As GF Data collects data from 150-plus middle market private equity firms, we hear more and more about the downward pressure being exerted on internal rates of return, and measures being taken by PE buyers in response.
Based on the data, conversations with our contributors and subscribers and transactional experience at Fairmount Partners, my M&A firm in suburban Philadelphia, it seems to me that: (a) the pressure is real; (b) the market is indeed responding; but (c) IRR remains the defining metric, particularly for top-performing financial buyers.
The widespread view is that target rates of return have declined from 30 percent or greater before the 2008-09 market collapse to the low-to-mid 20 percent range today.
Our quarterly reports chronicled the staggering increase in average equity contribution that occurred as a result of credit contraction in a two-year period. Equity as a percentage of average deal structure soared from about 40 percent in 2006-07 to 60 percent in 2009. As the debt markets have thawed, the figure is about 55 percent today – better, but still a challenging for buyers relying on financial leverage.
Many acquirers are responding by making the case for long-term lower returns in the asset class, using deal mechanics to realign their risk with lower expected rates of return and by emphasizing cash multiples of return as a more relevant measure of performance.
- 1. Expect long-term lower returns.
- The theory here is that investors in LP-based funds need to accept lower returns in the alternative investments asset class – what matters isn’t just raw percentage returns but the differential between public and private equities. It appears we are in a period of overall lower returns in the public equity markets, so that spread should remain intact.
- After tumbling 37.3% in 2008, the S&P generated annual returns of 23.7% and 12.8% in 2009 and ’10, respectively. Most analysts take the view that 2011 will be another up year.
- So, while the past decade overall was a period of punishing decline, it’s hard to say that there has been a correction away from long-term annualized returns of 6-7 percent. Sponsors hoping for more relaxed benchmarks do so at their peril.
- 2. Use deal mechanics to realign risk.
- There clearly has been compression between private equity and mezzanine returns. GF Data started collecting data on and calculating all-in return on junior capital in the second half of 2010. All-in return for that period averaged 18.1%. So, a PE firm pushed to accept a 24% IRR on its investment is not getting much of a premium above the average mezzanine return.
- We see equity investors responding by offering deal structures that attempt to cap or minimize their risk, in effect equating a “quasi-mezz” instrument in terms of return and exposure. This is easier to do and more prevalent in non-controlling investments, where the seller is retaining substantial equity interest along side of the new investors.
At Fairmount, we completed two minority recaps this fall with health care services firms that attracted a lot of interest from PE firms not requiring control. Many of the bids from financial buyers used reducing liquidity preferences or other devices to get the investor to an acceptable rate of return under even modest exit scenarios.
- 3. Focus on cash multiples of return.
- Cash multiples of return have certainly gained currency. You can see the point, particularly with high-quality funds that are not high-volume investors. A partner in one such firm commented, “We have always been focused on cash-on-cash returns since buying any company is hard work.”
- For such a firm, an investment that produces a quick exit at a lofty IRR is a mixed blessing. Let’s say you can invest $20 million for one year and earn $30 million at exit – a 50 percent IRR. Or you can invest the $20 million for a three-year holding period and earn $40 million at exit. The IRR is lower – 26 percent – but you’ve made a 2.0x return not 1.5x, a gain of $20 million rather than $10 million.
In the end, it all comes back to IRR. The high-quality, low-volume shop prefers the second investment because their experience tells them they won’t be able to redeploy the cash in another investment generating anything close to a private equity return. From the macro-perspective of the fund over its life, the first scenario is less desirable because it leads to a lower fund IRR.
The high-quality, high-volume firm, then, may talk about multiples of cash return because it’s in vogue, but there is always a demand for their capital in other portfolio companies or new investments. Internal rate of return remains a useful benchmark with much less of the punitive downside.
A lot of sponsors who have been strong performers in the difficult conditions of the past few years also tell us that they didn’t max out on debt when it was more widely available, so their ability to achieve a given level of return was not heavily effected when lending tightened up. This is particularly true for groups looking at acquisitions in the $5 million range and below.
In the universe we cover – PE firms doing deals in the $10-250 million value range — achieving 30 percent-plus IRRs is difficult but achievable. However, it wasn’t that easy even when that benchmark was being cited more frequently. According to Venture Economics, the average annual return for U.S. buyout funds from 1987-2006 was 12.2%.