2017 Private Equity Market Outlook - TorreyCove · received wisdom, did not collapse. In fact, US equity markets reached new heights in the month since the election. Perhaps this

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2017 Private Equity Market Outlook

Table of Contents

3 A Macroeconomic Overview

10 Tactical Summary

Buyouts

10 North America Buyouts

15 Europe Buyouts

Special Situations

20 Distressed Debt

25 Mezzanine

29 Secondaries

33 Venture Capital

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from TorreyCove Capital Partners. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding whether any investment is appropriate, nor a solicitation of any type. The general information contained herein should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Generally, alternative investments involve a high degree of risk, including potential loss of principal, can be highly illiquid and can charge higher fees than other investments. Private equity investments are generally not subject to the same regulatory requirements as registered investment options. Past performance may not be indicative of future results.

2017 Outlook

© 2017 TorreyCove Capital Partners | 3

Macroeconomic Overview A Brief Tour of the Globe

US Prospects Improve …

Certainly one of the most impactful occurrences in the US in 2016 was the election of Donald Trump as the 45th President of the United States. Time Magazine’s ‘Man of the Year’ surprised the country (and the world) by pulling off one of the most unlikely upsets in modern American politics, defeating Hillary Clinton by capturing states previously thought to be safely in her column. The next surprise came when the financial markets, once again contrary to received wisdom, did not collapse. In fact, US equity markets reached new heights in the month since the election. Perhaps this should not be too shocking, as many of Trump’s campaign promises bode well for stronger top‐line growth in the US economy over the next few years. These include a reduction in the regulatory burden, more business‐friendly policies, tax reform, and of course the vaunted fiscal stimulus, courtesy of a promised large‐scale infrastructure investment program. It is an open question as to how much of this agenda will actually come to fruition; however, the markets continue to exhibit a renewed confidence. As a result, GDP estimates for 2017 have been revised upward, with the consensus expectation for 2017 above 2.5% and approaching 3% for the year. Along with the good comes the not‐so‐good, which in this case means higher expected inflation (see graph)

Source: Cleveland Fed

US Expected Inflation

Equity Markets Climb Expectations for Higher Growth… but with Higher Inflation

0.00%0.20%0.40%0.60%0.80%1.00%1.20%1.40%1.60%1.80%2.00%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1 Year Expected Inflation 5 year Expected Inflation

2017 Outlook

resulting from the dual impact of fiscal stimulus and a more restrictive posture on trade. Overall, the macroeconomic prospects for the US appear rosier than they have in years (or even what was expected just a few months ago), primarily due to the increased likelihood of fiscal stimulus, increased business investment, and the unleashing of animal spirits as regulation goes into hiatus for a time. There will be headwinds as well. Rising interest rates will be the most visible, but the general level of uncertainty associated with a new, untested, and unpredictable administration will keep things volatile, and may provide a countervailing force to the largely more positive investment environment.

…While Europe Muddles Through

The EU continues to lurch from relative calm to disruption on an intermittent basis, though 2016 did not present any challenges of the existential variety. However, the big event, Brexit, sent shockwaves across the Continent and led to fears of populist contagion upending the established order. After a short‐lived flurry of market panic and insult‐hurling across the Channel, things calmed down considerably, as both sides wait for the real negotiations to begin once the UK formally gives notice that it will leave the EU. The ultimate outcome – hard or soft Brexit – and its impact on the EU and UK are more or less unknowable at this point, but it is clearly one of many uncertainties that continue to weigh on confidence in the European theater. So far, test votes in Spain and Austria have quelled the fears of the establishment‐


A Macroeconomic Overview

Rates Set to Move Up, but How Fast? Political Risk Intensifies

1.2

1.25

1.3

1.35

1.4

1.45

1.5

1.55

1‐Jan 31‐Jan 1‐Mar 31‐Mar 30‐Apr 30‐May 29‐Jun 29‐Jul 28‐Aug

GBP:USD Equity 2016

Historical Rates GBP:USD

Source: Bloomberg

2017 Outlook


arians to some degree, but the first big test ‐ the upcoming French presidential ballot – is yet to come in the first half of 2017. That contest may end up pitting the controversial populist Marine Le Pen against a more conventional candidate. Perhaps the biggest story of all centers on Italy, which is in the midst of a political crisis (not too unusual) after voters decisively defeated a proposed reform package put forth by once‐popular PM Matteo Renzi. Seen by some as yet another rebuke of the Europhile elites, it appears more likely that the vote was more simply a personal repudiation of Renzi coupled with a desire to maintain, for better or worse, a central government with strong checks and balances and the resultant highly circumscribed freedom of action. However, it may turn out that the election will be seen as a sideshow, as the sorry condition of Italy’s banks takes center stage. The headline is the meltdown of Italy’s third largest bank, Banca Monte dei Paschi di Siena (“MPS”), which is underwater and under the gun to raise about €5 billion just to stay afloat. But MPS is just the harbinger of a crisis within the larger Italian banking sector, which holds an estimated €360 billion of non‐performing loans (about 18% of total bank loans). With system‐wide capital of about €225 billion, the banking sector will require a massive bailout to get back on its feet. This is against a backdrop of poor‐to‐negative Italian GDP growth since the crisis and a continuously gridlocked government. This is immensely complicated by EU rules that make national bailouts of the banking system difficult; therefore, the entire matter will play out in the negotiations between the Italy, the EU, and the ECB, probably in 2017. Against this background, EU growth remains sluggish, with a projected GDP increase of 1.6% next year for the EU (1.5% for the Eurozone), rising to 1.8% in 2018 (1.7% in Eurozone). Inflation looks to be picking up, but is expected to undershoot the ECB’s target in both years The ECB has maintained QE, but will begin to scale back its monthly purchase volumes in April 2017.


Italian Bad Debt : Companies vs. Households

0

50

100

150

200Companies Households

Source: Thomson Reuters

Italian Banks are a Time Bomb Another Year of Growth, But Nothing Too Exciting

2017 Outlook

Another Year of Uncertainty over China

In Asia, the main story, as always, is China. If the latest numbers are to be believed (real GDP growth of about 6.7%, in line with the government’s target), the PRC is managing a “soft landing” as its growth shifts downward and it repositions its economy from a capital investment/export‐led to a consumer‐driven model. Further, consumer demand continues to grow at a healthy pace, as suggested by growth in retail sales of nearly 11% for the month of September 2016. Industrial production, though somewhat soft at around 6% growth per year, has at least stabilized around that number in 2016. An alternative view points to the mountains of debt (recently standing at around 250% of GDP) the economy has taken on in the years since the crisis to fund massive fixed investment in order to propel high economic growth. Perhaps of more concern is the indication that a good chunk of last year’s growth was the result of substantial fiscal stimulus combined with even more debt‐fueled fixed investments, suggesting that the country’s economic “handlers” are either unable, or more likely, unwilling to effect the desired shift from investment to consumption, in part due to the economic and political disruption attending such a massive shift. Large imbalances have built up in the system, causing major outflows of capital for much of last year as well as a bubble in real estate markets (particularly in first tier cities), both of which the government is attempting to manage. Overall, investors remain wary of China due to the high level of uncertainty; therefore, capital deployment to the country continues to be more restrained than in prior years. Elsewhere in the region, the Philippines posted a solid three quarters of growth in 2016



Chinese Debt to GDP

23 42 55 7 24

65 83

72

125

8

20

38

2000 2007 2Q14

Government Financial InstitutionsNon‐Financial Corporate Households

By country, 2Q14

Total debt 2.1 7.4 28.2 $ trillion

Debt-to-GDP ratio %

China

121

158

282

NOTE: Numbers may not add up due to rounding SOURCE: MGI Country Debt database; Mckinsey Global Institute Analysis

55

44

31

89

80

70

65

56

61

36

70

25

125

105

69

67

54

60

38

81

113

77

54

92

China

South Korea

Australia

United States

Germany

Canada247

258

269

274

286

282

China Slows, But How Much? Unheard-Of Debt Growth

2017 Outlook

(GDP growth of about 7%), but ended the year on a more uncertain note due to the geopolitical issues that have followed in the wake of the country’s new leader, President Rodrigo Duterte, along with unrelated pressures arising from the strengthening of the dollar, rising US interest rates, and the prospect of a more protectionist stance coming from America.

Japan continues to linger in a deflationary mode, despite consistent fiscal stimulus and a seemingly permanent accommodative monetary policy. Each quarter saw successively lower growth in GDP, with the third quarter turning in an annualized growth figure of 1.3%. Though the Japanese economy will turn in positive growth for 2016, the weakness in domestic consumption continues to cast doubt on the sustainability of these gains.

Challenging Times for Latin America’s Two Largest Economies

In Latin America, the major story is Brazil’s continuing fight to return to positive growth territory after two years of deep recession, a contraction in GDP of just under 4% for 2015 and a projected decline of over 3% for 2016. Recent projections from a survey of Brazilian economists put 2017 GDP at just over 1%. Though the situation appears bleak, a more optimistic case suggests that the economy may have bottomed. Though not robust, consumer confidence has stabilized, while the central bank’s lowering of interest rates (Selic) may provide some stimulus via encouragement of commercial and consumer borrowing. Finally, the possibility of economic reforms under the Temer government holds some promise for


© 2017 TorreyCove Capital Partners | 7 Source: IBGE

Brazilian GDP Growth Change by Quarter

‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

Japan Lingers

Brazil Struggles to Come Back

2017 Outlook

unfettering the large untapped capacity within the Brazilian economy, though it is too early to tell if these will be implemented and/or effective.

The region’s second largest economy, Mexico, took hits from two directions after the election of Donald Trump. Dollar‐strengthening and rising interest rates in the US put pressure on the peso, which moved from around 18 to the dollar right before the US election, to a recent mark of 21.5 to the dollar on the back of Trump’s jawboning of US auto manufacturers to forgo moving production to Mexico. The possibility of a major renegotiation of the NAFTA treaty and other proposed changes to trade relations between the two countries will continue to exert downward pressure on the peso and could dampen Mexico’s GDP, as it does the lion’s share of its trade (80%) with the US. Mexico’s expected 2016 GDP of 2.0% to 2.6% was already somewhat muted by developing country standards. For 2017, projections currently remain in the same range, but the eventual outcome will partially depend on the interplay between US trade policy and economic growth. The former is uncertain and likely negative while the latter appears poised to accelerate, which would normally provide a boost to the Mexican economy.



Tough Days for Mexico

Tactical Summary

North America Buyouts > page 8

12- to 18-month commitment

outlook >

SMALL ($500 Million and Below) and MIDDLE MARKET ($500 Million to $5 Billion) Favorable: Continued supply of low‐cost credit, higher GDP growth expectations in US, steady M&A flow, expected US policy shift in favor of domestic production and sourcing Unfavorable: High levels of dry powder, rising interest rates, stretched debt and purchase multiples in the upper‐middle market

M O D E R A T E O V E R W E I G H T

LARGE ($5 Billion and Over) Favorable: Continued supply of low‐cost credit, higher GDP growth expectations in US, steady M&A flow, disruptive US policy environment may create opportunity Unfavorable: High levels of dry powder, rising interest rates, stretched debt and purchase multiples

N E U T R A L

Special Situations Distressed Debt, Mezzanine, Secondaries > page 18

DISTRESSED DEBT > page 18

Favorable: Rising US interest rates and somewhat less accommodating monetary stance of Fed, potential opportunities in Europe stemming from weak financial sector Unfavorable: US high‐yield market recovery, improved quality of newer high‐yield issuance, default rates leveling off with energy sector recovery


MEZZANINE > page 23 Favorable: Rising US interest rates, adequate supply of buyout deal flow Unfavorable: Excess dry powder, high leverage multiples in buyout sector, interest rates still highly accommodative, competition from other capital sources remains high

N E U T R A L

SECONDARIES > page 27 Favorable: Limited partner rationalization of private equity portfolios, expected transaction volume increase in GP‐led transactions Unfavorable: Persistent upward price pressure, lack of limited partner liquidity concerns, large supply of dry powder, improved recent market performance, regulatory pressure may lessen

N E U T R A L

Venture Capital > page 31

Favorable: Moderation of later stage pricing, recent equity market strength, VC focus on bringing investments to profitability Unfavorable: Deal prices remain high across the board, exit markets have lost some steam over the past two years

M O D E R A T E U N D E R W E I G H T

It should be noted that TorreyCove’s private equity portfolio management methodology emphasizes the equal or greater importance of manager selection in relation to other elements of the portfolio management process, such as regional or sector weightings. For this reason, a client may pursue an investment with a top-performing investment manager even when a region, sector, or strategy is deemed less attractive on a relative basis. These are guidelines; an institution’s weightings may differ based on their current portfolio composition and overall goals, objectives, and risk tolerance.

Ratings are tactical recommendations and

assume a portfolio with a stable strategic allocation


Europe Buyouts > page 13

SMALL (€500 Million and Below) and MIDDLE MARKET (€500 Million to €5 Billion) Favorable: Monetary stance remains highly accommodative, deflation risk abating, political volatility and lackluster growth may create opportunity, slightly more attractive pricing in the lower middle market, credit shortfall creates opportunity Unfavorable: Deal pricing and debt multiples remain near record levels, tail risks have risen due to fluid political situation, weakness in banking sector may lead to disruption or crisis


LARGE (€5 Billion and Over) Favorable: Monetary stance remains highly accommodative, deflation risk abating, political volatility and lackluster growth may create opportunity Unfavorable: Deal pricing and debt multiples remain near record levels, tail risks have risen due to fluid political situation, weakness in banking sector may lead to disruption or crisis

N E U T R A L

Buyouts > North America

1. According to Buyouts, the numbers are about 20% less year‐over‐year.

North American buyout funds put together a fairly good year on the fundraising front, and it appears that last year’s haul will come in close to the 2015 level1. Buyout funds put capital to work at a brisk pace in 2016, propelling it to finish over 30% higher than 2015. The investment pace picked up by over 30% year‐over‐year. The exit picture appeared to have deteriorated significantly in 2016, as market volatility and uncertainty during the year kept a lid on the IPO markets and dampened M&A interest somewhat. Overall, last year looks to come in off the 2015 numbers by at least 15%.

The general picture for North American buyout shops brightened somewhat in the latter half of 2016. Whether well‐founded or not, the expectations for the performance of the US economy improved markedly in the wake of the election, as markets discounted a more pro‐business administration moving to reduce regulation, reform taxes, and focus on economic growth. Add to that the expectations for a large scale fiscal stimulus in the form of a massive infrastructure spending program, and projections for US GDP growth in the coming year are now running considerably ahead of where they were prior to the election, comfortably within the 2% to 3% range. As a result, US equity markets, which were supposed to swoon upon a Trump victory, have been rolling to new highs since the election. If the administration and economy deliver on these expectations and the markets continue to be buoyant – very big “ifs” – then 2017 should shape up as a solid year on the investment and exit fronts for North American buyout strategies.

Credit markets continue to be friendly to the buyout asset class. To be sure, interest rates moved up sharply after the election, with the yield on the US Ten‐Year Treasury rising by around 80 bps by December before settling in around 70 bps higher more recently. The Fed responded with its only hike of 2016, targeting a 25 bps to 50 bps increase in the Fed Funds Rate. Despite all this, interest rates remain exceedingly low and monetary policy remains highly accommodative from a historical context. Credit markets also did their part last year. After a terrible finish to 2015 and a rough run out of the gates through February of 2016, US high‐yield markets recovered strongly for the remainder of the year to post high‐teens returns by the year‐end. In the process, yield spreads were halved from their first quarter peak, overall quality of issuance improved, and the amount of securities trading at distressed levels declined appreciably. Total volume of new issuance has not returned to earlier peaks, but maintains at a healthy level.


A Good Year for Investment, but Exits Slumped

Interest Rates Rise, But Credit Still Plentiful

The Economic Picture Brightens a Bit


Purchase price multiples for North American buyout deals completed in 2016 remained near all‐time highs, essentially unchanged from the 2015 level of 10x EBITDA. Interestingly, the middle‐market cohort priced richer in 2016, moving from 9.6x to 10.7x, while the large cohort held steady at 10x. This may have been the result of mega‐funds straying down into the middle‐market space in order to deploy large amounts of unused capital as deals at the large end continue to be relatively infrequent and competition from strategic acquirers remains stiff. Only within the lower reaches of the market (deals under $500MM) was any moderation in pricing seen, with multiples dropping close to 9x, just off the 2015 peak. Total debt multiples for large LBOs moderated only slightly in 2016, from 5.7x to 5.5x. Middle‐market debt multiples held steady at 5.3x year‐to‐year.

The trend for deal valuations for 2017 presents a mixed picture. Just looking at the supply/demand equation for buyout capital in North America, the conclusion would be that the sell‐side will remain firmly in the driver’s seat. According to Preqin, the estimated level of dry powder within the buyout sector grew by nearly 10% year‐over‐year ($278 billion to $303 billion). This gives 2016 the all‐time lead for this metric, with approximately 14% more estimated dry powder than the peak years of 2007 – 2008.

However, other elements are now in play that might put some downward pressure on multiples. For one thing, the beginning of an interest rate hiking cycle suggests that we may have reached or even passed the peak for buyout deal leverage, and consequently purchase multiples. Debt capital remains quite plentiful and attractively priced, but that picture is likely to change over the next year or two as the Fed (presumably) normalizes rates, which will factor into purchaser’s pricing assumptions. More importantly, the new administration has promised disruption of the existing economic order, which it appears dead‐set to deliver. The impact of expected major policy shifts will vary considerably by sector. For instance, the proposed border tax (if enacted) will create major headwinds for some of the best performing US companies, multi‐nationals that are heavily reliant on global export and import flows, while domestic producers may get a boost. The administration’s deregulatory stance should create tailwinds for the energy and financial sectors, with the latter further benefitting from rising interest rates. The shape of the widely anticipated overhaul or repeal/replacement of the ACA (“Obamacare”) is still largely unknown, as are its chances of implementation, but further turmoil and change in the healthcare sector is almost a certainty. As we are not even one


Pricing Remains Rich Have Multiples Peaked? Will Disruption Create Opportunity?



S T R O N G O V E R W E I G H T


N E U T R A L


S T R O N G U N D E R W E I G H T


outlook >



N E U T R A L




outlook >

Buyouts > North America Small and Middle Market

Buyouts > North America Large

month into the Trump Administration, the policy outlook – both in terms of what is desired and what can be enacted – is as shifting and opaque as it has been in years. Such an environment tends to favor purchasers of financial assets, as they foster volatile markets, mispricing of assets, and more motivated sellers. For this reason, there is good reason to think that deal values will moderate somewhat this year and that the hunting grounds for attractive deals may be better in the coming year than they have been for most of the post‐crisis era. Perhaps in anticipation of this, or simply out of caution in a volatile environment, early data for 2017 suggests an easing of purchase price multiples. So far, it appears modest: around half a turn of EBITDA for larger transactions, but closer to one turn for smaller transactions. It should be noted that it is still early in the year and the sample size is small, but the direction suggests that some of the upward pressure on multiples may have eased. Despite what may end up being a more attractive deal environment, it must be noted that there is no indication that the floodgates will open on buyout transactions this year, nor that euphoria has taken hold in the space. Whether out of

Source: S&P Capital (12.2016) M&A Stats

Purchase Price and Debt Multiples for North American Buyouts ($ millions)

0x

2x

4x

6x

8x

10x

12x

2010 2011 2012 2013 2014 2015 2016 4Q16

Purchase Price Multiples Debt Multiples


some residual discipline borne out of the experience of the financial crisis, or simply being by corporate acquirers on deals, buyout funds have generally deployed capital at a reasonable pace in recent years and should continue to do so in 2017. As noted, major shifts in policy are likely to create attractive buying opportunities, so there is a good chance that more capital will be deployed this year than last.

Add‐on acquisitions should continue to prove popular, as buyout funds seek to implement cost savings and synergies to purchase assets at valuations that are effectively below market. Some improvement may be seen in the exit environment this year, as the continuing rise in the US equity market opens the IPO window wider and provides acquisitive corporates with additional equity firepower for executing deals. There are a few wild cards in all of this: rich equity market valuations, the relatively late stage of the US economic cycle, and the unusually volatile political and policy environment with the new administration. With markets priced to perfection, a major policy misstep could easily break the current sanguine mood of the market and newfound consumer/corporate confidence. In such a case, North American buyout strategies will be facing a rough year on the exit front, though the effect on the deal making side should be more positive, as disruption opens up more opportunities.

Our tactical rating for the North American large buyout sector is moving to “Neutral” from “Moderate Underweight” last year. Positive factors impacting the strategy include: continued availability of inexpensive credit, steady M&A flow, an improving US economy, and the chance of improved investment opportunities flowing from the volatile policy environment in the US. The

© 2017 TorreyCove Capital Partners | 13 Source: Preqin

Dry Powder - All Funds by Type ($billions)

232.0 253.8 264.0 267.0 238.1 212.6 187.6 235.3 245.6 277.5 302.8

485.4

583.0 606.5 604.3 552.3 541.2

501.9

633.1 648.0

775.1 816.9

‐

100.0

200.0

300.0

400.0

500.0

600.0

700.0

800.0

900.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Buyout Distressed PE Growth Mezzanine Other Real Estate Venture

An Uncertain Year, but Some Trends Should Persist

Tactical Assessment


latter point is the predominant reason for the upgrade in our tactical rating this year. Though deal pricing may moderate slightly this year, the competitive environment for deals is still a major negative pressure on the space, and so far its intensity has not let up, as heavy competition from strategic acquirers and a large pile of dry powder at buyout funds combine to keep purchase price multiples high.

Our tactical rating for the small and middle market buyout sector will move from “Neutral” to “Moderate Overweight”. The middle market space will benefit from the same tailwinds enjoyed by the large buyout sector, with added benefit of a US government policy shift in favor of domestic versus global sourcing and production, which disproportionately benefits the small/middle market company universe. On the negative side, the space continues to suffer from rich pricing, especially in the upper middle‐market, which once again looks to be even more competitive than deals in the large buyout sector. Deals in the lower end still exhibit somewhat more moderate pricing. The rating upgrade is primarily based on the expectation of a more attractive deal environment due to policy uncertainty and change (in common with the large buyout group) and the above‐noted shift in favor of domestic versus international enterprises.


dterry

Cross-Out

Buyouts > Europe

The fundraising environment for European buyout strategies boomed in 2016, a somewhat unexpected occurrence given all of the market angst over the June Brexit vote. Europe‐focused buyout funds pulled in €66 billion in fresh commitments during the year, a 50% increase from 2015 and over 10% better than the pre‐crisis year of 2006 (€59 billion), the next best showing. It should be noted that an important contributor to the big fundraising year was the close of several large funds, such as Apax (€6.8 billion) and Advent (€10.8 billion). Investment activity stayed more or less even, dipping by only about 3% from 2015 to 2016. Exits slackened meaningfully: 2016 saw approximately $100 billion in total exits compared to $138 billion in the previous 12 months, a slide of nearly 30%. This was not too surprising, given the strong exit performance from 2015, and the 2016 figure still comes in comfortably above the average of the past ten years.

In keeping with the trend of the past few years, the macroeconomic picture in Europe for 2016 showed modest incremental improvement. Overall real GDP growth for the EU and Euro Area (“EA”) are projected to come in at 1.8% and 1.7%, respectively, just shy of Eurostat’s projections from last fall. For 2017, the forecast calls for a mild deceleration in GDP growth – 1.5% for the EA and 1.6% for the EU ‐ as certain tailwinds fade. On a positive note, the countries of the Periphery continue to work their way out of the holes they found themselves in after the financial crisis. In particular, Spain and Ireland are both expected to post reasonable, though slightly lower, growth rates in the coming year, while Portugal will eke by with a marginally positive year, and even Greece is expected to post a positive number in the coming year. Of the major Euro Area economies, Italy continues to be the laggard, as it is not expected to break 1% growth next year. Inflation, which has been anemic in the post‐crisis


European Buyout Fundraising Past Five Years

Source: Preqin

0

10

20

30

40

50

60

70

0

10

20

30

40

50

60

70

2012 2013 2014 2015 2016

Aggregate Capital Raised (bn EUR) Number of Funds

Strong Fundraising, But Exits Slowed

EU Economies Recovering, But Pace is Still Moderate

Buyouts > Europe




N E U T R A L




outlook >



N E U T R A L




outlook >

Buyouts > Europe Small and Middle Market

Buyouts > Europe Large

era, should reappear in the coming year (projected at 1.6% for the EU, slightly lower for the EA), driven in large part by firming energy prices. The euro has weakened considerably over the past couple of years, but has remained, somewhat surprisingly, resilient versus the dollar. Nevertheless, the preponderance of forecasts assume further weakening in the face of improving economic growth and rising interest rates in the US. The ECB’s monetary posture remains highly accommodative, with continuing QE and negative interest rates still in place, while fiscal policy at the aggregate level appears neutral.

The trade environment has in recent years weakened considerably and currently offers little, if any, tailwind to the EU economies. To that point, the European Economic Forecast Autumn 2016 projected that net trade would not contribute to EU GDP growth in 2017. The WTO recently revised its estimate of 2016 global trade growth from 2.8% to 1.7% and also reduced its 2017 estimate considerably, from 3.6% to a range of 1.8% to 3.1%. Directly impacting the EU is the ongoing slowdown in China, as well as the secondary effect it has had on other emerging countries, particularly commodity exporters. Also, US dollar strength is acting as a headwind to recovery for many of these EMs, as it has shifted the terms of trade unfavorably against them (and put pressure on holders of US dollar‐denominated debt). The reduction in export flows to these countries continues to weigh on EU economic growth. Further, developed market imports also slackened last year, so the EU will not be able to offset lost EM trade from that source.

The news from the financial sector is mildly positive with one glaring exception. Continental banks have slowly repaired their balance sheets over the past few years via equity raises and offloading some of the more capital‐intensive loans within their portfolios. Credit provision, which has been anemic for much of the post‐crisis era, has picked up, albeit only mildly, over the last couple of years as banks finally began to loosen their lending standards.

Little Help from Trade this Year

Financial Sector Struggles Toward Health and Credit Flows Pick Up

Italian Banks – Total Gross NPL Ratios 2016

Loan demand, though recovering slightly, still remains relatively weak. In spite of these improvements, it would be tough to characterize the European banking sector as being in robust health, especially with non‐performing loan (“NPL”) levels still well above the norm and negative interest rates battering profitability and capital formation within the sector. The European high‐yield market has followed much the same trajectory as its US counterpart: after a rough 2016 it has rebounded strongly, with significant spread compression and a recovery in volume.

The glaring exception to this story of slow and steady recovery is the Italian banking sector. As mentioned earlier, Banca Monte dei Paschi di Siena, one of Italy’s largest banks, is effectively insolvent and desperately trying to recapitalize. However, this is only the tip of the iceberg, as there are an estimated €300 billion to €400 billion in NPLs weighing down the Italian banking sector. All‐in‐all, Italian banks are likely to require a bailout in the order of €50 billion or more this year to stay afloat. This is complicated by EU rules that make it difficult for governments to directly bail out the banking system, thereby setting the stage for a potential showdown between the EU and its third largest economy in 2017.

The rolling crises that have plagued the EU since 2012 do not appear set to abate in 2017. Last year, it was Brexit, and not the ongoing Greece saga, that shocked the EU. For the coming year, the It crisis is likely to occupy center stage, but there is no shortage of other catalysts to spark volatility, many of them from the political sphere. 2017 will see important elections in France, Holland, Germany, and Italy. Anti‐EU, populist, nationalist movements have been gaining strength over the past few years. Most observers continue

Buyouts > Europe

© 2017 TorreyCove Capital Partners | 17 Source: Business Insider 11/29/2016

24.10%

16.00% 17.70%

34.40%

15.30% 15%

23.30%

15.70% 16.30%

34.80%

14.90% 14.50%

35.50%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Banco Popolare Intensa Banca Popolare DiMilano

Monte Dei Paschi UBI Unicredit

1Q16 2Q16 3Q16

But Italy Lags and Bank Crisis Looms

Crises Will Not Abate

Average LBO PPM of Pro Forma Trailing EBITDA by Transaction Size: €500M or More

to discount the chances of a successful populist uprising in any of these elections; however, as we saw quite clearly in 2016, we are living in one of the most unpredictable political environments in memory. On top of all this, there is still Greece, whose problems have not been resolved, but rather kicked down the road for later years.

Despite the challenging environment in Europe, buyout multiples remain sky high. Last year even saw a bump upward in average purchase price multiples on the larger end (€1 billion and up), which came in over 11x, compared to 10x for the 2014‐2015 period. There was some moderation as the deal size declined, as the €500 million and above cohort came in at 10x (higher than 2015) and the €250 million to €500 million cohort was just under 9x. Debt multiples eased very slightly from a recent high in 2014, as equity contributions approached 50% in 2016, up meaningfully from the 2015 level of just over 40%. Nevertheless, debt levels remain high at an average of 5x EBITDA.

Tactical Assessment

Our tactical rating for the European large buyout sector for 2017 will move up one notch from “Moderate Underweight” to “Neutral”. The positive side of the equation includes moderately improving economic conditions throughout much of the EU and Euro Area and continued monetary accommodation. On the negative side, pricing within the private equity environment, especially at the larger end, remains quite rich. Further, the tail risks facing the EU ‐ including a banking crisis, major political shakeup, or a departure from the euro ‐ are significant and appear to have intensified going into next year. Unfortunately, these tail risks

Buyouts > Europe

© 2017 TorreyCove Capital Partners | 18 Source: S&P (12.2016) M&A Stats

7.0 6.9 7.9 8.0 7.5

8.7 8.8 9.6 10.1

8.4 8.5 8.8 8.8 8.3 10.1 10.0

10.9 0.5 0.3

0.3 0.3 0.4

0.4 0.4 0.3

0.4

0.8 0.5 0.5 0.4 0.4

0.4 0.4 0.4

4.0x

5.0x

6.0x

7.0x

8.0x

9.0x

10.0x

11.0x

12.0x

Purchase Price Fees/Expense

Despite EU Troubles, Buyout Pricing Remains Rich

A Little More Opportunity This Year, Mostly In Credit and the Middle Market

are not likely to reduce in the near‐to‐medium term, as the problems besetting the EU are on‐going and structural rather than cyclical. It is likely that that EU will continue to implement stop‐gap measures to forestall a reckoning with the imbalances between core and peripheral countries (made worse by the euro), as it has done for the past several years. This suggests another muddle‐through year for the region, and that may be about the best outcome that can be hoped for. In such an environment, the risk‐reward proposition relating to growth‐oriented large buyouts is not particularly favorable. However, a major increase in volatility resulting from one or more of the catalytic events described above may force pricing adjustments that would open up value opportunities in the space. This possibility, in conjunction with the modestly positive economic trajectory of the region, justifies this year’s higher tactical rating.

Countercyclical strategies promise to be more immediately attractive in the market environment that is likely to prevail in 2017. In this regard, credit provision strategies focused on the European middle‐market should encounter fertile ground, as the flow of bank credit to smaller European companies continues to be constrained. For the same reason, equity investments in the smaller middle‐market should also be more attractive this year, especially in light of the slightly more favorable pricing within that market segment. Based on these factors, our 2017 tactical rating for European small middle‐market strategies moves from “Neutral” to “Moderate Overweight”.

Buyouts > Europe


Special Situations > Distressed Debt

After a relatively strong run from 2012 through 2015, where distressed funds gathered over $35 billion in each year, fundraising slumped in 2016. For the year, approximately $27.7 billion was raised, off about 23% from the previous year. Investment declined in similar fashion, with last year’s deployment down about 21% from 2015. However, 2016 was still a reasonably good year on this front, as its $44.2 billion was good enough to beat all but two of eight post‐crisis years.

Distressed debt markets were more volatile in 2016 than they have been since 2009. The primary culprit, unsurprisingly, was the energy sector, which had a tough first half and almost singlehandedly bucked the Fed‐induced record‐low default rates of the last seven years. For the year, the sector accounted for just under $50 billion in high‐yield defaults, about 80% of total high‐yield defaults for the year ($62 billion). This pushed the year‐to‐date dollar‐denominated default rate to 3.72%, the highest figure seen since the dark days of 2008‐2009. However, it looks like the worst is now behind, at least for now, as the energy sector stages a moderate recovery as a result of the tailwind provided by the stabilization and rebound of energy prices that began about mid‐year. The third quarter default figure of 0.76%, which is considerably lower than the second quarter’s 2.14% and roughly in line with the third quarter of 2015, provides some evidence of stabilization. Further, the fear of a breakout of defaults from the energy/mining sectors to the larger high‐yield universe has clearly not materialized. This is not to say all is perfect. According to Altman‐Kuehne, the third‐quarter default rate was the fifth in a


Historical Default Rates ($ millions)

1.60%

4.15% 5.07%

9.80%

12.80%

4.66%

1.25%

3.38%

0.76% 0.51%

4.65%

10.74%

1.13% 1.33% 1.62% 1.04%

2.11% 2.83%

3.72%

0%

2%

4%

6%

8%

10%

12%

14%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 3Q16

Note: Straight bonds only, not including defaulted issues in par value outstanding.

Source: NYU Salomon Center (10/2015) Altman & Kuehne High-Yield Bond Default and Return Report

Fundraising and Investment Slump

…but Leveling off with Energy Sector Stabilization

Default Rates Elevated in 2016…


row of quarterly default rates above 0.50%, a level that had not been breached in two‐thirds of the quarters since 2009. Overall, it appears that the high‐yield sector is currently on the mend as a result of the recovery of the energy sector (as evidenced by the strong performance of defaulted and distressed bonds in the sector during the latter half of 2016), though it is likely that the nadir of post‐crisis default rates is now in the past.

US high‐yield markets put together a strong comeback in 2016. After flirting just south of 900 basis points in the first quarter, high‐yield spreads dropped more or less steadily during the next three quarters to end the year at less than half that amount (just over 400 basis points). Further, the market does not appear to be drawing major distinctions between quality, as the relative spread recovery was also observed across the ”BB” and “CCC” tiers of the high‐yield universe. For instance, the “CCC” spread peaked at over 2,000 bps in the first quarter before halving over the rest of the year to end at around 970 bps. Both spreads are now trading significantly below their long term averages. European high‐yield markets also rebounded, though not as dramatically, with spreads moving from a high of just over 630 bps to just under 380 bps by year end. US High‐yield issuance of $237 billion was off 9.6% from 2015 levels, continuing a downtrend that began in 2013 and representing the lowest volume of the past five years. However, it should be noted that by historical standards, 2016 issuance is still quite strong, exceeding issuance in all but one year of the 2000‐2011 period. Perhaps more importantly, the quality of issuance has been improving, as “CCC” rated‐paper accounted for only around 10% of total issuance in 2016 (through the 3Q), continuing a downtrend that began in 2014.


BofA Merrill Lynch US High-Yield Master II Option-Adjusted Spread

Source: BofA Merrill Lynch

0

2

4

6

8

10

12

300bps

400bps

500bps

600bps

700bps

800bps

900bps

Jan‐2014 Jan‐2015 Jan‐2016 Jan‐2017

BofA Merrill Lynch US High Yield Option‐Adjusted SpreadBofA Merrill Lynch US High Yield Effective Yield

A Wild Ride for US High-Yield, Ending in a Solid Year High-Yield Quality Improves


In addition to the upgrade in high‐yield quality, most other metrics relating to distress in the credit markets improved, if only moderately, during the past year:

• The distress ratio – high‐yield bonds trading with yield spreads over 1,000 bps – has declined dramatically, moving from 16.4% at the end of the second quarter of 2016 to 10.4% as of the third quarter end, a number that is well below the historical average seen in the 2000s.

• In a related vein, the face value of defaulted and distressed debt trended dropped from $1.19 trillion to $962 billion, or approximately 19% from the second to third quarter of last year.

One important factor for the distressed debt strategies did move, ever so slightly, in their favor last year. Almost immediately after the US election, bond yields jumped, with the benchmark 10 Year UST yield ramping up over 50 bps (180 bps to 230 bps), reflecting the market’s expectations for stronger economic growth and inflation in the coming year. The Fed followed suit for the short end of the curve in December by raising its benchmark rate target by 25 bps to a target range of 50 bps to 75 bps. All else equal, rising rates should put more pressure on over‐indebted companies and make it marginally more difficult to refinance existing debt or undertake new borrowing. However, when viewed from a historical perspective, interest rates are not yet near the level they would have to be to begin to squelch the flow of credit to any but the most leveraged and weakest companies. For comparison, the US Fed Funds Rate stood at over 5% on the eve of the financial crisis. Further, widening rate differentials between the US and the rest of


Percentages of new High-Yield Issuance Rates B – or Below (Based on Amount of Issuance)

Source: NYU Salomon Center (11/07/2016) “Altman & Kuehne High-Yield Bond Default and Return Report

31.56% 29.62%

27.04% 26.13%

29.22% 29.19%

31.95%

12.13%

19.93% 20.71%

24.34% 26.34%

2.19%

16.34% 16.11% 15.77%

17.20%

0%

5%

10%

15%

20%

25%

30%

35%

2011 2013 1Q14 3Q14 2015 2Q15 4Q15 1Q16 3Q16

Rising Rates, but Not Enough Yet




N E U T R A L




outlook >

the world, along with better economic growth, should serve to attract capital inflows from the rest of the globe, leading to dollar strengthening and increased liquidity for US capital markets, which in turn should keep credit flows strong.

On the economic growth front, the market appears to be shifting to a less favorable position vis‐a‐vis distressed strategies. Projected growth in the US has been upgraded on the back of expectations for a more business‐friendly regulatory environment (resulting in higher investment flows), fiscal stimulus, and more growth‐oriented public policy. Europe, though not in robust health, continues to plod along with expected sub‐2% growth; emerging markets have stabilized, at least for now.

In the US, it looks like the economy is setting up to enter a “sweet spot” whereby government policy, stimulus, and business/consumer confidence will propel higher growth, yet interest rates will remain broadly accommodative. Of course, this “good news” is “bad news” for investors in distress. It must be noted, however, that much of this good feeling may be ephemeral post‐election wishful thinking and may recede before the year is halfway through. Further, most of the public policies that are expected boost the economy, including fiscal stimulus, will take time to enact and make an impact. In the meantime, any number of events could derail today’s optimistic expectations.

Though the situation in Europe is relatively stable at present, the region is now relatively more attractive to distressed investment, in comparison to the US. Though the European high‐yield market has grown considerably over the past several years, its role in providing financing for the corporate sector in Europe is considerably less than that held by its US counterpart. Banks still play an outsize role in credit provision on the Continent. Therefore, the continued challenges facing the European banking sector – most recently highlighted by


Less Fertile Hunting Grounds in the US Better Counter-Cyclical Opportunities in Europe


the emerging banking crisis in Italy – have the potential for breaking out into a largescale crisis, though the EU and ECB will go to almost any length to avoid this.

Overall, looking to the next two years, distressed debt strategies have lost some attractiveness relative to the beginning of 2016. The main contributing factors include:

• Moderating default rates (though they remain above the average of the post‐crisis period) • Continuing strength and liquidity of high‐yield debt markets, especially in the US, which

contributes to a relatively forgiving refinancing environment • Trend toward higher quality in US high‐yield market • The wind has been taken out of the sails of the distressed energy trade, due to: i) higher,

more stable oil prices that took hold in mid‐year 2016 and ii) a new pro‐energy administration in the US

• Renewed optimism and expectations of economic growth and corporate profitability growth in the US

• Reduction in the size of distressed/defaulted debt universes.

There are some tailwinds for the strategy. Interest rates appear to be firmly on track to rise, which will eventually increase the opportunity set for distressed strategies, though this could take a year or two to develop. At this point the increases are simply too modest to create much disruption. While the US does not appear opportunity‐rich going into 2017, various factors in Europe, including still sub‐par growth, bad loan books in the banking sector, and the potential for political upheaval, are likely to make it the more attractive hunting ground for at least this year. Further, higher GDP growth in the US, as well as dollar strengthening, should make non‐US distressed plays more interesting on a relative basis in the coming year.

Aside from the potential opportunity in Europe, we recommend a continued overweight to distressed debt strategies in part as a hedge against disappointment in US growth expectations and as a counter to the persistent high valuations in other private equity strategies. However, based on a somewhat less compelling outlook compared to last year at this time, our tactical rating is moving from “Strong Overweight” to “Moderate Overweight”.

Less Tailwind for Distress in 2017


Tactical Assessment

Special Situations > Mezzanine

Mezzanine investment funds logged a decent year by their post‐crisis standards in 2016. Fundraising was strong at just over $24.1 billion, approaching twice the 2015 level (which itself was a better than average year) and leading all years since 2008, in which total commitments ranged from $3.0 billion to $14.6 billion) well behind. However, it should be noted that this year’s fundraising statistics were significantly impacted by the closing of a handful of very large funds, including HPS Mezzanine ($5 billion) and GSO Capital ($6 billion). The investment pace was likewise strong last year, as mezzanine funds looked to take advantage of some disarray in the BDC universe as well as the weak opening half for high‐ yield markets. Approximately $10.6 billion was deployed in 2016, a vast improvement over 2015 and good enough to put it in second place behind 2014 ($17 billion) for the entire post‐crisis period.

The market environment for mezzanine debt strategies offered something of a mixed bag in 2016. The outlook appeared favorable going into the year, as one of the strategy’s most formidable competitors, the high‐yield bond market, was on the back foot. Heavy deterioration in the energy segment of the high‐yield universe pushed default rates to levels not seen since the crisis, the levels of distressed issues soared, and yield spreads blew out across the board. The high‐yield sector turned in a losing performance for 2015 and new


US Mezzanine Investment ($ billions)

20.9

56.6

2.0

10.4 5.6 5.8

2.6

17.1

1.7

10.6

545

450

210

300 336

374

210 229 164 165

0

100

200

300

400

500

600

$0.0

$10.0

$20.0

$30.0

$40.0

$50.0

$60.0

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Sum of Deal Value ($B) No. of Deals

Large Funds Have a Good Fundraising Year Investment Strengthens

The Year Started with Promise…




N E U T R A L




outlook >

issues all but dried‐up by the year end. Further deterioration in the default rate was expected for 2016 and the fear that the contagion could spread outside the energy sector was in the air. Against this backdrop, mezzanine lenders (and other debt providers) enjoyed a brief window in which they could provide liquidity while their most important competitor had effectively left the field. It did not last long. By March, high‐yield markets had begun to stabilize and recover. The resurgence of energy prices (oil over $50/barrel) around mid‐year stabilized the energy sector and forestalled further waves of default. Relieved of the drag from the energy sector, high‐yield performance turned up a notch in the latter half of the year, putting up a return of over 17% for the year, making it one of the best performing asset groups. And while cumulative default rates did indeed push well past the 3% mark in 2016, by the end of the year they look to have stabilized (though at a level meaningfully higher than the post‐crisis average). By year‐end, yield spreads had contracted considerably (by close to 50%, depending on issue quality), as investors found their appetite for yield once again.

Mezzanine funds got some help from interest rate movements at the end of 2016, when the post‐election fixed income markets priced in higher economic growth and inflation expectations, leading to a significant bounce in yields. All things equal, a higher interest rate environment will be positive for mezzanine strategies, as it raises the cost of capital relating to some of the strategy’s primary competitors – banks, high‐yield, and BDCs – and reduces the spread between mezzanine coupons and the yields on paper underwritten by these competitors. However, we are clearly in the early innings of an interest rate hiking cycle, and it bears noting that the markets are far from uniform with regard to the expectations of the magnitude of interest rate increases. Therefore, while interest rates have begun to move in a direction that is positive for the attractiveness of mezzanine debt, any impact will be marginal at best, as the rate differentials remain reasonably wide. More substantial further movements, of perhaps 100 bps or more, will be required to begin to shift the balance in favor of mezzanine.


…But Ended Back in a Challenging Environment

Interest Rates are Up, but Not Enough to Help


The level of dry powder within the mezzanine space remains at elevated levels. Strong fundraising in 2016 more than offset a reasonably decent year for deployments, resulting in total dry powder of about $40 billion as of the 2016 year end, 25% greater than 2015 and the highest level on record. Even at 2016’s relatively high deployment pace, this works out to four years’ worth of investment activity. As if pricing in the credit markets were not already tight enough, the oversupply of mezzanine capital further intensifies the competitive pressures felt within the space.

Buyout deal volume in 2016 was essentially a neutral factor for the mezzanine group, as deal‐making dipped during the year. According to Buyouts, North American buyout investment in 2016 came in modestly lower, by about 5%, compared to the prior year. Despite this, going into 2017 there are several factors that are supportive of buyout investment, including: upward trending equity markets, renewed consumer and business confidence, a more business‐friendly administration in Washington, expectations for higher economic growth, and a still‐accommodative monetary posture by the Fed. Given this, there is good reason to think that the pace of deals will pick up in the coming year.

In 2016, mezzanine debt strategies got a little good news and a little bad news. On the positive side was the bump in interest rates at the end of the year, along with the signaling by the markets and the Fed that we are entering a multi‐year rate hike cycle. On the other side, the headwinds for the asset class include the strong recovery of the high‐yield markets last year and an even larger pile of dry powder in the mezzanine space. Further, the risk equation for


North American Mezzanine Fundraising vs. Dry Powder ($ billions)

$4.

7

$4.

8

$4.

4

$15

.5

$6.

6

$23

.6

$3.

0

$6.

9

$9.

0

$8.

3

$14

.6

$5.

1

$14

.3

$24

.1

$12

.7

$11

.6

$13

.1

$21

.0

$20

.3

$29

.7

$28

.0

$24

.2

$29

.7

$22

.4

$33

.2

$27

.8

$32

.3

$40

.4

$‐

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

$35.0

$40.0

$45.0

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Aggregate Capital Raised Dry Powder

Too Much Dry Powder

A Little Good News, A Little Bad News

Buyout Deal Flow was a Neutral Impact


mezzanine funds has not improved, as buyout deal and debt multiples across developed markets persist at or near peak levels.

What all of this means is that, though the prospects for deploying capital by mezzanine funds have improved on the margin, their pricing power still remains weak, primarily due to the large supply of inexpensive capital that is still available to finance buyout deals. As we have noted before, mezzanine funds that can drop below the radar to do smaller deals, or are willing to take on unsponsored deals, should be able to wield some pricing power, while the larger, sponsor‐focused funds will generally remain price‐takers. This may well be a secular trend for the strategy. What is more certain is that, until interest rates move much higher, or a major market disruption sidelines a good part of the competition, mezzanine lenders are unlikely to escape their current status as commodity capital providers or achieve the type of returns they saw in the pre‐crisis years.

Due to this persistent structural dynamic, we do not see cause to raise the outlook for mezzanine debt strategies from last year’s “Neutral” rating. A lower rating is not warranted due to the support provided by a moderately more positive credit cycle trend.


Tactical Assessment

Special Situations > Secondaries

The secondaries strategy turned in another solid year on the fundraising side in 2016, besting 2015’s figure by about 16% ($23 billion), putting the year in all‐time second position behind 2014, when just over $26 billion was gathered. The picture was not as good on the investment front, with the 2016 amount ($37 billion) showing an approximate 12% decline from the past year’s deployment pace, primarily as a result of a weak first half due to global macroeconomic concerns such as Brexit, which threw a measure of doubt into asset valuations. Though 2016 turned out to be the worst performance going all the way back to the dark year of 2009, it should be noted that only about $5 billion was deployed in that year. When seen from this perspective, the 2016 number does not raise too much cause for concern, as it is not too far off the trend of the past few years.

Pricing remained broadly stable throughout the year, with average bids across all strategies hovering just under 90% (of NAV), with only marginal slippage (1% to 2%) for most strategies. Good quality buyout fund interests continue to get the best pricing, with both mega‐ and middle‐market funds commanding bids ranging into the 90s, with bids over par not unheard of for particularly sought‐after names. As usual, the venture strategies fared more poorly, with bids ranging from the low 70s to 80. Commodity price volatility and increasing pressure on the energy sector, along with the uncertainty these engendered, made secondary investors wary of the space, at least for the first half of the year before energy prices began to strengthen. As a result, funds in this sector performed the worst from the seller’s perspective, with bids

© 2017 TorreyCove Capital Partners | 29 Source: Greenhill Cogent (01.2016) Secondary Market Trends & Outlook

Secondary Pricing Over Time

Seco

ndar

y Pr

icin

g (a

s a %

of N

AV)

Avg.

Clo

sing

Pric

e –

S&P

500

500

700

900

1100

1300

1500

1700

1900

2100

2300

50%

60%

70%

80%

90%

100%

110%

120%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

All Strategies Buyout Venture Real Estate S&P 500

Solid Fundraising, but Volume Declines

Pricing Dipped Slightly, but Recovered Fully by Year-End




N E U T R A L




outlook >

dropping down into the 60s. However, with the recovery of oil prices, NAV’s are expected to stabilize and improved pricing should ensue in 2017.

The view into 2017 does not call for too much excitement for secondary strategies, mostly just more of the same. Downward‐pressure on pricing should remain muted as the supply/demand dynamic remains favorable to the sell‐side. A major contributing factor is the large overhang of capital on the demand‐side of the table (general partners). According to Greenhill Cogent, secondary funds entered 2016 with an estimated $58 billion in dry powder, well over the best annual deployment pace of over $40 billion seen in recent years. The relatively slow deal environment for the first half of the year allowed additional capital to pile up, thereby pushing dry powder to around $65 billion at mid‐year, a solid increase of about 12%.

The moderation in NAV growth that occurred in 2016 does not look set to repeat, and may even reverse somewhat, due to the relative strength of the US equity markets since the November election. Furthermore, limited partners are still not feeling pressure on allocations to alternate assets.

Even the regulatory environment, which has worked in favor of secondary interest purchasers since the financial crisis, looks to have shifted, if only slightly to a more neutral stance (at least in the US). Spurred by the probable Dodd‐Frank reform in general, and the Volcker‐Rule in particular, US financial institutions have been under pressure over the past several years to divest private equity assets, thereby providing a source of supply with motivated sellers to secondary funds. A new, business‐friendly administration in the US has led to expectations of a dramatic rollback, or even repeal, of the Volcker Rule. While visibility on the ultimate outcome is not clear, it seems reasonable to conclude that the Rule has seen its peak influence and may be watered‐down, especially given the policy preferences of the Trump administration, Republican Congress, and the lobbying effort being orchestrated by powerful Wall Street interests.


Plenty of Dry Powder Will Keep Prices High

Deregulatory Environment Takes Some Pressure off of Financial Institutions


The constellation of factors influencing secondary market deal‐flow and pricing is almost uniformly arrayed to favor the secondary seller: private equity continues to perform well as an asset class and distribution remain reasonable, equity markets have been resilient, regulatory pressures in the US are easing, dry powder continues to grow, and fundraising has been robust. All of this means that, absent some sort of major financial/economic dislocation, secondary funds will continue to be price takers in 2017. Given the significant capital overhang, secondary funds will focus on getting capital out the door and overall pricing and profitability will suffer. In this respect, the trend of the past few years towards increasing use of leverage will persist and may intensify, as secondary funds seek to approach private equity style returns in a tough pricing environment. Another trend – GP‐originated transactions – should also show upward momentum (last year they made up an estimated 25% of transaction volume), as secondary investors welcome any and all sources of additional deal flow.

As we have noted in prior Outlooks, the private equity secondary markets have morphed over the past decade from a cottage industry to a routine, institutionalized, reasonably efficient part of the private equity investment landscape. Information flow and availability, as well as LP and advisor sophistication, continue to deepen and improve, and capital continues to flow into secondary strategies. Most transactions of size now occur at the initiation of limited partners for the purpose of regular, even routine portfolio management; therefore, selling‐pressure is low and the timing and general terms of the transactions are broadly set by the LPs.


Secondary Fundraising

Source: Prequin

0

5

10

15

20

25

30

35

0

5

10

15

20

25

30

2010 2011 2012 2013 2014 2015 2016

Aggregate Capital Raised ($B) No. of Funds

Still a Seller’s Market

Secondaries Go Institutional


Off‐the‐run‐transactions of size are rare. As mentioned earlier, only a meaningful financial dislocation is likely to put pressure on LPs and disrupt the pricing regime to the GPs’ favor; however, most of the benefits of such an environment are likely to accrue to smaller funds that can profitably pursue transactions with smaller sellers. As we saw during the financial crisis, most sellers can hold on until the crisis abates and pricing improves. Also, the pricing for the most sought‐after names is likely to hold up well, leaving the large discounts to apply only to the lower quality funds.

In the current environment, there are only a few pockets of inefficiency left to exploit. Smaller transactions should offer more attractive pricing terms to secondary purchasers, as larger funds are typically unable to pursue them. Venture capital funds should continue to trade at steeper discounts to buyout funds due to the lower visibility on performance and valuation challenges. However, adverse selection is a major issue with VC funds, as high quality fund interests rarely come to market. Pricing for energy/resource funds has been depressed over much of the past two years, but with oil prices appearing to have stabilized in the 50s, there may be some opportunistic plays as NAVs stabilize and sellers are more willing to transact.

Our tactical weighting for secondary strategies is moving from “Moderate Overweight” to “Neutral” for 2017. Last year, we recommended an overweight to the strategy as a countercyclical hedge to existing primary private equity investments and as an opportunistic positioning in the event of a major downturn in private equity markets. Since that time, the prospects of the US economy (and to a lesser extent, the EU economies) have improved and financial markets are reflecting increased optimism and strength. We expect that the prospect of a major downturn in the private equity markets over the next year has lessened, suggesting a lessened need to use secondaries as a hedge. Therefore, our tactical view relies more heavily on the internal dynamics of the strategy, which are less favorable from a risk/return perspective.


A Few Areas of Opportunity Tactical Assessment

Venture Capital

The momentum behind venture capital strategies from 2015 rolled into another solid year in 2016. Fundraising topped $40 billion in 2016 and surpassed the prior year’s already impressive number by over 15%, as VCs took full advantage of continued investor enthusiasm for the asset class. The investment pace in 2016 slackened, breaking a strong three‐year uptrend, with VCs deploying about 12% less capital year‐over‐year (for perspective, 2016 still ranks as the second best year of the past ten in terms of investment). As we anticipated at the beginning of last year, exits were slightly tougher to come by as equity market volatility continued to reign throughout much of 2015 and 2016. The past year saw total exits dip by slightly under 10%, the second year of decline after the blowout performance of 2014 when exits were around 70% higher. However, 2016’s exit performance is respectable, given that it ranks right at the top third of the past eleven vintage years on this metric.

After an impressive run over the past few years – easily the best since the dot‐com crash – the venture asset class appeared to pause for a slight breather in 2016. Investment flows for the first half of the year were very much in line with the brisk pace set in 2015, but the second half of the year saw a notable decline of about 30% in the value of new investment. Not only were VCs deploying fewer dollars, they were also investing in fewer companies; the quarterly deal count had been more than 2,000 since the end of 2012, but the last two quarters of 2016 saw the deal count dip below that threshold, and by a significant margin for the fourth quarter.


Dry Powder – North America

63.6

81.4 76.1

71.7 67.1 66.7

71.8 77.3

71.4 67.2 64.2 63.2

57.1 62.4

68.8 73.3

83.9

0

10

20

30

40

50

60

70

80

90

Booming Year for Fundraising

A Bit of a Lull in the Pace

Investments and Exits Slacken

Venture Capital

Digging below the surface reveals that the later‐stage investments were the primary cause of this decline. Late‐stage investing has been the most popular flavor amongst VCs over the past three years, as they have rushed to put capital to work in companies that would be able to access the strong IPO market that began in 2013. Rounds exceeding $25MM accounted for about two‐thirds of total VC funding in 2015 and 2016 and were not far away from that level in 2014. As a result, a herd of Unicorns were born during those years and deal values soared: the average VC round size for later stage deals peaked in 2015 ($29MM) at just over double the 2013 level ($15MM). 2016 backed‐off this figure by a modest 5% as VCs finally began to adjust to the choppier equity markets that began in 2015 by becoming somewhat more selective and about deploying cash, which led to a flattening of funding round valuations for later stage companies. Fewer companies were funded in 2016, and later stage deal counts were off by about 13% year‐over‐year. It should be noted that funding round‐sizes have been increasing for angel/seed and early‐stage deals as well (and continued to do so in 2016), but not nearly to the extent that later‐stage rounds have done so.

The moderating trend in deal valuations that took hold in the latter half of 2016 should continue into 2017, as VCs continue to focus their attention on getting their portfolio companies to break‐even and improving their operating efficiency. However, a major decline in later‐stage deal valuations does not look to be in the cards, since the markets appear relatively benign, though fully priced, at this time. In addition to this, pricing should be supported by the existence of a relatively sizable pool of fresh capital sitting on the sidelines.


Average Deal Size by Stage of Development ($ millions)

Source: PWC & National Venture Capital Association

1.67 1.74

9.43 10.75

28.28 26.92

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016*

Angel/Seed Early VC Later VC

Valuations Stay Strong, but Later Stage Eases 2017 Valuations Should Moderate, but Not By Much

Venture Capital

According to Preqin, North American VCs held $84 billion in dry powder as of December 2016, a 14% increase over the figure from 12 months earlier and one of the highest levels seen going back to 2000. It is important to keep this number in perspective: it represents substantially less than two years of the investment levels we have seen over the past few years. Nevertheless, assuming another decent fundraising year, dry powder levels should remain high and will continue to provide a meaningful positive incentive to VC investment over the next few years. Therefore, expect venture valuations to remain relatively sticky, though some minor slippage may occur. In particular, later stage valuations should remain well above the post‐crisis average. It seems more likely than not that investment flows will slow down moderately, in‐line with the trend of the past. After last year’s record haul, it seems reasonable to assume fundraising will slacken somewhat, but limited partner interest in the space remains strong, so a major decline is not likely.

Exits are something of a wildcard for 2017. As noted earlier, 2016 exits lost a little steam from the prior year, and neither year was able to put up numbers like 2014, which was a standout for the decade. That being said, 2016 was still a good year by the standards of the current market cycle and conditions in the equity markets have not changed appreciably, but in fact have improved on some fronts. One cautionary note was provided by the poor exit showing in the fourth quarter of 2016, one of the lowest volumes in several years (going back past 2010).Whether this is a blip, or the beginning of a trend remains to be seen. However, current conditions suggest that next year should be another fairly good one for exits. M&A should be the dominant exit channel as it was in 2016. The IPO window has steadily declined since 2014: the number of IPOs is off about 30% and 16%, respectively, from 2014 and 2015. Further, the total value generated from IPOs declined over 60% from 2015 to 2016. M&A flows actually rebounded by about 14% year‐over‐year in 2016, and it ranks as the second best year (after 2014) going back to 2006 on this measure. With corporate balance sheets still flush with cash and rising confidence in the US economy suggesting a higher propensity to invest, it is a fair bet that strategic acquirers will continue to be active in 2017.


Exit Environment Tough to Call



N E U T R A L




outlook >

IPO Outlook is Hazy, but M&A Should Hold Up Well

Venture Capital

Last year at this time, our tactical rating for venture capital strategies was “Moderate Underweight”, with a cautious outlook primarily due to valuations that appeared to be at or near a peak, and US equity market conditions, which appeared to offer higher risk for diminishing potential returns. Last year, investment flows, though still healthy, cooled somewhat as VCs recalibrated expectations of time to exit in light of more volatile equity markets. As a result, later stage valuations look to have hit their peak in 2015. Both factors moved in a favorable direction for venture capital in 2016. As 2017 opens, the equity markets have extended a rally that began after the US elections in November and confidence in US growth is running higher than it has in years. Within the venture space, later stage valuations finally eased, but not by much, as they remain about 85% higher than 2013 levels. These factors suggest a slightly more favorable environment for venture over the next year. However, given the highly uncertain political and economic environment in the US at present, the durability of the equity market rebound is very much in question, while the magnitude of the downward shift in later stage venture valuations is as yet too minor to have a major impact. Larger moves in these or other factors would point to an upgrade for the venture strategy, but for now our rating will remain at “Moderate Underweight”.


Tactical Assessment

Documents

2017 Private Equity Market Outlook - TorreyCove · received wisdom, did not collapse. In fact, US equity markets reached new heights in the month since the election. Perhaps this