We believe the private equity market should continue to experience strong activity in 2016, but with changing dynamics as public market volatility and regulation exert an influence.
Buyouts: Multiple Forces Point to an Active Year
In 2016, we believe that buyout activity should remain robust as private equity firms appear to have significant dry powder to complete new deals and the economy is showing sustained, moderate growth. After a period of aggressive underwriting by debt providers, market volatility, increased regulatory oversight and the prospect of rising interest rates have tightened credit conditions. As transaction financing becomes more difficult to obtain, we believe valuation multiples will moderate from the elevated (but below pre-crisis peak) levels of recent months. Moreover, we think companies are likely to carry more conservative capital structures. Overall, however, valuations at their current levels are still high, and we believe that, for 2016, managers who rely less on financial engineering and possess sector or industry expertise could outperform--specifically those who focus on increasing earnings through operational changes, cost structure improvements and acquisition growth. Elsewhere, we believe distressed sectors such as energy could see significant activity as established companies seek required equity funding or dispose of assets to raise capital.
Buyout Volume Remains Strong
PE Buyout and Leveraged Loan Volume ($BN) 1
Source: S&P Leveraged Buyout Quarterly Review, LCD Q3 2015 Quarterly Leveraged Lending Review. EU volume converted at average FX rate during period.
Special Situations: Turnaround and Distressed Debt Opportunities on the Rise
Special situations encompass a variety of equity and debt strategies, including operational turnaround investments, distressed debt purchases and distressed asset purchases. Over the past few years, a combination of low interest rates, moderate economic growth, limited volatility and low default rates have contributed to a relatively muted opportunity set for distressed debt investors. Recently, however, a number of factors have contributed to higher volatility and the potential for greater distressed opportunities. These include the sharp decline of commodity prices, the associated dislocation in the energy sector and related industries, the potential for slower economic growth, uncertain global monetary policy, concerns over market liquidity, global terrorism and complex geopolitical issues. Notably, the amount of bonds trading below 50 cents on the dollar is now greater than $100 billion based on total face amount, and the dollar amount of "fallen angels" (companies that have moved from investment grade to junk status) year-to-date through November is more than in 2012, 2013 and 2014 combined. Weaker credits continue to be punished in the market and it has become more difficult for those issuers to refinance as a way of "kicking the can down the road." In addition, distressed financial assets continue to be traded, particularly in Europe, where banks are de-levering-a process that will likely continue for a number of years. Finally, operational turnaround prospects remain strong and represent an ongoing opportunity driven by individual cases of poor company management.
Venture/Growth Equity: Search for Stability
2015 has been the year of the "private IPO" in venture capital. As of November 2015, there are over 130 private, VC-backed companies valued at over $1 billion, including more than 20 companies valued at over $5 billion. 2 Many of these companies raised over $100 million of equity capital in their most recent financings. 3 In part due to these large private financings, technology IPO numbers are down in 2015. Participants in late-stage private financings have often included large, long-only equity platforms; this has negatively impacted those public offerings by reducing demand from potential large buyers who already hold equity in the relevant companies. Conversely, merger and acquisition exits from venture capital have continued at a reasonable pace, which may suggest that a strategy built around these exits could be less volatile over time.
Looking at the environment for new investments, late-stage VC companies' valuations have soared in recent years and, as a group, appear to be excessive. It should be noted that late-stage financing rounds often include complex terms that provide significant downside protection and, as a result, earlier investors are subordinated to the late-stage capital raised at huge headline values. However, we believe the noise and media attention around these companies give a somewhat misleading impression of the overall venture capital environment. In our view, the earlier stages of venture have more moderate valuation and fundraising levels.
Overall, we believe early-stage venture capital and growth equity could be relatively stable through cycles and we view them as attractive areas to deploy capital in 2016.
Secondaries: Growing Force in Private Equity
In our view, the strong activity in the private equity secondary market seen over the past several years should continue in 2016. Recent growth drivers, namely the expansion of the universe of sellers, changing regulations, more active portfolio management and the growth in private equity generally are, in our opinion, sustainable, long-term trends that we believe will continue to drive supply over time.
In addition, the secondary market continues to grow in sophistication and, today, offers what we believe are creative and customized liquidity solutions to both limited partners and general partners globally. As the private equity asset class matures, one trend that we believe will continue is the secondary market's ability to provide viable solutions for mature, end-of-life private equity funds where limited partners want liquidity but their interests are not necessarily well aligned with those of the general partner.
The secondary market can be volatile and has demonstrated a tendency to change quickly in response to public market conditions and distribution activity from underlying portfolios. In our opinion, such rapidly evolving market conditions can provide attractive opportunities for value-oriented buyers and sellers who have an understanding of the underlying fundamentals and are well positioned to capitalize on potential market dislocations.
Secondary Market Transaction Volume Remains Healthy
Secondary Transaction Volume ($BN)
Source: Cogent. Estimated secondary transaction volume is based on Neuberger Berman estimates. Estimates may not be realized.
Changing Formula, Same Appeal
Private equity, in our view, remains an appealing asset class for 2016, with the potential to generate attractive returns with low correlations to other investments. Trends that could slow buyout activity could also make for more attractive valuations, while the gradual approach of a new distressed cycle could provide more opportunities and the still-moderate pricing of early venture and growth equity offers appealing risk/reward prospects. The growth of the secondary market, meanwhile, points to continued demand for private equity but with greater flexibility tied to reduced lock-up periods and ready liquidity. As we assess the shifting appeal of these areas, we believe the broad range of investments available in the asset class will provide ample opportunities for investors in the coming year.
1 Source: JP Morgan Credit Strategy Weekly Update, as of November 13, 2015.
2 Source: The Billion Dollar Startup Club, as of November 2015. Wall Street Journal, Dow Jones VentureSource.
3 Source: Venture Capital Journal News.
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