, and new areas of the market are opened up.
This works particularly well for consumer because, simply put, you need fewer synergies to make a platform play. Bringing together a set of brands under a ‘house of brands’ umbrella doesn’t require the kinds of cross-business functional integration that other plays might.
Andrea Bonomi, founder and managing principal of InvestIndustrial has called buy and build deals the future of the industry – “The game will increasingly be to generate returns from more follow-on investments to the platforms.”
The joy of the approach is that it leans on a key source of strength for PE firms – intimate knowledge of the deal process and deep M&A expertise. A recent example of the strategy in action is Exponent’s approach with Big Bus Tours and the Leisure Pass Group. Exponent acquired Big Bus in 2015 and in late 2016 bought Smart Destinations, a maker of city attraction passes. The two companies were bundled together until 2017 – the buy and build approach was in fact so successful in this case that the company ultimately exceeded Exponent’s threshold and had to be split up. Ultimately, Exponent acquired LPG and The New York Pass, combining these two businesses with Smart Destinations to create the Leisure Pass Group.
On a larger scale, there’s KKR’s hold of Selecta. The vending machine business announced plans to IPO in late June with Reuters reporting that it may sell shares worth over $1bn. When KKR acquired the company in 2015 it was in difficult financial straits, having incurred significant debt through a leveraged buyout in 2007. Under KKR’s management, Selecta moved to cut costs and added on two businesses, Pelican Rouge and Argenta, to ensure that it was the number one or two in every market in which it operated. Including unrealised synergies, Selecta is targeting a 2018 EBITDA of over €300m.
The upsides are evident, but there are also obvious risks to the strategy. A clear plan of action needs to be in place ahead of time to ensure the deal-flow required to grow the companies through acquisitions. Particularly with bolt-on’s, cultural due diligence is a necessity – as Adam Holloway of Livingbridge has said, “There needs to be a meeting of the minds. You can’t combine totally diverse cultures.” Additionally, there’s a talent aspect, with the M&A volume requiring a management team with the experience to navigate the complex legal and tax issues involved.
Of course, it’s worth noting here that these strategies, while they are becoming ever more common, are not at all new. Exponent, Sovereign and August to name just a few have all historically been specialists in the approach. The difference between then and now is that more and more of the non-specialist PE houses are starting to treat it as a viable option and effective investment thesis.
It’s not just deal strategy; the consumer private equity market has also seen an innovative approach to fund structure from the larger firms. The market has in fact run counter to the prevailing trends in the industry at large. Where Marco Compagnoni, a senior partner at law firm Weil, Gotshal and Manges LLP predicted that more and more buyout firms would team up to bid for assets that are too big for them to buy alone, consumer has seen larger funds debuting smaller investment vehicles to take stakes in the mid-market.
Bridgepoint established a lower mid-market fund with a target of £100m to invest in the UK. Further examples can be found in KKR, EQT Partners, Eurazeo and IK Investment Partners. This trend is also evident in the midmarket where Inflexion Private Equity has been particularly active, launching two funds – a minority stake growth capital vehicle, and a lower mid-market vehicle, to capitalize on LP demands for more places to put their money.
It’s a win-win – private equity firms get to expand their reach and raise more funds while minimizing their risk profiles, and LPs get to reduce the number of GP relationships and deploy greater amounts of money.
The consumer industries are evolving at pace and these are just two examples of the way private equity is adapting to new market conditions. Alternative investment strategies and new fund structures aren’t the only ways to tap into the current of potential running through so much of the market, but they represent the cutting edge of new approaches to the consumer-facing world. Despite the challenges of the present and the current and imminent disruptions sweeping over our sectors, private equity has so far been forward-thinking in its approaches to growth. I for one am excited for what’s next.