There's no doubt that M&A market activity has shifted down a gear in 2019, and private equity is no exception. That extends to exit activity. Across the three different types of exits—IPOs, secondary buyouts (PE to PE sales) and trade sales—it is secondaries that have declined most steeply by value, falling 24% to US$85.8 billion year on year in the first three quarters of 2019.
IPOs find themselves in the middle. There were 128 listings in the nine months up to the end of September 2019 of companies backed by private equity or venture capital. Those listings were worth a combined US$260.9 billion in market cap at their offering, 20% down on the first three quarters of 2018, and down a full 35% by volume.
Which leaves just trade sales. This exit route has fared the best, registering not only the highest value (US$267.4 billion) but also the smallest year-on-year decline (18%).
The PE cycle turns
It might be expected that, taken as a whole, exits would trend down after an abundant multi-year sellers' market. Few asset classes have benefited as much as private equity from years of low interest rates, which has made the equity-enhancing qualities of leveraged financing attractive.
According to the American Investment Council, an industry association, US PE firms delivered a horizon IRR (internal rate of return) of 15.9% over the three years to the end of Q1 2019, compared to 13.5% for the S&P 500 (including dividends).
The strong rate of return compared to other asset classes explains the continued health of PE fundraising. Last year, according to Preqin, PEs raised US$426 billion in capital globally. While this is lower than the total closed in 2018 and 2017, it is still a robust figure by historical standards, and even more so when one considers that PE still has around US$1.2 trillion in dry powder unused.
So why might trade sales be faring better than IPOs, and IPOs better than secondary sales?
One explanation is the nature of the bid-ask spread in these different pockets—exacerbated by the high levels of capital available to PE.
Financial sponsors are canny buyers and sellers. They push for the lowest possible entry values and highest possible exit values. In today's environment, facing the prospect of economic headwinds and lower earnings, it can be difficult for parties in sponsor-to-sponsor deals to meet in the middle.
On the buy-side, the weight of dry powder in the system means that private market valuations as a whole are becoming a hindrance. An analysis by Bain & Co shows that multiples in public markets have begun to trend lower than private market multiples, even accounting for the take-private premium.
In 2005 there were 58 US public companies with an enterprise value between US$2 billion and US$10 billion that could be purchased for a multiple plus a take-private premium that was lower than the average private-market multiple, representing little more than 1% of the US stock market. By 2018, that figure had more than tripled to 183 such take-private prospects, nearly 4% of the stock market. A natural consequence of this has been more take-private activity and fewer PE-to-PE deals.
IPOs have definitive advantages for PEs when times are good. A rising tide in public equities allows sponsors to cash out piece by piece, dollar cost averaging their return upwards. Of course, the opposite is also true. Concern over potential volatility in equities makes this route less attractive as sponsors face lock-up periods during which markets may face a correction.
The number of examples of underperforming private equity and venture capital IPOs are also stacking up considerably. The largest IPO of the year, Uber, is trading around 30% below its offering price, and the story is similar for other prominent sponsor-backed IPOs including Lyft, SmileDirectClub, and Chewy. BeyondMeat, which listed at an offer price of US$25 per share, began trading at US$65.75 the next day and reached a peak of US$234.90 per share in July, has now fallen back to US$84.19 per share.
Investors appear to be shying away from growth stocks which have small or even negative margins. In many cases, these companies, particularly those with a tech angle, have achieved eye-watering valuations in successively larger funding rounds in the private markets.
Where VCs have rewarded growth of users, market share and the promise of future profits, public market investors appear to be taking a more conservative approach, opting at this stage in the market cycle to buy exposure to earnings, not earnings potential. This again speaks to the valuation disconnect between public and private markets, where highly capitalized funds have bid up the valuation of assets to highs that investors in the public sphere are now finding difficult to justify.
While still down year on year, selling to a strategic buyer is holding up better as an exit route for PEs. One advantage of selling to corporations is that, unlike IPOs, they offer PEs a clean break. And it is typically easier for corporate bidders and PE vendors to meet in the middle on price as, unlike financial sponsors in secondary buyouts, strategic buyers can pay higher prices as they factor in synergies, post-integration. This helps to explain the recent favorable bias towards trade exits, especially for companies acquired at full valuations in the last five-year sellers' market. In general, corporations simply pay more for assets than PEs do.
Another factor conducive to trade sales is the upward march of the stock market. The S&P 500 has gained more than 50% over the past five years. In order to justify relatively high valuations, there is an onus on corporations to deliver commensurate growth in earnings. Buying this in via M&A, in some cases acquiring it from PE, is one means to achieve this. And with valuable shares, corporations have the means to do so.
Opportunities in a downturn
It is likely that the market is now past the peak of the cycle. Given the strengths of fundraising and its high levels of dry powder, PE has never been better equipped to transact, and any softening in the economy could play into funds' hands. Downward pressure on earnings and earnings multiples would create an opportunity for private equity to buy at relatively attractive valuations after years of multiple appreciation.
If indeed economic growth does stall significantly, we might expect healthy private equity deal volume (even if deal value does not rise) as funds put record sums of dry powder in the ground. Just don’t expect secondary buyouts to be the preferred exit option for sponsors in such a scenario.