2018 Private Equity Year in Review

Andrew J. Nussbaum, Steven A. Cohen, and Victor Goldfield are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell Lipton memorandum.

2018 was a banner year for private equity. As of late December, PE buyout volume had reached almost $384 billion, the highest since the PE boom before the financial crisis. The pace of activity overcame various macro challenges to PE dealmaking, including competition from strategic acquirors, high-multiple valuations and, in the fourth quarter, rising interest rates and disruption in the high-yield and leveraged loan markets.

How did financial sponsors succeed in a volatile and uncertain environment?

Finding Deals and Being Creative

Many of the larger transactions depended upon strategic partnerships. Blackstone, for example, partnered with Thomson Reuters to carve out its financial and risk business into a $20 billion strategic venture owned 55% by Blackstone and its co-investors and 45% by Thomson Reuters. One high-profile activist’s willingness to take more long-term risk supported major PE deals—Veritas’ and Elliott Management’s pending acquisition of athenahealth and Siris Capital Group’s and Elliott Management’s pending acquisition of Travelport. Whereas activist hedge funds have often advocated for target companies to sell, including to PE firms, it remains to be seen whether other activist hedge funds will also be willing to partner as co-buyers with PE firms.

Sponsors also built transactions based on their relationships with owners of private firms and public company CEOs. In these bespoke public target situations, to retain the “first-mover” track, PE firms often accepted, or even proposed, “go-shop” provisions to address concerns about the absence of a more full pre-signing market check (about 20% of private-equity deals in 2018 had a go-shop provision).

Better Deal Roadmap

The legal landscape also supported the PE deal environment. Appraisal rights arbitrage is quickly becoming a much more risky investment strategy. The Delaware Court of Chancery and the Delaware Supreme Court issued a series of decisions in appraisal actions over the past few years (e.g., the AOL, Aruba, Dell, DFC, PetSmart and SWS appraisals) that held that the “fair value” of a dissenter’s shares equals, or on occasion is less than, the deal price. Process still matters, and Delaware judges retain some skepticism of the fairness of PE deals outside an auction context, but the courts have made clear that the negotiated merger price should often be regarded as a strong indicator of fair value, if not a ceiling, and that there is no “private equity carve out” from the reliability of market evidence. The Delaware Court of Chancery also recently upheld a waiver of appraisal rights involving a closely held company in Manti Holdings v. Authentix Acquisition. These helpful case law developments may also reduce settlement costs.

Separately, court decisions such as Trulia discouraged disclosure-only settlements and dampened some of the more egregious plaintiffs’ litigation tactics. Many state courts, with a notable exception in New York, have systematically rejected disclosure-only settlements that effectively impose a “merger tax” on public company acquisitions. However, plaintiffs are increasingly bringing M&A disclosure litigation in federal courts, which generally have not (yet) adopted the Delaware courts’ views of these claims.

“Clean Break” Deals Increasing

In the private M&A setting, representation and warranty insurance is now firmly established as a tool to facilitate a clean exit for PE sponsors, while providing the buyer with protection akin to a post-closing indemnity. Likewise, we find PE firms considering R&W policies when acquiring public companies, which supports dealmaking on the buy-side through the possibility of some post-closing protection. While R&W policies vary in scope, policy forms have become more standardized, pricing has become more competitive, the time required to obtain a policy has become more streamlined and substantial insurance coverage is available in the market. In addition, whereas in the past carriers generally required sellers to have some “skin in the game,” in the form of a limited indemnity obligation, we have seen more recently R&W policies where carriers retain all risk, above a negotiated, de minimis deductible.

Private Equity Exits

Financial sponsors took advantage of robust capital markets earlier in 2018, with over 35 private-equity backed companies completing their IPOs by the end of the third quarter. Exits via sale were also active, including in many cases with targets held for two years or less (e.g., Siris Capital Group’s sale of Intralinks to SSNC and Vista Equity Partners’ sale of Marketo to Adobe).

Fundraising Falls; Dry Powder Remains High

Fundraising in 2018 remained strong by historical standards, but down from the elevated levels of 2017, the highest since the financial crisis. As in 2017, fundraising was concentrated in a relatively small number of large funds raised by established PE firms. With over $1 trillion of total dry powder in PE funds, deal equity capital supply is more than ample.

High Leverage Multiples and Flexible Structures Make a Comeback; Financing Markets Shudder at Year End

In 2018, almost three quarters of large LBOs were levered at 6x EBITDA or higher; well over a third were levered at 7x or higher. Under the current administration, bank regulators, whose previous leveraged lending guidelines sought to preclude financing deals levered over 6x, have instead deferred to the marketplace. For now, lender risk tolerance rather than regulatory stricture is the limiting factor for leverage levels, making target companies with predictable cash flows appealing.

That market at year end supported $0 (zero dollars) of new high-yield bond issuance in December (a first for any month since 2008), and also saw leveraged loan deals withdrawn due to lack of demand, as well as heavy withdrawals from bond and loan funds. Lender risk tolerance may be changing, at least in the short term. PE firms, of course, have seen tough financing markets before, and we expect they will continue to use competitive financing processes and creative debt structures to navigate these rough waters.

Prior to the cooling of the debt markets, “covenant not” and other flexible capital structures supported further dealmaking by PE portfolio companies, with some debt structures portable in the event of a sale of the company. This built-in financing may well facilitate transactions in an otherwise-challenging new issuance leveraged debt market.

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We enter 2019 in a period of significant uncertainty across a variety of macroeconomic, geopolitical and financial factors, with accompanying substantial volatility in equity and debt markets. Such an environment tends to chill strategic deals, and makes other deals more difficult. However, we expect that nimble and innovative financial sponsors will find opportunities even in these challenging conditions, or in fact because of them.

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