2014 saw an improving transaction environment with a resurgence in the IPO market and strengthening buy-out activity, particularly in the second half of the year. High-quality assets coming to market commanded high prices in competitive auctions. In this market, investors sought new ways to deploy capital and minority investing, and buy-and-build strategies came to the forefront. So, what does 2015 have in store for the U.K. private equity (PE) community?
In comparison to the U.S. private equity market, which looks to continue to grow in 2015 off the back of a positive, deal-rich 2014 and buoyant economy, uncertainty around private equity activity still lingers in Europe, where its 1.1% GDP growth projection casts doubts about the economy and limits the ability of European companies to generate meaningful organic earnings growth.
Overall, businesses are performing better in the U.K as the economy leads ahead of its European peers, with 2015 GDP growth forecast in the 2%-plus range, translating into better valuations for businesses than before, with more confidence amongst business owners who are seizing the opportunity to sell. The U.K. economy also benefits from perceptions – particularly in the U.S. – that is remains a good commercial hub for their European operations and benefits from transparent accounting standards and relatively sophisticated management teams. Equally, the focus of international PE funds on the U.K. is adding to the pool of potential buyers and the resulting pricing tensions in the market.
With the macroeconomic climate on the upturn, the U.K. economy in decent shape, lots of capital to invest and growing pool of sellers, we would expect to see the increase in deal flow that we saw in 2014 continue through 2015.
The health warning here is that there are a number of potential shocks to the system which could dampen activity including the U.K. general election in May, the impact of political change in Greece on the stability of the Eurozone, a slowdown in the Chinese economy, and the geopolitical risks around the likes of Russia and the Middle East. The impending and unpredictable U.K. general election in May could result in shareholders looking to sell out in the first half of the year to avoid any risks, for example in relation to changes in the taxation system (e.g. entrepreneur relief). With at least a 50% perceived chance of a Labour-led coalition, the business community is potential facing a less supportive political agenda. Shareholders hate uncertainty, and we may see an acceleration in deal activity in the early part of 2015 as a reaction to this.
There has been a shortage of PE deals during the downturn, with a number of PE firms reluctant to buy or sell and instead choosing to sit on capital or hold existing investments until markets improve. We predict that those firms will now be inclined to sell this coming year to take advantage of higher valuations and ahead of the uncertainty caused by a new government, where issues such as leaving the European Union and changes to capital gains taxes will have an impact on a number of firms.
Deal activity to flourish
With the economy thawing and a large pile of unspent capital, much in recently raised funds, PE firms' appetite for doing deals is increasing and helping to push prices higher, creating even more of a seller's market. Debt is also much more readily available across the lending spectrum, not only from the usual high-street providers, but from a myriad of alternative lenders and debt funds. We expect that the PE community will be more circumspect around leverage ratios and will look to maintain a more conservative debt-equity balance in their transaction structures but the requirements to meet vendor's price expectations will challenge this approach, particularly in the larger-deal market. The unwillingness or inability to over-leverage the funding structure will put greater pressure on equity returns and drive an even greater focus on operational improvement, bolt-on acquisitions and active investment management.
Even with these higher valuations, because of where we are in the cycle, in many cases prices are still reasonable enough for this to be a buyer's market too, fueled by stabilizing and improving macroeconomic conditions and buoyant equity markets. Sure, some assets are selling at 12-13x EBITDA on the basis that their future growth potential and quality of earnings justifies the high price. However, a high entry price without a credible growth story leaves little upside for investors to realize a meaningful return. In the lower middle market, we can still find businesses at 6 or 7x EBITDA, which translates to significant opportunity for creating value. Often there is more work to be done to improve these companies but for investors with the right skill set, these returns can be very attractive.
In summary, whilst there may be a few bumps in the road, we foresee a healthy increase in transaction activity in the year ahead. Confidence is rising that now is both a good time to buy and sell. Competition will keep prices high and investors will need to be attentive to value creation opportunities through operational improvement. Better keep those holiday plans on ice for the time being.