After virus-induced pause, M&A, fundraising to return

Private equity is expected to stage a comeback in 2021 from its pandemic-induced hiatus, with industry insiders predicting a return of mergers and acquisitions as well as fundraising to pre-COVID-19 levels.

Capital raised worldwide dropped by 19% to $542 billion in the first three quarters of 2020, while the number of funds fell by 28% to 754, according to a PE Pulse report by Ernst & Young LLP's private equity unit. Meanwhile, exits declined by 17% to $281 billion as of Sept. 30 compared with the same period a year earlier, mainly caused by a falloff in mergers and acquisitions, the report shows.

But while private equity fundraising and exit activity might have been down, many investors are not leaving the asset class and are waiting in the wings. At the same time, some private equity areas continue to suffer, but there will be sectors that are expected to thrive as a result of the pandemic.

PitchBook expects U.S. fundraising to bring in about $330 billion in 2021, surpassing the all- time high of $316.9 billion in 2019, according to its private equity outlook report. However, the high hopes could be dashed if vaccines are not widely administered and herd immunity not attained around the world in coming months.

Investors, particularly university endowments and health-care systems, "may pause new allocations to conserve cash," the report said. "Further economic carnage could drive investors away from risky assets, which would hamper new fundraising efforts."

Jason Thomas, Washington-based managing director and head of global research at The Carlyle Group Inc., said: "There's quite a bit of optimism around 2021; part of that is that it is not 2020."

Carlyle had $230 billion of assets under management as of Sept. 30.

More than a third of investors around the globe, 35%, expect to increase their private equity allocations in the next 12 months, 9% plan to decrease and the remainder anticipate keeping their allocations the same in the next 12 months, according to the latest biannual private equity limited partner survey by secondary market manager Coller Capital Ltd., released on Dec. 7.

At the same time, 70% of private equity investors surveyed anticipate annual returns of 11% to 15% over the next three to five years, and another 13% expect annual returns of 16% to 20% over that period, Coller Capital's survey showed. By comparison, U.S. private equity returns were 10.66% for the three years and 10.3% for the five years ended June 30, according to Cambridge Associates LLC's U.S. legacy private equity index. Global private equity produced an internal rate of return of 13.4% for the three years and 12.5% for the five years ended June 30, Preqin data shows.

"The only strategy where the majority of LPs see lower than 11% returns are fund of funds," said Paul Lanna, a partner in Coller Capital's New York office. "It surprised me that LPs are so bullish given the markets are not cheap and we still have a fair number of concerns in the world today."

Most investors, 90%, said there are many opportunities for careful investment by private equity managers in the months ahead, with 10% indicating private equity general partners should slow or pause their investment pace until the COVID-19 crisis is resolved.

Mr. Lanna said that he was surprised by this response.

"Considering that the financial markets are trading at all-time highs and we have a pandemic that is not controlled, I would have expected a more cautious response," he said.

A survey by placement agent Eaton Partners also showed continued interest in private equity by institutional investors.

Some 57% of limited partners surveyed said they expect to modestly or significantly increase their private market allocations, with 43% planning to make no changes. No respondents anticipate cutting allocations. Sixty-one limited partners responded to Eaton Partners' survey, which ran between Nov. 30 and Dec. 9.

Eric Deyle, a Rowayton, Conn.-based managing director at Eaton Partners, expects a rebound in fundraising for new private equity managers in 2021.

Emerging managers had a tough time last year raising capital for their first funds, he said. There was a "flight to the familiar" for most LPs.

"Most LPs were focused on shoring up their portfolios and backing established relationships," Mr. Deyle said. However, by the fourth quarter of 2020, investors had adapted to the remote environment, embracing technology and leaning on a trusted network of consultants and other LPs in lieu of in-person meetings with potential managers.

At the same time, institutional investors are looking for outperformance, he said. Most investors already have a stable roster of core general partner relationships. However, if LPs are looking to invest in the inefficient parts of the market, they may end up investing with a first-time fund.

Emerging managers "tend to be more nimble in market dislocations," Mr. Deyle said.

Overall, Mr. Deyle noted that private equity has more than $1 trillion in dry powder, which is capital that has yet to be invested or deployed, and that managers also have ready, available financing.

"This will drive competition for the best assets," he said. But none of these 2021 projections may come to pass if the pandemic persists, he said.

Matt Nord, New York-based senior partner and co-head of Apollo Global Management Inc.'s $76.8 billion private equity business, expects high valuations to persist in 2021, "particularly as the economy recovers with the rollout of vaccines."

"When you combine this with the industry's huge amount of available capital and some of the ongoing market uncertainty, we have seen some sponsors (private equity managers) pay big prices for assets, which often leads to overleveraging and a fundamentally worse risk-reward profile," Mr. Nord said in an email.

Apollo has a value orientation to buy companies at reasonable prices and not overlever its assets, he added.

Apollo executives, like others in the industry, expect to see a lot of mergers and acquisitions and, in particular, corporate carve-outs in which companies sell business units.

"With the rollout of vaccines and U.S. election complete, business leaders and boards should have more confidence and certainty to do deals, and there's a backlog of M&A activity that had been put on hold," Mr. Nord said.

COVID-19 has focused corporate boards "to get businesses in the best possible shape," he said. "We're seeing directors act with much greater urgency to divest non-core businesses."

Apollo executives expect more accretive acquisitions by its portfolio companies in 2021, Mr. Nord said. For example, portfolio companies in its 2013 $17.5 billion flagship private equity fund, Apollo Investment Fund VIII, have completed more than 90 follow-on transactions, representing more than $12 billion in total enterprise value.

"So, this is a core value creation strategy and one where we should see increased opportunity," Mr. Nord said.

But while valuations have been high, they are not overheated, Carlyle's Mr. Thomas said.

"Large private company or unicorn IPOs in 2020 have really shown that this is not the case," he said. "Valuations are high but valuations are high everywhere, with most of these businesses trading up sharply post-IPO."

A total of 23 private equity-backed companies went public in initial public offerings in the first three quarters of 2020, up from 20 during the same period in 2019, according to PricewaterhouseCoopers data.

On the lending side, Walter Owens, New York-based CEO of middle-market private credit manager Varagon Capital Partners, which has $13.4 billion in AUM, said he has seen valuations closing in on where they were before COVID-19 swept the globe.

"I'll caveat this by noting that our Q4 valuation process is ongoing so numbers aren't final, but on average, mark-to-market valuations have increased to near pre-pandemic levels, driven primarily by increased confidence around credit performance, but also by continued market spread tightening," Mr. Owens said.

But not all companies are getting private equity funding, said Lori Campana, Boston-based partner at placement agent Monument Group Inc. Some emerging hot sectors such as business-to-business, software, health care, e-commerce and long shelf life food products have seen more capital flowing to them, Ms. Campana said.

But in 2020, new investments were off the table for institutional investors unless it was with a "brand-name manager," she said.

Looking at the funds that closed in 2020 "almost tells the story of where investors see the opportunity," Ms. Campana said. For instance, in November, Goldman Sachs Alternative Investments closed a $10 billion fund to invest on the alternative investment secondary market, and in July, Blackstone Group Inc. closed its inaugural life sciences fund with $4.6 billion. In April, Clearlake Capital Group LP, which invests in technology, industrials, and consumer companies and is known for special situations investments as well as corporate carve-outs and buyouts, closed its sixth flagship fund. Clearlake Capital Partners VI closed with more than $7 billion in commitments and was oversubscribed.

The funds that were raised in 2020 were by managers that started raising funds early enough to do their first round of meetings with investors or by managers that didn't need many new investors.

This could change in 2021. Ms. Campana said she expects investors to make more new investments in 2021 rather than sit out another year and that by the second half of 2021, investors will be ready to invest with managers new to them.

While managers will be eager to spend some of the dry powder, it's an open question as to whether exits also will increase, she said.

"It is contingent on what happens with COVID and whether we get back to something like a more normalized business world," Ms. Campana said.

Not all companies are able to attract private equity capital — consumer and retail companies are among the hardest hit, unless the company has an e-commerce angle to it, said Manoj Mahenthiran, partner and U.S. private equity leader, private equity leader at PWC U.S. Even so, bankruptcies are not as high as you would expect them to be, Mr. Mahenthiran said.

"In 2007 to 2009, there were a lot more bankruptcies. That was more of a liquidity crisis," he said.

In this recession, there is so much capital chasing yield due to the lower interest rates around the world that this capital is buoying companies that might have otherwise filed for bankruptcy protection, Mr. Mahenthiran said.

"Any potentially distressed company is getting capital from a variety of sources including (special purpose acquisition companies)."

Meanwhile, private equity firms are focusing on trying to figure out a data strategy for each of their portfolio companies to improve their earnings, he said.

"If you buy at a high price, you have to improve the company," he said. In the past, a data strategy was nice to have, but now it is critical because portfolio companies have to improve their earnings, Mr. Mahenthiran said.