Relying on multiple effect and leverage is no longer enough to generate profit. European private equity must not only adapt to the challenges of digitalization and new technologies, but also to the ageing of the European population and comparatively lower growth economies. Increasingly investors look towards Asia as the macroeconomic center of gravity shifts East.
Without being able to read from a crystal ball, we can say the coming decade holds a lot of promise for Private Equity:
We are finally recognized as a profitable asset class (perhaps the MOST profitable) in a downpour of liquidity continuing to rain down on us, because we are the only sector offering attractive long-term returns in the face of negative interest rates for risk-free assets.
Even if this strong trend has finally taken hold, we will continue to operate in an environment which our Anglo-Saxon friends would describe as “challenging”…
In summary one could say that PE professionals will increasingly have to create value outside of multiple arbitrage and simple leverage, as we may well experience a recessionary environment and receive increasing criticism on the old recipe of financial engineering as a model for returns.
This value creation requirement is particularly necessary as the global economic center of gravity has (and continues to) definitively shifted to the East (China and India), and as the growth of old Europe is durably affected by headwinds in demographic trends and comparatively limited economic growth.
Let’s go into detail: When I started working on LBOs (in France historically referred to as “RES”) in 1984, the technique was mysterious: how with 5 in his/her pocket, could an executive buy out the company which he/she worked for, worth 100? Acquisition debt becoming available was a decisive factor in the acquisitions of companies (with its evolving sophistication such as mezzanine, senior, junior, tranche A, B, C). The expansion and professionalization of the market have increased valuation multiples (we used to buy on the basis of the net result, then on EBIT, followed by EBITDA, and now the new IFRS 16 standard will enable us to push the aggregate which serves as a basis for the multiple). Due to the increasing valuations and/or the use of debt, almost everyone has made money (apart from during the two crisis periods of 2001-2002 and 2008-2009).
The question of a next recession is the subject of regular feverish debates, generally at the start of the school year, in a context where the LBO world is boosted by historically low rates and erratic valuation examples set by VC IPO’s in the USA.
The recipe is known: adding value to equity investments. But while there are many contestants, there are only few great chefs and even fewer cooking schools. This is evidenced by the increasing presence of the Operating Partners, which are proving their worth in the US/UK markets, but today predominantly center around a few large funds.
Two factors are profoundly changing our European Business Models:
First, technological change such as an acceleration in digitalization which is transforming customer relationships both in B to C (Brick & Mortar to Bricks & Clicks) and B to B (e.g. training or professional publishing), and artificial intelligence which is as much an issue as it is an opportunity for the years to come (e.g. medical analysis, autonomous mobility, etc.).
Second, the emergence of a Europe with sustainable but only moderate growth, entangled in heavy societal transformation due to demographic shifts and particularly the problems of retirement and medical expenses. One challenge is the re-imagination of the welfare state and democracy required in response to the surge of anti-establishment movements such as the yellow jackets. Another challenge is to capture the aforementioned rise in importance of Asia. Not only do we need to adapt our production capabilities by setting up operations there, but our funds or portfolio companies also need to invest significantly and sustainably in these areas.
To adequately respond to these two factors, the majority of PE players will have to extend their capabilities at a rapid pace in order to stay relevant.
The public opinion plays an important part in the future successes of PE:
We, as private equity investors, are regularly subject to criticisms to which we must now, more than ever, demonstrate and communicate the positive impacts of our activity (employment, research, asset liquidity, meritocracy, maintenance of decision-making centers, taxes, etc.). The significant number of “profit-driven” aspects can appear as an “extreme” form of capitalism at first sight: how many times have each of us had to explain to our interlocutors at dinners that we are not vulture funds which prosper thanks to factory closures and staff reduction. We must remember that US presidential candidate Mitt Romney’s lack of good communication about his role as founding president of Bain Capital contributed to his failure in the presidential race, while Donald Trump managed to pass himself off as a great entrepreneur symbolizing the American dream!
In this respect, ESG is also an increasingly common topic in our daily lives and is a two-sided coin. Positively, we encourage (and are encouraged to) contributing to a better world, and defensively, as it is a demand and pressure coming from LPs. The French PE industry and its association ‘France Invest’ committed to sustainable growth from 2008 with a charter promoting respect for its principles. For the most recent 2018 report, 129 management companies answered the questionnaire and took actions in more than 1,800 companies involving nearly 1.5 million employees!
The key to success in changing the often-negative narrative about our industry is to continue our efforts to explain, evidence, and demonstrate to everyone, especially our critics, the usefulness and necessity to society of this fantastic profession.