Private equity and venture capital activity has surged during the pandemic – But what’s driving the rise in appetite for PE and VC? and will their purple patches continue into the ‘new normal’?
Private equity and venture capital investment has been one of the clear winners of the pandemic.
Despite a difficult first and second quarter of last year – as PE managers, investors and businesses paused their activity amid the uncertainty of the economic lockdowns – a third and fourth quarter revival more than made up for the early shortfall.
According to White & Case, global annual deal value in 2020 climbed 5% year-on-year to $555.1bn, despite deal volumes dropping 18%.
Activity has accelerated in the first quarter of 2021 too, with the value of PE deals doubling year-on-year to $360.3bn and volumes up 28%.
Venture capital broke records, according to figures from Preqin, with a total of $297bn invested and $391bn realised through exits in 2020.
Notable deals hitting the headlines included Blackstone buying a majority stake in genetic testing services group Ancestry.com for $4.7bn, and Thoma Bravo’s $12.3bn purchase of cloud security firm Proofpoint.
In the UK, according to research from Refinitiv, there have been 345 PE bids for UK companies already this year, the highest since records began in 1984.
Car breakdown firm the AA was taken over by Towerbrook Capital for £219m earlier this year, and supermarket group Morrisons finally accepted a £6.3bn takeover bid by US investment group Fortress in July, after rejecting a £5.5bn proposal from Clayton Dubilier & Rice.
VC exits included the direct listing of cryptocurrency exchange platform Coinbase Global, which sold $43.8bn in public equity shares last April.
Turning negative into positive
“The pandemic has clearly been a negative event, but it’s created a positive for PE and VC in terms of investment opportunities,” says Alex Smyth, Director at Oakbridge Fund Services (Jersey).
“They are either buying at discounted prices firms that haven’t done so well in the pandemic or exiting firms in sectors that have flourished, such as in digital technology, communication platforms and healthcare.
“And we’ve seen larger, more established fund managers speeding up the launch of their next fund to take advantage.”
Nick Stevens, Partner in the Private Equity Group at KPMG in the Crown Dependencies, agrees that ‘smart’ PE managers have benefited from sectors that have done well in lockdown, such as media streaming and online retail. “Portfolio diversification has really come into its own,” he says.
Meanwhile, acquisitions have been underpinned by increased capital allocations from institutional and private investors, as well as family offices, that are tired of record-low interest rates making investments such as bonds less attractive.
According to Preqin, global assets under management in private equity rose 6.1% to $4.74trn in June 2020. It expects this number to hit $9.11trn by 2025, with family office demand leading the way.
“We have seen a number of institutional investors backing some of the first-time fund managers as their cornerstone investors for niche fund strategies,” says Smyth. “It also has a theme of ‘business as usual’ for them, as they need to continue to find ways of allocating their capital.
“With interest rate rises pushed even further into the future, investors will continue to be attracted by expectations of high returns. Over a 10-year horizon as of June 2020, buyout has an annualised net internal rate of return of 15.1%, while growth has 17.5% and VC 12.4%.”
Challenges remain
Stevens adds that, even before the pandemic, the alternative asset sector was growing strongly because of those returns and favourable demographics.
“There is an ageing population and pension pots are growing larger,” he says. “Covid-19 has been the perfect storm for PE and VC.
“We had the immediate monetary economic response, where governments ensured that interest rates were as low as possible, meaning assets that paid an interest base yield were not attractive.”
However, there have been challenges for investors and fund managers in the PE and VC sectors, particularly around valuations. “Sky-high asset prices are by far the biggest challenge facing PE investors,” says Smyth.
Indeed, according to Preqin’s survey, amid heavy competition and a flood of investment capital – both debt and equity – buyout multiples averaged 11.4 times earnings before EBITDA across the US as of year-end, and a record 12.6 times across Europe.
Richard Hansford, Director, Alternative Investments, at Ocorian, says this has a lot to do with supply and demand.
“The bigger players have raised record amounts of capital, and investors want them to use that cash,” he says. “They are all chasing the same assets, driving up the multiples.”
As such, Hansford has seen a number of PE firms pulling away from deals because they are just too expensive.
“They are sitting on cash and trying to find value in the market,” he explains. “Some are changing strategies and looking at different types of asset class.
“Maybe before the pandemic they had a pure tech focus, for example, which has now filtered down into specific routes, such as insurtech or biotech.”
Stevens agrees that valuations at the moment are unprecedently high, but adds that market participants are willing to bid up if they want a company that has done well in lockdown.
He points out that PE firms are increasingly changing the way they source assets to cope.
“You don’t want to go into investment bank-led auction processes. That’s where assets bid up to crazy multiples,” he says. “They are looking at striking bilateral deals with sellers in private.”
Not all valuations are frothy, however. Morrisons’ share price, for example, looks cheap – and therefore attractive to PE – as, despite high sales in the pandemic, it has seen costs such as staff wages and online deliveries rise.
It is therefore harder for PE firms to work out the correct valuation for a target, or indeed their own holdings, if they have had a strong or even-less-than-stellar pandemic.
It may mean taking on more debt to land an acquisition – which is possible now with low interest rates but a challenge if the rates do rise to combat inflation in the economic recovery.
All of this has meant making strategic changes, including introducing slightly longer exit horizons as they shore up investee companies.
“Take a furniture shop,” says Smyth. “Before the pandemic, everything may have been working well, with people coming in to view products. But in lockdown, if that furniture shop wasn’t online, it was in trouble.
“It meant PE and VC firms working with clients on new strategies, such as going online and introducing ecommerce.”
Change of focus
Stevens says fund administrators and advisers have helped in this endeavour.
“We have a number of London-based managers domiciling funds here in Jersey. There’s been a lot of close working with service providers, administrators and boards looking at the balance sheets of investee businesses and making sure they are not going to collapse,” he explains.
“I saw PE managers very quickly changing focus – away from traditional investing to looking at processes such as renegotiating terms with lenders and suppliers. You have to roll up your sleeves, create value and get the company ready for sale at a sufficient level of return for the fund.”
The Channel Islands is playing an increasingly crucial role in the development of PE and VC. According to the Jersey Financial Services Commission, PE and VC funds under administration grew 21% year-on-year in 2020 to £164.6bn.
In addition, almost 100 new Jersey Private Funds were registered, bringing the total to more than 400, most of which are Jersey-domiciled structures.
“We are seeing a lot of enquiries – from first-time fund managers, including family office set-ups, to spin-outs from established firms looking to set up in Jersey,” says Smyth. “Part of that demand is Brexit-driven – managers are looking to market to the EU through the National Private Placement Regimes.”
Hansford sees the Channel Islands as a PE and VC hotspot because it is a “very cost-conscious, pragmatic jurisdiction when it comes to setting up fund structures”.
“Our legal set-up, tax advice and regulations make it a favourable regime – we’re picking up decent deal flow,” he adds.
Adding further to the islands’ attractiveness is its use of technology.
“The pandemic has taught us a lot about being flexible,” Smyth explains. “We are almost entirely cloud-based in our IT applications, and we are looking at other cloud tech services that are not the norm for the industry. For some PE clients, it is a big tick.”
Hansford says we are now in a virtual world of investing. “A lot of investors like to meet a new PE firm, go to presentations and understand the structure and strategy,” he says.
“The lack of that during the pandemic has been a barrier for some in our sector, but those who have adopted virtual processes have been more successful. Our clients and investors are demanding smarter tech. They want more frequent information.”
So, what can we expect in PE and VC circles in the months ahead? “The third and fourth quarter will be very busy with next generation funds as well as new fund managers launching and raising money,” says Smyth.
“There is a lot of dry powder capital and opportunities. ESG is massive and we will see more activity in that space – we are looking at helping an ESG sustainable agricultural fund at present.”
Hansford expects a cooling-off period in terms of deals, given how expensive the market is. “We’ll see a moment of reflection, but if you’re an investor, where else are you going to put your capital?”
Indeed, Preqin says 44% of investors are looking to commit more money over the next 12 months, compared with 36% for venture capital.
“VC has become more relevant as a result of Covid,” says Stevens. “This is because the technology and pharmaceutical sectors have surged, and they have traditionally been very relevant sectors to VC managers.
“They need early-stage capital to develop these ideas and grow rapidly. But I continue to see rich opportunities for PE as well. It is an increasingly attractive asset class post-pandemic.”