Term Sheet — Wednesday, February 28
THE STATE OF PRIVATE EQUITY
Good morning, Term Sheet readers.
Let’s start with the big news of the day: Amazon is buying smart doorbell company Ring for more than $1 billion. Ring previously raised approximately $209.2 million in funding from investors including DFJ Growth, Kleiner Perkins Caufield Byers, Goldman Sachs, and Qualcomm Ventures. The acquisition is notable because it cements Amazon’s place in the home. (Amazon has a line of smart home solutions including CloudCam and Blink.) Read more at Fortune.
In lieu of Term Sheet’s ‘5 Qs With a Dealmaker’ this week, we feature a Q&A with Hugh MacArthur, the head of Bain’s global private equity practice. Nine years ago, MacArthur and his team decided to release a global private equity report each year because many of the studies focused on PE were inaccurate, he says.
“The way I re-phrase the old saying is that, ‘There are lies, there are damned lies, statistics and then facts about the private equity industry,’” he said. “So we felt we needed to set the record straight about what was really happening in private equity.”
Bain released its 80-page global private equity report this week, and Term Sheet caught up with MacArthur to discuss industry trends, Trump’s tax overhaul, and rising company valuations.
TERM SHEET: Dry powder is at record levels. At the end of 2017, buyout funds were sitting on an all-time high of $633 billion. What does this mean for the industry at large?
MACARTHUR: The good news is that the capital has been deployed in terms of the percentage of dollar value capital in an increasing fashion in 2017. It picked up 10 or 15% over 2016. The problem is that the number of deals are flat, so the average size of the deals has increased but the amount of deals getting done is down from 2014. So the trouble is that we’ve got a mountain of dry powder, but we’ve got a flat number of deals and an increasing value per deal, so you quickly come to a situation where the industry is becoming much more competitive for each deal that is done. As a result, the prices are at an all-time high.
Company valuations remain the No. 1 concern facing private equity fund managers. As a result, more than one third of managers are planning for lower returns. Do you think high prices and increasing competition are likely to continue in 2018?
MACARTHUR: I do. We think prices and competition are only going to increase from a number of perspectives. One is, if you look at the returns the industry has had over the last several years, they’ve been very good. Private equity is typically, over any kind of reasonable time horizon, the highest performing asset class that most LPs have. Over the last six or seven years, they’ve been getting more distributions back from their GPs than they’ve been getting capital calls. Last year, they got $2 back for every dollar that was called to go into an investment. So obviously, that makes them want to put even more money in.
The pressure to put money into the industry has created ideal conditions for fundraising, which is why we have such a high amount of dry powder and that’s creating even more intense competition for deals along with continued favorable credit markets which allow for cheap debt.
In this type of environment, how can LPs expect funds to generate attractive returns?
MACARTHUR: Funds really need to up their game in a number of ways. Firstly, over 38,000 deals were done in corporate M&A last year, and private equity represented only about 8% of that. So it’s not that companies aren’t being bought and sold at large numbers, it’s that private equity isn’t getting enough of them to put this money to work. One way that some players are competing with corporates is that they’re actually behaving like a corporate. I call it “being a corporate on steroids.” Private equity funds are basically “corporates on steroids” because they can’t simply compete and perform the same way any other corporate would because corporates have a lower cost of capital and are able to accept lower returns than a PE firm. So private equity firms need to use their balance sheet skills and they have to be more ruthless in wringing every last dollar of synergy out of the purchase for a company that they possibly can. We’re definitely seeing a secular move in the industry to act more like a corporate.
On the tactical side, we’re seeing a lot of different plays. These assets that are being bought at high prices are assets that really need to be transformed. It’s not just business as usual anymore. Private equity firms have recognized for a while now that they can’t just expect management teams to conduct business as usual at the current price environments to deliver the types of returns that people expect. For many years through the recession and afterward, the PE industry built a lot of muscle around cost-reduction. Cost-reduction was critical during recessionary times for a lot of the portfolio companies to survive. But now the industry has gotten so good at that, they’ve flipped the lens and paid a lot more attention to revenue generation. We’re starting to see more and more PE firms employ playbooks that really have commercial acceleration programs embedded into them that deal with issues like pricing, customer segmentation, the right value proposition — much more on how to generate more organic revenue growth and gain share in the market than we’ve seen in the past.
Donald Trump’s tax overhaul has been referred to as “a net positive for private equity,” but there are questions about what it will mean when some of the “leverage” is removed from leveraged buyouts. In your opinion, how will the new policy affect bigger PE firms that rely heavily on the use of leveraged financing?
MACARTHUR: We’ve done some modeling of the new tax laws and their impact on deals in the U.S, and we found that it’s absolutely going to be a positive. The cap on debt deduction is a modest negative, and we believe it’s modest enough that it won’t impact most deals at all. The overwhelmingly positive factor that dwarfs this the net reduction in corporate tax rates from 35% to 21%. We do believe this will result in a modest positive for returns — there’s no guarantee obviously that all of that money goes into the return. But the tax law will not be a substantial negative for the industry.
SoftBank agreed to buy Fortress Investment Group for $3.3 billion. Since then, SoftBank executives have reportedly discussed various investments in the financial sector, from acquiring traditional investment firms to stakes in major PE firms like KKR. What kind of effect would this have on the PE industry?
MACARTHUR: We’ve seen a move toward permanent capital in the private equity industry and in the financial investment industry for many years now. This is not actually anything new. Before these financial investors existed, LPs, wealth sovereign wealth funds, and large Canadian pension funds owned minority stakes in private equity investors, so we don’t view it as something all that different.
It may accelerate a trend. I think there are more GPs out in the marketplace who are finding there’s value in having permanent capital in the business. A lot of people read about the many assets under management that GPs have, but we have to remember that those assets are generally other people’s money. Many PE firms don’t actually have a balance sheet of their own, so having private capital to either cash out owners who want to retire or open or extend new lines of business, or enter new geographies, those are all uses of permanent capital that I think different GPs find very valuable. Having SoftBank is yet another source of that type of capital coming into the capital. I’m sure it will accelerate a trend that’s already going on.
What are some of the lesser known trends for 2018 that are on your radar right now?
MACARTHUR: There are at least two that are emerging. One is that there are new types of long-hold strategies that LPs would really like to see come to fruition, and they’re starting to be offered. One of them is called “core buyout funds,” which occupy the space between infrastructure fund returns and traditional buyout fund returns. We think this is a trend we will continue to see.
The second thing we’re seeing is something we call, “the final frontier of private equity.” It’s about getting much better at talent assessment and talent performance management in portfolio companies. We’re now seeing a bigger push to get fit-for-purpose talent. By fit-for-purpose talent, I mean finding a management team that has the capability to execute on the investment thesis underwritten by the GPs. It might sound like something that’s obvious but it’s actually not. In 50% of the cases, private equity owners wind up changing out the CEO during the course of the holding period. When prices were much lower, you could afford to change out a CEO, wait, worry about the risk, let a year or two slip and still wind up making a decent return. In an era where we’re paying over 11 times for half the properties we’re buying, that margin for error is now gone.
THE LATEST FROM FORTUNE...
• Why Big Data-Cruncher Splunk Is Buying Cyber Startup Phantom for $350 Million (by Robert Hackett)
• Women Need An Extra Academic Degree to Achieve Equal Pay With Men (by Claire Zillman)
• The Best Companies to Work For Are Beating the Market (by Catherine Yoshimoto and Ed Frauenheim)
• House Prices Are Soaring (by Lucinda Shen)
• Gaana, an India-based music streaming services company, raised $115 million in funding. Tencent led the round.
• Mist, a Cupertino, Calif.-based maker of a self-learning wireless network powered by artificial intelligence, raised $46 million in Series C funding. Kleiner Perkins led the round, and was joined by investors including Lightspeed Venture Partners, Norwest Venture Partners, GV, NTT Docomo Ventures and Dimension Data.
• Citadel Defense Company, a San Diego-based drone system developer, raised $12 million in Series A funding. Investors include Lightspeed Vventure Partners.
• Nomad Health, a New York-based online marketplace for healthcare jobs, raised $12 million in Series B funding. Polaris Partners led the round, and was joined by investors including First Round Capital, RRE Ventures and .406 Ventures.
• Niche, a Pittsburgh, Penn.-based platform that helps people choose schools and neighborhoods, raised $6.6 million in Series B funding. Allen & Company LLC and Grit Capital Partners led the round.
• CounterFlow AI, a Virginia-based cybersecurity startup, raised $2.7 million in seed funding. Investors include Osage University Partners and the Charlottesville Angel Network.
• Maude, a developer of sex-focused products, raised $550,000 pre-seed round led by XFactor Ventures, and was joined by investors including Regenerative Investment, Pecari Ventures, and Next Level.
• ByteCubed, an Arlington, Va.-based technology provider and consultancy for commercial and federal government customers, raised funding of undisclosed amount. The investor was Enlightenment Capital.
HEALTH AND LIFE SCIENCES DEALS
• Generation Bio, a Cambridge, Mass.-based developer of genetic medicines, raised $100 million in Series B funding. Fidelity Management & Research Company led the round, and was joined by investors including Invus, Deerfield Management Company, Casdin Capital, Foresite Capital and Leerink Partners’ affiliates.
PRIVATE EQUITY DEALS
• The Riverside Company sold Insurance Claims Management Inc, an Eau Claire, Wisc.-based third-party claims administrator that serves large property and casualty insurance companies. Financial terms weren't disclosed.
• LNC Partners acquired Crosslink Professional Tax Solutions, a Tracy, Calif.-based provider of professional tax software solutions to tax preparers. Financial terms weren't disclosed.
• Palm Beach Capital made an investment in Lyneer Staffing Solutions LLC, an Ewing Township, N.J.-based provider of permanent, temporary and temp-to-perm placement services. Financial terms weren't disclosed.
• Satori Capital acquired a controlling stake in Zorch International Inc, a Chicago-based maker of branded merchandise and promotional products. Financial terms weren't disclosed.
• Gala Kerzen, which is backed by Equistone Partners, will buy a majority of Ramesh Flowers, an India-based maker of potpourri, air fresheners, incense sticks, and candles. Financial terms weren't disclosed.
• Applied Composites, a portfolio company of AE Industrial Partners LP, acquired San Diego Composites, a San Diego, Calif.-based composites supplier. Financial terms weren't disclosed.
• CR3 Capital acquired Xymat Engineering, a Colorado Springs-based maker of specialty containers and material handling solutions for specific operational sites of the U.S. Department of Energy. Financial terms weren't disclosed.
• SloanLED, a portfolio company of Baird Capital, acquired Litecorr, a Canada-based global LED lighting solutions provider. Financial terms weren't disclosed.
• Kingswood Capital Management acquired AutoAnything, a San Diego-based online retailer of automotive performance parts and accessories. The seller was AutoZone Inc. Financial terms weren't disclosed.
• Humatics Corp acquired 5D Robotics, a Carlsbad, Calif.-based provider of a positioning and navigation technology and its subsidiary Time Domain. Financial terms weren't disclosed.
• NIO, a Chinese electric car maker, is preparing for a U.S. IPO potentially of up to $2 billion, Reuters reports citing sources. The firm has reportedly hired Morgan Stanley and Goldman Sachs alongside six other banks to helm the offering. Read more.
• iQiyi, a Beijing-based video streaming service, filed for a $1.5 billion IPO. The company posted revenue of $2.7 billion and earnings of $146.4 million for 2017. Baidu (69.6% pre-offering) and Xiaomi Ventures (8.4%) back the firm. Goldman Sachs, Credit Suisse, and BofA Merrill Lynch are underwriters in the deal. The firm plans to list as on the Nasdaq as “IQ.” Read more.
• Vingroup, Vietnam’s largest property developer, tapped Citigroup, Credit Suisse, Deutsche Bank, and Morgan Stanley for the $1 billion IPO of its residential property unit, Reuters reports citing sources. Read more.
• Grail Inc., the Menlo Park, Calif.-based cancer detection startup, may seek an IPO of up to $500 million in Hong Kong, Bloomberg reports citing sources. Bill Gates and Jeff Bezos back the company. Read more.
• GreenTree Hospitality, a Shanghai, China-based hotelier, filed for a $200 million IPO. The firm posted revenue of $119.6 million and earnings of $43.8 million in 2017. Morgan Stanley, BofA Merrill Lynch, and UBS are underwriters in the deal. The firm plans to list on the NYSE as “GHG.” Read more.
• BioXcel Therapeutics, a Branford, Conn.-based firm seeking AI solutions to neurological disorders, said it will raise $60 million in an IPO of 5 million shares priced between $11 to $13 a piece. The firm posted loss of $4.5 million in 2017. Barclays, UBS Investments, and BMO are underwriters in the deal. The firm plans to list on the Nasdaq as “BTAI.” Read more.
• Stone Point Capital agreed to acquire a majority stake in LegalShield, an Ada, Okla.-based provider of identity theft solutions. The seller was MidOcean Partners. Financial terms weren't disclosed.
• Chorus, a social workouts app startup, shut down operations. The company had raised approximately $9 million in venture funding from investors including Index Ventures.
FIRMS + FUNDS
• Kindred Capital, a U.K.-based venture firm raised £80 million ($110 million) for its first fund.
• Prelude Growth Partners, a New York-based private equity firm, raised its $80 million for its first fund.
• Kinzie Capital Partners named Danielle Cupps as a managing director.
• Mark Manheimer joined Capview Partners as managing director and chief investment officer.