Private equity sees increased exit activity and improved returns in 2010

- Exits increased sharply in 2010 from 2008 and 2009 – signalling a return to normal levels
- EBITDA growth drives returns
- Right management from the start critical for superior returns

Private equity (PE) exit activity improved in 2010, compared with the previous two years, according to Return to warmer waters – How do private equity investors create value, two separate annual studies by Ernst & Young of the European and North American PE market.

Jeffrey Bunder, Global Private Equity Leader at Ernst & Young says: “PE has performed well coming out of the recession as evidenced by the return of exit activity, particularly IPOs. It has proved itself far better able to weather the storm than anyone had anticipated in 2008. Over the long term, PE-backed businesses should continue to outperform public markets.”

North American and European 2010 exits
The recovery in exits was evident in 2010. North American PE exits, increased to 118 in 2010, compared with 51 in 2008 and 76 in 2009. The market started to normalize as PE began divesting its largest portfolio companies across industry sectors, reaffirming more positive market conditions, especially in the public equity markets. The best performing sectors across the study period were energy and telecommunications, followed by health care, industrials and technology.

In Europe, there were 57 exits in 2010, a sharp rise from the lows of 2008 and 2009, when just over 30 exits were completed each year. The return of Initial Public Offerings (IPOs) was one of the most notable drivers of this, as a total of 11 portfolio companies exited via IPO across Europe – the highest number since 2006. Exits via IPO also accounted for some of the largest companies in PE portfolios by entry Enterprise Value (EV): 19% of exits by number were by IPO, while 56% by entry EV were by IPO.

Bunder comments: “The average entry EV for exits by IPO in 2010, at over €2.5b in Europe, is almost double the previous high of 2007. This demonstrates that the public markets have been a key route to realizing large portfolio companies, with 2010 a particularly strong year for this. This was also true in North America, where the average entry EV for PE-backed IPO exits in 2010 was US$1.1b.”

Another key driver of increased exit activity includes the return of secondary buyouts. However, despite the improvement in 2010, the difficult conditions over the past three years have resulted in a further ageing of portfolios (4.2 years both in Europe and North America in December 2010). The shortage of corporates from the M&A market present a challenge to the PE market recovery. Given the importance of trade sales as an exit route, the market will not fully recover until corporates return in full force.

EBITDA growth drives returns

For both North American and European exits, the 2010 returns were positive with EBITDA Earnings before interest, taxes, depreciation and amortization growth through operational improvement remaining the most important driver of PE’s value creation, rather than multiple expansion and leverage.

Harry Nicholson, private equity partner at Ernst & Young LLP, says: “The most striking finding is that within operational improvement, organic revenue growth is proportionally the largest contributor. In Europe, it accounts for 46% of profit growth across 6-years study period and 42% in North America.”

Graham Stokoe, Africa Private Equity leader for Ernst & Young commented: “The findings in respect of revenue growth stem well for Africa as one of the ways Private Equity owned companies will seek top line growth is through expansion into faster growing emerging market economies, including Africa. We are seeing increased appetite by large global Private Equity firms for investments in Africa. An example of this is CVC Capital Partner’s recent announcement in respect of acquiring a controlling stake in Virgin Active, which contains a sizeable part of its business in South Africa. Carlyle establishing a presence in Africa this year is another example.”

Cost reduction also drove a significant amount of the value created in PE portfolios over the long and short term. This became even more evident especially in North America, where the recession was deeper and lasted longer. Thirty percent of profit growth in North American exits was attributable to cost reductions.

PE working more closely with their management teams
Based on exits achieved during the two study periods, the report found that replacing management during the investment adds up to 1.6 years in Europe and 2 years in North America to the average holding period, and reduces returns anywhere from 10 to 40% depending on deal and geography. Failing to have the right team at the beginning of a deal can prove costly to businesses, especially during these difficult economic times. Both studies also found that PE has increased use of operating partners to work with management teams to drive additional business improvement.

Continues Nicholson: “It is encouraging to see that the drivers for organic growth in the different markets have been working, despite continued volatility in the markets. PE houses have proven their capabilities to weather the storm by working more closely with their portfolio companies and management, for the best returns.”

Future outlook

Concludes Bunder: “Even though exit activity has improved, the uncertainty in the economy — with threats of a double-dip recession and volatility in the public markets — challenges whether this increase in activity can continue. Corporates have not staged a major comeback on the M&A market, despite having built up significant cash reserves.” However, PE is proving that its active ownership enables it to create stronger and more profitable businesses and that its industry remains robust.

Stokoe comments: “PE exit activity across Africa has also started to pick up, albeit at a slower pace. Increased appetite by global Private Equity houses as well as generally greater investment appetite from international corporates bodes well for a healthy environment for increasing levels of exits for African PE owned companies.”