Private equity deal volume likely to rise; investor power may wane

Private equity experts are split on whether prices paid for portfolio companies will continue to rise in 2014, leading to a potential bubble, or prices will drop as a consequence of rising interest rates and the resulting higher cost of capital.

In the new year, some experts see an end to the negotiating power institutional investors have had over their general partners as more capital is committed to the alternative asset class in 2014.

One school of thought predicts that rising interest rates will lead to an increase in transaction volume, which stalled in 2013 because plentiful cheap debt fueled ever-rising valuations for portfolio companies.

Higher interest rates are likely to be a key event in 2014. Higher rates are expected to mean less real corporate cash flow, lower company valuations and more private equity-backed purchases, said Antoine Drean, founder of Paris-based private equity manager Triago and online private equity fund platform Palico.

“It's quite remarkable how high the deal prices were, driven in part on how robust the financing markets were,” said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc.

“Fund managers who had been chastised for the high leverage and high deal prices in the pre-2008 period were very reluctant to pull the trigger” and make investments in 2013, Mr. Mansukhani said.

Private equity managers were reluctant to make investments because the high prices — based on high valuations — “didn't fit into their model for robust private equity returns,” he said.

Mr. Drean echoed this sentiment. “In 2013, I was surprised by the relative discipline of private equity fund managers. Faced with a record $145 billion wall of expiring dry powder, (general partners) returned capital or sought investment period extensions rather than give into frothy prices for assets,” he said.

The volume of private equity-backed mergers and acquisitions is expected to increase in 2014. In 2013, there were nearly 18,000 U.S.-based private equity-backed companies, up considerably from the nearly 10,000 in mid-2010, noted Jeff Golman, vice chairman of the investment banking group at Chicago-based Mesirow Financial Holdings Inc. “This bodes well for increased sale activity, as the PE firms will need to realize on many of these investments for the benefit of their limited partners.”

Mesirow also expects increased private equity-backed sales because of the overhang of deals done in the 2007 industry heyday, Mr. Golman said. These deals include transactions such as Hilton Worldwide Holdings Inc., which Blackstone priced for an initial public offering on Dec. 10. Hilton's “values have increased substantially, which will facilitate some type of liquidity event whether an IPO or sale now that the values are close to or above what was paid for many of these companies,” Mr. Golman said.

At the same time, some market participants say deal prices should go even higher in 2014 than they did in 2013.

Edward Powers, managing director at Chicago based BAML Capital Access Funds Management LLC, a fund-of-funds manager and adviser, said one of the price drivers will be an increase in institutional investor commitment to private equity.

“The combination of distributions received in 2013, increases in public market values and (investors') need for returns will drive up the amounts committed by institutional investors in 2014,” Mr. Powers said. More commitments added to “an improving economy and higher leverage levels in buyout deals will lead to higher purchase multiples on transactions,” he said.

This will mean that 2014 will be a great time to be a seller but a year when buyers need to be choosy because they will be buying into a market on its way up, Mr. Powers said. “Over the past 12 months, we've seen the prices firms are willing to pay for companies steadily increase,” he said.

Indeed, if the price keeps rising unabated, “it can potentially lead to a bubble building up in the (private equity) space, which can potentially play out negatively three or four years down the road,” Mr. Powers cautioned.

At the same time, institutions might lose their negotiating edge.

“After several years of having more negotiating power with funds and showing more discipline and getting better terms, institutional investors may see that power fade as distributions increase and capital flows more freely,” Mr. Powers said.

More capital from existing and new investors will flow into private equity, he said. Investors will be attracted by “a combination of increased distributions in 2013, increases in public market values and need for returns. Investors will need to stay focused on shrinking the costs of their investments,” including making more co-investments, Mr. Powers said.

Peter Cornelius, chief economist and strategist for New York-based AlpInvest Partners, Carlyle Group's fund-of-funds subsidiary, is cautiously optimistic that private equity fundraising as well as buyout transaction activity should both pick up in 2014.

The growth should be encouraged by private equity returns that should provide a premium over the public equity markets. Also, the favorable global economic outlook should prompt further fundraising and buyouts, Mr. Cornelius said.

Limited partners “currently seek to increase their exposure to private equity in an effort to rebalance their portfolios amid higher public valuations,” he said. “Given the outlook for monetary policy and the broader economy in key markets, including the larger emerging economies, I would expect this to continue in 2014.”

But a number of wild cards could affect the growth, including uncertainty about the amount and speed of the tapering by the Federal Reserve in the U.S. And although the situation in Europe has clearly stabilized, “there is always potential for increased risk.” Mr. Cornelius said.

Another wild card is elections in key emerging markets of Brazil, India and Indonesia, Mr. Cornelius said.

However, economic growth that is not too robust and not too weak would be perfect for mezzanine debt financing, which Mr. Cornelius expects will return in 2014.

“In the last couple of years, mezzanine has been very much on the back burner in the sense that there is little need for issuers to issue mezzanine debt because the capital markets are so liquid,” he said. “Going forward, however, investment opportunities look set to improve as the trough in bond yields is now probably behind us.”

Given that interest rates are likely to rise only gradually, the volume of buyouts should be able to continue to recover, he said. “This bodes well for mezzanine, which is a function of buyout activity,” Mr. Cornelius said.

As a result, mezzanine will come back gradually over the next two or three years starting in 2014, he said.

The year 2013 came with a few surprises for private equity investors. The hotly anticipated initial public offering market in China failed to materialize, Mr. Drean said. The Chinese government abruptly shut down the prospect of an IPO market in November 2012, closing an exit route for private equity investments.

But that Chinese IPO market might launch in 2014. In December, China released guidelines, presaging the opening of the IPO market.

Another surprise was how quickly debt terms returned to the looser standards, just five years after the 2008 financial crisis. “Attractive terms such as getting "covenant lite' (loans without the typical agreements protecting the lender), payment-in-kind loans, where the borrower can defer the interest payments — those are back, which surprised a lot of people,” Mr. Mansukhani said.

It was a surprise “how short the memories are,” he said.