A bad vintage – what is happening with the 2020/2021 PE-backed buyout class in Europe?

[Music] Hello and welcome to DealCast, the M&A podcast from Merge Market. I'm Julie Ananidim. Now it's one of the most pressing issues facing European private equity. What is happening with the 2020 to 2021 buyout vintage? Deals done during that time were done at peak valuations and with cheap debt. Well Merge Market has crunched the numbers and here to tell us more about that research is Rachel Lewis who's the co-head of News in Europe for Merge Market. [Music] Hi, Rachel. Thanks very much for joining me. Hi, Julie Ananidim. It's great to be back on the podcast. So, can we start with a bit of scene setting? What does the data show for the number of deals that were done by private equity firms in the period 2020 to 2021? Sure, I think to answer that question really, we need to take a little bit of a step back. I've been really interested in these buyout years for a long time. Not only, you know, it was a super fun time to be an M&A reporter, but it was a very busy period. You know, it was the busiest year ever for M&A. And just to give you an idea really of how much so sponsor, entrances that year in Europe, totaled just shy of 300 billion. And to put that into perspective, the year, the highest year before that was 2018, virtually half, 176 billion euros. So, what that means today, and I was actually reading some further research on this yesterday from Hamilton Lane, is that these years, the 2020-21, Hamilton Lane actually takes 2022 as well. They form actually about 40% of current NAV. So, nearly half the underlying value of all private equity funds at the moment. And we know that that was a year where people were buying at the top of the market. They were deploying very fast, very fast, very hard. So, all of this coupled with those high entry prices means that those assets are now starting to enter the typical divestment period. And are going to have to be realised. So, to go back to your original question, look to buy-outs from the period of which we looked at around 1,600 deals and mapped out their status. This has been a huge data project that I've been working on for the past few months. There are so many takeaways from this data. I'm going to try not to reel them off too many statistics at once. But the first, which I found quite astounding and speaks as much to the state of the equity capital markets of anything else, is that we've seen more companies from that period seed control to their lenders than have gone public. It's just quite a catchy statistic off the bat. Two-thirds of that whole class are unrealised, which is perhaps not that unsurprising considering that we are at the start of the divestment window. But considering there's been so much pressure which we'll talk about to make sure that distributions are returned, those thirds that have been able to get away so far are likely the best in class which kind of leaves big questions over what will happen to this remaining two-thirds. Okay, and we will try and include a link to your data report in the show notes. So, if anyone's interested in reading more and getting into the numbers, there will be a link to that in the show notes. Rachel, could you just briefly touch on the conditions that meant that it was a great time to buy assets in the year 2020 to 2021? Sure, and you know, this is not going to surprise anyone listening, but just to put it into some data. So, media and the EBITDA multiples hit a peak of around 17 times in late 2021. So, it was fueled by incredibly high competition for assets coming out of the pandemic and cheap debt. Buyers and lenders were a lot less risk off, particularly when it came to things like EBITDA adjustments where the growth story was around significant buy and build. But now we're coming into a period where actually a lot of those growth plans have been difficult to achieve. So, it's on average probably taken a lot of companies three years, at least to grow into the initial valuations that they were bought at back in those periods. Okay, and we're going to have a look at 2026 in a moment, but could you just briefly touch on the wider trend of how the market was evolving perhaps before this year? So, the market still hasn't really recovered from the dip that started in 2022, and I will give some quick figures for this year. So, I checked the data this morning and sponsor exits by count are down 20% in the year to date, and that is on a year that was already down, that was already down, that was already down. So, not to say we haven't seen some pretty sizable exits in good sectors so far, so partners group sold at North to see people, he investments and equinix for around about $4 billion US dollars. That's in the data center sector. I don't need to tell anyone why data centers are important right now. We also saw Pamirra and Warburg Pinkers exit Eveline partners to nap west in the wealth management space for around about 2.7 billion sterling. Again, wealth management is important, sponsors are increasingly looking to wealth for their next capital pool, and I think this is what I'm trying to get at here. The market is characterised by bifurcation. There are outliers across all segments that will get deals done at a high price and relatively quickly, but there is a really big pool of exits that will languish a little bit more and really struggle to find the necessary price to to generate the necessary returns. Okay, and so turning our attention to this year, could you talk through what the Merge market data shows without perhaps including too many statistics, but what did it show for the pipeline or logjam for this year? I think this is a really hard question to answer right now. So my job really is to make sure that Merge market is reporting on all of the deals happening in the market. I lead our private market practice here. And the market does feel busy. So since the beginning of the year, we've added, I'd say over 300 new deals in Europe to our pipeline at the pre-launch or the early stage, and then we've got over 300 that are currently live as well. But in terms of things that are progressing at the speed which they would or they should, it does feel a little bit weak. And if we talk about the wider geopolitical crisis, everything is in a position of flux at the moment. We've had the big AI sell off recently in markets and it definitely seems that people are being more risk off at the moment. People are being cautious with what they take into their IC. They're being cautious at where they're positioning. But I'd also like to just use this question to be back to the original data set as well, because I think it's important to look at exactly where sponsors have been able to exit. So just from that period of those companies bought in 2020, 2021. So of the full exits from the period to break it down by type of exit, 37% went to another sponsor, 36% to a strategic, so not much difference between those. We have seen 13% to a sponsor backed platform, and I think that's an important distinction to make because it's strategic work in on its own versus with another private equity fund, 6% to a continuation fund and IPOs are a rounding error. We've seen six successful IPOs from the vintage so far, which I really think speaks to evidence to, as I said earlier, the state of the equity capital markets, the move we're seeing towards longer trends of pools of capital continuation fund. But just to quickly round up some of the big exits in the pipeline as well, so I know that's probably what people are listening for. We've got EQT coming up this year, Sousa, which is actually a company which it owned and then took private again, and now is selling again. And then we've got icon infrastructure selling eco-eridania, which is in the waste management space, both of those large capacitors. So again, it comes back to that bifurcation. What sectors, what assets can you get deals away in this market? And you mentioned IPOs. We're going to come onto that in a moment, but looking at the valuation challenge, how a GP's bridging the valuation gap between the carry value and what a buyer is prepared to pay for the assets. So this has been the biggest problem in M&A over the past three years. People just haven't been able to some mount that valuation gap. And if you look at the maths right, let's keep it simple. So if you haven't been able to rely on multiple expansion to hit the enterprise value that you were aiming for, then you have to make sure that you've grown a bit, right? It's just the other number on the other side of the equation. And that's why we've seen such a focus on value creation in recent years. So that's really the first port of course, you know, 15% is the new 5% and by that I mean that you now have to be growing at 15% every year as a company to hit a 20% IRR which is kind of the standard benchmark in the industry. And if you're still seeking 17, 18 times multiple, then growth needs to be above that even. Now look at the economy that we're in, right? You know, UK GDP is expected to grow 1% in 2026. You're a zone by 1.1% inflation, oil prices influx. Supply chain stocks seemingly a new wall every quarter. It feels all but impossible for all but a really small pool of companies essentially. So now to come back to your original question, which is how do we bridge that gap if we haven't been able to achieve the underlying growth to get there in the first place? I think this is a really interesting point in the market because we're seeing new terms come in to deals all the time. So vendor rollover has been a big one, which means that we're seeing the seller committing some capital to reinvest at the new valuation, which means the buyer has to put in less equity. It potentially has to seek less debt on that side of the deal. We see an earn-ups, which means that part of the purchase price is paid later only if certain performance targets are met. And I'm, you know, I was speaking to a lawyer recently who's told me that he hasn't worked on a deal in the past 12 months. That hasn't had some kind of negotiation like this baked into the terms. And I think that's that's so important really to get in exits done in this market. IPOs, you mentioned there were six from that vintage 2020 to 2021. It feels like an incredibly difficult time yet again to do an IPO. The popularity of capital markets or public markets has gone down significantly. It's kind of propped up by those big tech stocks in the US. And then in the last 10 days we've had a war starting in the Middle East. Are IPOs off the table as an exit option? No, but only for specific businesses. I think the main beneficiary of this weird IPO window has been defense companies, which you know speaks to itself in why people are investing in these kinds of businesses right now. So just in the past week, we recently saw Gabla close and Vin Corey and launch both in front of a big huge defense IPOs. Visma has been probably the one big tech IPO that everyone has been waiting for that launch is now pushed in light of the recent tech and AI sell off. I think one interesting thing to know is at the beginning of the year, it really seemed like dual track was back. So a lot of the big exits would be running both an M&A track and an IPO track at the same time. What we have witnessed when we've been reporting on, and this is quite quite new really over the past couple of months, past few weeks even is that people are now really opt in to take the M&A route. Alström is one of the big ones is a big special team materials group owned by Bane had been expected to launch a dual track. It seems that they're likely to launch an M&A track, hopefully in the second quarter. And if that doesn't succeed, then they will look to run an IPO. So rather than going dual track simultaneously, it looks like we're in a market where we'll go M&A track first, then IPO for M&A track doesn't work out. So you know IPO window is narrow is close to most companies, but we are still seeing certain breakaway successes. Yeah, and things in the geopolitical space and macro are changing very fast as we keep seeing. But given all of that, the valuation challenge harder to get returns, the very limited opportunities for IPOs apart from the defence companies, could you talk about how GPs are kind of facing these challenges? And if there are any kind of more creative or innovative solutions and perhaps where continuation vehicles fit into that? Yeah, so the second year's market has been a huge tool of liquidity in this period. And just to go back to the 2021 period, I think it's quite interesting that we've seen 29 continuation funds from this data set. And especially because so continuation funds used to be a tool for when you got to the end of your divestment cycle and you hadn't managed to sell all of them, you almost like a fund restructuring tool. Now to have so many continuation funds when we're only just entering the divestment period is a really interesting dynamic. And that goes back to the pressure for realisation. So if you're a sponsor, you need to return some capital to your LPs, you take your best performing asset, you put it into a continuation fund, and then you manage to get some capital back for your LPs. So what I think the worrying thing is and this comes back hugely to the pressures that we're seeing on the 2020-21 vintage is that we've known for a long time that the bulk of fund returns, the best fund returns are made from outlying returns on one or two sales from that fund. That's where the majority of the distributions and the best returns have come from. If you're selling your best asset too quickly and put it into a continuation fund, you'll ultimately have the potential to damage your overall fund returns. And I think again to come back to why this 2020-21 period is so worrying is if you've sold your best asset and the rest of it is difficult to sell, that is really going to impact your long term IRR. Maybe not so much your DPI, I know everyone says these days that DPI is the new IRR, but IRR still matters according to a lot of the LPs that I've spoken to. And I think for a while people haven't known that this is going to be a bad vintage. It just really depends over the next few years quite how bad that is and depends on how exposed to certain sectors, these different funds and this class of assets is. Okay, and your research shows that a quarter of the investments from 2020 and 2021 had targets in the tech sector. Could you talk about in a bit more detail about that bifurcation in the exit market where you've got a separation with the high quality software assets, which is still very much in demand and then other assets. Well, I'm going to be honest, I don't know if those high tech quality tech assets are in demand at the moment. You know, anything from enterprise software, anything that is impacted has the potential to see entire business models are obliterated by AI at the moment is really in question. And we're just we're seeing real people taking real risk off moments on the tech space at the moment, even in this high quality software. It feels very fickle, you know, again, five years ago software was so in demand people were paying 20, 25 times a bit. I was speaking to someone recently who's telling me that they were looking at a large capital in the space with a possible entry valuation of eight times. That is such a huge cut from valuations that came in before and I'm just still not really sure where this sector is going to shake out. I think people aren't even bothering to take these kinds of deals to their investment committees at the moment. So bifurcation is is a difficult word to apply for it because actually I think what people are doing is almost the opposite of bifurcation people are lumping all tech and software into one bucket at the moment. And it's really hard to see anyone breaking out of that even if their business isn't actually impacted that much by AI. Thank you and looking at exits in other sectors. Could you talk through any notable sectors as mentioned things are changing pretty quickly, the conflict in the Middle East good for defense, but potentially bad or good for energy. It's energy, you know, difficult. I think we're and again, I keep calling the market fickle, but it is we've seen people really trying to scope for anything which is unaffected by AI. We've had a bit of a long standing joke inside the market for a news newsroom for a long a long time about widget makers, but someone genuinely mentioned to me recently that they were. They were looking to buy widget makers because you know it's it's a sector which is unlikely to be impacted so industrial. really big at the moment. Some certain kinds of chemicals, again, are source brought up recently. They would be in, you know, I don't want to be the guy or woman selling laundry detergent, but I do want to be the person who's selling the active ingredient in laundry detergent because that's going to be an impacted by pricing pressures. Something that people will always need. And it's really looking at those long-term sectoral trends, which everyone says they're doing anyway, but it's one of those things where not everyone will do it. Well, aging population, circular economy, energy, natural resources, anything which speaks to the long-term needs of the human race, essentially. And again, it goes back to people, people trading at the moment, with a very short-term vision, but some people trying to trade towards longer trends. And yeah, well, I guess we'll wait and see who the winners are in another few years. And talking about timing, could you perhaps finish off by talking about the pressure that LPs are putting on GPs for distributions because they want their money back. It's four to five years since they've invested. They want their money back. Yeah, absolutely. I mean, I think poverty whole periods have been increasing for a while anyway. We're now at probably about an average of seven. DPI distribution-depaling capital, your distributions is one of the most important metrics in private, at the moment. Distributions have been squeezed for a long time. It's preventing LPs from being able to reinvest, to reinvest in different new managers. We've seen huge rise at, well, LPs seconders have existed for a long time, but we've seen a certain proliferation to get LPs back. But that's kind of aside from the point. I think really when we think about the market right now, it is really getting to crunch time. And people have been saying this for years, that managers need to prove that they can return capital sustainably and on an ongoing basis, particularly at a time when LPs are really trying to consolidate their manager relationships and thinking seriously about who they reinvest with. Managers have to start delivering. You know, to go back to the question of can an LP forgive a bad vintage if 2020-21 turns out to be as bad as we expected, I actually asked quite a few LPs this. And the answer was surprisingly unanimous, you know, it was, okay, yes, we can forgive it, but it depends how honest the GP with us was with us in the first place about how much we expect to deliver. They've overpromised and under-delivered the subsequent ventures, then we have to seriously rethink that relationship. If they were honest with us about, okay, this is what we invest in, these are our returns and have more consistently delivered, then that's okay. So it's an important time. Some people are going to be stunned. Some people will succeed. Yes, as I said, we just have to wait and see. You mentioned the approach and LPs are willing to forgive one bad vintage, but will this period change the approach of private equity in the future and potentially change the structure of the markets? I think it already has to a certain extent, because I think the thing that people often forget about when talking about everything, the valuation gap, bad vintage is that people sit on both sides of the table, their buyers and their sellers, so they experience the market from both sides. People know that they hold large portfolios, bought in this period at high valuations that they now might struggle to sell to get the return that they need. People now are being a lot more disciplined in terms of deployment. They're really thinking, okay, if I am going to pay 17 times for this company, really does it justify it, have I priced this deal correctly, which is quite surprising to me, because so much of the competition, the reason we saw this period come in 2021, is coming out of that COVID period where they couldn't buy anything because the markets were closed. Now we're coming out of a period which is still difficult, but it's not like everyone is rushing in. People are being cautious, disciplined on deployment, focusing on that valuation creation, and I think that's really going to differentiate and pull out kind of the top and bottom quartile performers over the next few years. Rachel, wise words to end on, great to talk to you, thank you. That was Rachel Lewis, co-head of News in Europe Performer, Jamanket, and just to mention we're recording this on Tuesday, the 10th of March. Thanks for listening to this episode of Dealcast, I'm Julianna Needham. For more information about this episode, including a link to Rachel's report, please see the show notes. Join us again next week. (upbeat music)