Trends Watch: July 19, 2018
EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.
This week, Elana talks to John Lenahan, Partner, Wincove Private Holdings.
What is your outlook for private equity?
Private equity deal activity will continue to be robust, driven both by an abundance of capital and companies for sale, and the compression of returns will persist. I don’t track macro data too closely, but I know that 15 years ago it was standard to run an LBO model at a 30% return, and today that would be considered very aggressive.
From a seller’s perspective, this means that valuations are at an all-time high (buyers endlessly complain about this). I’ve heard “6x is the new 5x” evolve to “8x is the new 6x.” And while private equity is cyclical, I don’t see valuations receding anytime soon (maybe modestly if the debt capital markets contract). The reality is a massive amount of capital has shifted to private equity. According to Preqin, private capital assets under management have increased from $1.2 trillion in 2005 to $4.2 trillion in 2015. This will keep valuations high.
Meanwhile, there will be more and more businesses for sale, largely the result of Baby Boomers, a very successful generation. According to the California Association of Business Brokers, retiring Baby Boomers will sell or bequeath 12 million companies comprising $10 trillion of assets over the next two decades, and more than 70% of these companies are expected to leave family hands. We see evidence of this every day: The children of Baby Boomers are often more interested in careers in technology, investing or law in the big cities than they are in manufacturing or distribution in other parts of the country. Nevertheless, people still drive (or at least use) cars, and cars still need parts, so these companies are critical to the economy.
Buyers secretly hope the Baby Boomers will cause a wave of supply so intense that valuations will normalize, but this remains to be seen. Regardless, private equity is the most natural outlet for these owners (assuming they want to maintain their company legacy). Not only can private equity facilitate a financial transfer, but most firms have spent years building networks of executives, operating partners and consultants with tangible resources. These tools will be critical to succession planning and sustained growth for the companies, and serve as a key driver of investment returns, separating successful managers from those chasing deals.
Over time there will be a continued bifurcation between mega funds and smaller opportunistic managers. Mega funds, who have captured much of the capital increase mentioned above, will differentiate themselves on scale and the ability to identify attractive sectors, and CEOs are generally warm to the idea of running their businesses without the daily scrutiny of Wall Street. I think of this as “privately managed public equity.” On the smaller side, managers will carve out niches based on skillset and relationships, identifying scalable companies and executing “buy-and-build” strategies. Where you don’t want to be is in the middle, where capital is abundant and auctions are won on price, with no differentiation or strategy for creating value.
What areas present the most attractive investment opportunities?
We have identified several themes that we are investing around that we believe will give companies some wind at their back. These trends are usually subtle as our focus is on industrial and service businesses, as opposed to blatantly high-growth industries. For example, we see strong demand for material handling products – equipment used to safely move and lift goods. Do you receive more or less packages at your home than you did five years ago? While this change has made things much easier for the consumer, producers and retailers need more equipment to ship your packages. And not only do they want them to arrive in good condition, but they want to do it safely for their workers.
Often there may be a contrarian element to the themes. For example, we are bullish on investment in automotive production infrastructure – the equipment used to make the cars as opposed to the numbers of cars produced. Whereas unit sales and production seem to be getting near their peak, OEMs are indicating they will make substantial investments in capital expenditures to facilitate line change-overs for model upgrades and electric vehicles.
Other positive themes we see are automation, IoT (aka Industry 4.0), cloud migration, health and wellness, residential housing starts (though this may only have a few years left) and cellular infrastructure/services.
What keeps you up at night?
I think our economy is incredibly resilient and will handle many “bumps,” but the uncertainty of trade disruptions is the one “systemic risk” that keeps me up. A few of our companies purchase a fair amount of steel. While 100% of our purchases are domestic product, the tariffs on imports have created tremendous price volatility in the supply chain. Our management teams have done a fantastic job of managing through this (no doubt with some new gray hair), but the long-term challenge is uncertainty. Theoretically prices should normalize as U.S. mills increase production to take advantage of the protection. But no one knows if the protection is going to stick, so the mills have not invested toward new capacity. Meanwhile, our companies are cautious about investing in their own businesses, as the long-term impact of higher prices is hard to predict.
Where I start to worry is if you extrapolate that uncertainty across the global supply chain, with the emotion and complexity of broader trade war. Those could be the ingredients for a situation where things grind to a halt. I’m all for creating a level playing field, but clarity and stability are important too.