Private Equity—Year in Review and 2020 Outlook

Andrew J. NussbaumSteven A. Cohen, and Karessa L. Cain are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell Lipton memorandum.

Private equity had a strong finish to the decade. Global PE-backed buyout volume reached nearly $400 billion by year end, which represented a 20% decline relative to 2018 but was still quite robust by historical standards, fueled by a number of megadeals, significant dry powder and record-low interest rates.

We review below some of the key themes that drove PE deal activity in 2019 and our expectations for 2020.

Megadeals. There were a number of $10 billion-plus PE deals in 2019, including Blackstone’s $18.7 billion purchase of the U.S. warehouse portfolio of Singapore-based GLP (the largest private real estate deal in history), EQT’s $10.1 billion purchase of Nestlé’s skincare unit, and the $14.3 billion sale of communications infrastructure services provider Zayo Group to Digital Colony Partners and EQT. In addition, in November, it was reported that KKR had approached drugstore giant Walgreens Boots Alliance about a potential $70 billion take-private transaction—a deal that, if successful, would be the largest LBO in history.

While a handful of megadeals took the spotlight in 2019, several other deals, including Apollo’s reported bid for Arconic, collapsed after months of negotiation; and the strong reported PE activity in 2019 does not take into account the extensive sponsor participation in auctions and other deal pursuits that ultimately did not succeed. Given lofty equity prices and significant efforts by strategic buyers to achieve scale and synergies, PE sponsors had their greatest successes where they had a portfolio company to build on or strategic bidders lacked interest.

The challenges and risks associated with big take-privates led some PE firms to focus their attention on the opposite end of the deal size spectrum. PE buyouts and investments with a price tag of less than $500 million now account for nearly 30% of the industry’s dealmaking by value, the highest level in nearly a decade. Smaller transactions can provide an alternative path to growth and scale, and a basis to compete with strategics, through “buy and build” strategies where PE funds buy a number of small companies within a sector, roll them up and exit through a listing or sale. Deals of this size may also offer more “one-off” advantages to PE bidders, as auctions are less common and relationships with management or a large stockholder may offer more “first-mover” advantages.

Spotlight on Tech. PE continues to make significant inroads into technology, a sector historically dominated by venture capital. After a two-year drop, tech deals rose to nearly 40% of U.S. PE deals as of August 2019, the second-highest share of deal value since 2010. PE firms are increasingly focused on acquiring technologies and other innovations that have the potential to transform industries, in some cases even outbidding strategic bidders, and have the cash to back it up: tech-focused dry powder has almost doubled since 2016. The interest is mutual—tech companies are turning to PE as an attractive exit route, opting for continued private ownership rather than public market scrutiny. We expect this trend to continue, building on the strong recent performance of tech-focused buyout funds relative to non-tech funds.

Where’s the Exit? All forms of exit—IPOs, secondary buyouts and acquisitions—were down in 2019, finishing the year with one of the lowest exit totals in the last six years in the United States. The decline in exit activity can be explained in part by a drop in PE-backed IPOs, mirroring an anemic IPO market more generally. After the WeWork debacle, public investors questioned IPOs that once seemed certain—for example, the Silver Lake-backed talent agency Endeavor pulled its IPO one day ahead of the planned launch date amid weak demand. PE firms were also willing to explore less conventional exit options in the M&A context—instead of the typical straight cash deal, some PE firms have expanded into taking stock of a publicly traded acquiror, in order to achieve liquidity for their investments.

Continued Support from Financing Markets; Structural Flexibility and Optionality as a Result of Direct Lending. The debt markets were generally strong in 2019, continuing a decade-long bull run, though at times borrowers rated single B—the sweet spot for most LBOs—or lower faced headwinds. As usual, sponsor-backed borrowers responded to these challenges with targeted adjustments to their debt offerings, revising debt structures, covenants and, when necessary, pricing to address market concerns.

In addition, as discussed in more detail in our recent memo, Acquisition Financing Year in Review: The Decade of Debt, many turned to the fast-growing direct lending market, with 2019 seeing direct lenders fund multiple billion-dollar plus deals. While debt provided by direct lenders—many of the most prominent of which are sister funds to traditional PE funds—is not necessarily cheaper than customary syndicated financing (and indeed is sometimes more expensive), it can offer unique advantages, including increased certainty of terms, elimination of a cumbersome debt marketing process, structural flexibility and optionality during challenging financing markets. Traditional syndicated loan and bond markets are likely to remain the primary sources of financing for most large-scale leveraged acquisitions, but the direct lending market has clearly emerged as a viable alternative in certain large-scale transactions.

Fundraising Falls, but Dry Powder Remains High. Global PE fundraising in 2019 continued its downward trend relative to 2017, its all-time high, while U.S. PE fundraising had a banner year. As in recent years, fundraising was concentrated in a relatively small number of large funds raised by established firms. Blackstone Capital Partners closed the largest-ever buyout fund in the third quarter at $26 billion, and Vista Equity Partners raised the largest-ever tech fund at $16 billion. With over $1.5 trillion of dry powder, the highest year-end total on record, capital supply is more than ample. Yet, this massive stockpile of cash is fueling both optimism as well as concerns. Over the 25-year period ended March 2019, private equity funds returned over 13% per year on average, compared with about 9% for the S&P 500. With asset values at all-time highs and heavy competition, PE firms face an uphill battle to sustain outperformance.

Blurring the Lines between PE and Traditional Activism. The line between hedge fund activism and private equity continues to blur, with some activist funds becoming bidders themselves for all or part of a company, and a handful of PE funds exploring activist-style investments in, and engagement with, public companies. For example, Starboard Value announced a $200 million strategic investment in Papa John’s in February; Elliott’s PE affiliate, Evergreen, closed its take-private of Travelport in partnership with Siris Capital in May; and KKR recently disclosed a minority ownership position in Dave & Buster’s. TPG was also reported to be raising an activist fund focused on building minority stakes in large public companies. While their attitudes toward publicity and methods to bring about change at companies are often quite different, they often share objectives and in some cases limited partners. We expect the PE landscape will continue to evolve as these two traditionally distinct forms of investing find common ground.

Big Names Opt for Structural Transformation. Over the past year, several major PE firms, including Blackstone, Apollo and Carlyle, converted from partnerships to C corporations, as Ares and KKR did in 2018. Carlyle went a step further in adopting a one-share/one-vote structure, a decision perhaps motivated by S&P index rules, which no longer permit the inclusion of dual-class companies in the S&P 500 (although many such companies are grandfathered since this rule change in 2017 following the Snap IPO). The trend toward C-corp conversions by publicly traded PE firms is tied to changes in tax laws, including the lowering of the highest corporate tax rate in the United States from 35% to 21% in December 2017, and the healthy process of succession planning at these firms, which will in turn promote their long-term stability and enable a broader set of investors to participate in the growth and profitability that PE can deliver.

PE Fund Liability for Portfolio Company Pensions: To Be or Not to Be?

Since 2013, PE firms have carefully monitored the continuing legal challenges by the New England Teamsters’ pension fund to PE firm Sun Capital Partners’ claims that, under ERISA, Sun Capital’s investment funds are not liable for obligations to the Teamsters’ pension fund of the bankrupt portfolio company in which its funds had invested. In December 2019, a panel of three judges in the First Circuit found in favor of Sun Capital, based on the facts and circumstances of the structure and observed operational formalities of the Sun Capital funds’ investments in the company. Although a tentative watershed decision for PE funds, it should be noted that the Teamsters’ pension fund has requested an en banc review of the case.

In the Political Crosshairs. With the U.S. presidential election on the horizon, 2019 was a year of heightened political backlash against the PE sector. Democratic presidential candidate Elizabeth Warren has been particularly outspoken about reining in PE, unveiling proposed legislative changes targeting the industry in a bill called the Stop Wall Street Looting Act. In November, Congress also held a hearing—“America for Sale? An Examination of the Practices of Private Funds”—focused on the costs borne by employees, shareholders and smaller unsecured creditors, including vendors and suppliers, in connection with PE ownership. Attacks on the PE industry from the likes of Taylor Swift and other public figures no doubt mean financial sponsors must continue to be heard in Washington, and to rebut unsubstantiated rumors and beliefs with the strong historical track record of the beneficial role that private equity has played for investors, pension funds, employees and other stakeholders in the United States and globally.

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We enter 2020 with continued political uncertainty, trade tensions, recessionary fears and volatility in equity and debt markets. Such an environment tends to have a chilling effect on deal activity. However, given the vast amounts of capital that PE firms have to put to work, we expect that financial sponsors will continue to make deals, find exits, raise capital and find creative ways to create value.

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