Oil price turbulence benefits the opportunistic
The prolonged turbulence in oil prices has brought cost reduction programmes, the shelving of projects, and insolvencies in the oil field services (OFS) and exploration and production (E&P) sectors — and has presented a oncein-a-generation buying opportunity. Although many companies are focused on pure survival, there are buyers willing to bet on an eventual recovery. Indeed, the situation presents a significant opportunity for private equity, either alone or in partnership with corporates.
Sellers must structure their deals to minimise execution delay and completion risk. In a buyers’ market, simplicity matters
Paradoxically, the consensus that no significant price recovery is imminent could simplify parties’ agreement on valuations in 2016. Q1’s Eon/Premier deal showed a pronounced softening of asset valuations with an implied price per barrel of under US$2. At these levels sellers need a strategic reason to sell or else a strong financial imperative. With financing alternatives limited, asset sales will be unavoidable for a number of companies in 2016.
Oil price stability will be key to consummating deals, especially in the upstream segment. Sharp changes in price scuppers deals, as experience in Q3/4 2015 has demonstrated. The only way to mitigate the risk is to transact quickly. Sellers must structure their deals to minimise execution delay and completion risk. In a buyers’ market, simplicity matters.
Though upstream is challenged, the market for downstream and midstream assets, especially infrastructure, remains relatively buoyant, and there remains a significant pool of potential buyers, PE included. With many E&P players needing to keep producing to generate revenue and service debt, tariff-based infrastructure, such as gas transport pipelines, can be attractive. Robust refining margins in 2015 have generated downstream interest, especially for emerging market assets. Consolidation within the oil field services subsector is widely anticipated and appears to be gaining momentum. As well as straight buy-outs, involvement in the OFS sector may also include taking positions in the increasing number of OFS work-outs, perhaps to leverage existing debt positions or provide new equity to unlock a restructuring.
Many PE buyers will look to team up with oil and gas corporates to benefit from these opportunities. Creating a successful, sustainable joint venture between PE and strategics can be challenging, with the parties often having varying outlooks on matters such as governance and exit, as well as different investment horizons and ideas on valuation. To overcome these challenges, the parties must clarify each party’s role based on their strengths, and concentrate on the issues important to them as an organization, rather than the numerous differences between them.
2016 promises to be challenging for all those involved in the oil and gas industry, but opportunities definitely exist.
Preqin shows that while the total value of deals fell from 2014 to 2015, PE investors continued to show interest in the US oil & gas sector with 23 investments over $50 million – the highest number of deals in the second half of the year for the past 10 years.
The liquidity crunch spurs creative PE deal financing in the US
Since the 2008 financial crisis, the US Federal Reserve and other central banks in Europe have pumped trillions of dollars into the financial markets. Notwithstanding the amounts injected, a liquidity crunch in 2016 is unavoidable and could have a significant impact on available financing for PE sponsors.
Several regulatory factors point to this liquidity crunch, including new financial regulations that demand higher capital and liquidity requirements from banks, which must hold more cash in reserve. Basel III, for instance, requires banks to maintain certain liquidity coverage ratios such that they have high-quality liquid assets that cover total expected net cash outflows over 30 days. Similarly, the Board of Governors of the Federal Reserve has brought in significantly tougher liquidity requirements for the larger bank holding companies in the US. In addition, increased enforcement of leveraged lending guidelines means that US banks are no longer as active in the syndicated markets as they once were, and are no longer in a position to hold certain risk-weighted assets on their balance sheets.
The reduction in liquidity and corollary increase in cost of available financing will have a profound impact on PE sponsors’ strategies. Since large institutional lenders are shying away from targets they perceive to be riskier, whether due to the industry involved, lack of market familiarity with the target in the case of carve-out transactions or because of leverage levels, private equity firms looking to tap traditional financing markets are likely to continue shifting their focus to lower risk targets. Banks are expected to be more willing to provide financing for lower risk targets in an effort to ease risk-related concerns tied to regulatory requirements.
With PitchBook’s 2016 Crystal Ball Report indicating that traditional banks will only account for some 40% of overall debt financing during the year, PE sponsors may be forced to look at The liquidity crunch spurs creative PE deal financing in the US non-traditional sources of finance, including mezzanine lenders, business development companies, other private equity firms and corporate financial sponsors. New sources of capital include both private companies and debt funds: Koch Industries’ investing arm, Koch Equity Development, recently made a preferred investment that served as part of an overall acquisition financing package; and French buyout firm Eurazeo financed their acquisition of Fintrax with €300 million provided by Ares’ direct lending arm, the largest amount lent by a single debt fund on a deal in Europe to date.
The reduction in liquidity and corollary increase in cost of available financing will have a profound impact on PE sponsors’ strategies
Many US PE firms may also take advantage of the “Reverse Yankee” phenomenon. In the last several years, we saw many European sponsors accessing the US leveraged loan markets because of attractive pricing and significant operational flexibility from Term Loan Bs. Although much of the regulatory regime will also affect European banks, there are still opportunities for US PE firms to look “across the pond” for access to capital in an environment where US regulators are further restricting the banks’ ability to pump liquidity into the markets.
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Alternatively, PE sponsors may decide to write-out higher equity checks when acquiring assets. Apollo Global Management, alongside several other PE groups, recently took Apollo Education Group private in a transaction with no debt funding. The entire transaction was equity funded at closing, and leverage may be added when debt markets improve. According to Preqin, there has been a steady rise in 100% equity funded deals since 2005 as seen in the chart above, and we anticipate this trend will continue in 2016.
Although these liquidity constraints create a challenging environment for PE firms, the outlook for transactions is still positive. The level of dry powder available to private equity funds reached US$752 billion at the end of 2015, according to Preqin, and will continue to grow in 2016 with additional fundraising activities planned. With the enduring uncertainty in the financial markets, PE firms will simply need to be creative in leveraging all of this unspent capital.
Tough exams for investments in the education sector
The growth of private spending on education presents an opportunity for private equity. While public spending on education in the OECD as a proportion of gross domestic product decreased slightly between 2003 and 2012, the number of students attending private secondary institutions in the OECD rose from 11.07% to 15.99% during the same period. An indication of the global demand for quality private education is that by the end of 2015, UK elite public schools had set up 44 international branches around the world, most notably in the Middle East and the Far East.
The opportunity for private equity is in both direct education providers, those businesses that “teach” students – childcare, infant, secondary and tertiary institutions – and for service providers to those institutions – for example, providers of technology solutions. The latter type of investment space, frequently referred to as “Edtech”, has seen aggregate global deal size grow from $1.82 billion in 2009 to $5.5 billion in 2015.
It’s a similar marker of growth for the number of buyouts globally in education businesses, which has increased year on year from 2010 until 2015 with a five-year increase of 61.25% against 2010.
But like investments in other sectors that have historically been dominated by public investment (for example, healthcare or aged care), investments in the education sector, particularly direct providers, are not without their challenges. Most obviously is the tension between business performance and educational outcomes: the ease with which the performance of a business can be assessed – distilled in revenue and earnings numbers – is in contrast with the variety of factors relevant to determining the quality of the educational experience; exam results are but one indicator. In short, investments in the direct educational sector are prone to the challenge that educational outcomes are being compromised for the sake of business performance, whether actual or perceived. Such a challenge can have significantly adverse impacts on the reputation of a private equity investor.
In addition, there are a number of industry specific issues that are relevant to investments in direct education providers, a selection of which are listed in the box below.
In our view, the relatively flat public investment in the education sector and the increasing proportion of enrolments in private education providers mean that the education sector will continue to be attractive for private equity. This is the case both for investments in direct education providers and investments in service providers to those institutions.
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KEY ISSUES FOR PE INVESTMENT IN DIRECT EDUCATION PROVIDERS
- Certainty regarding future enrolment and tuition fee income – Enrolment rates can be affected by many factors outside of a PE firm’s control, including poor macroeconomic conditions, political instability and expatriate relocation
- Collective bargaining agreements for teachers and staff may prevent or delay initiatives – Collective bargaining agreements may require union approval to, for example, amend employees’ working hours and request teachers assist with potentially profit-generating activities, such as winter or summer camps
- Certainty regarding maintenance and location of school sites if leased – If school sites are leased, any failure by a landlord to comply with its covenants could disrupt the operation of the school. Further, PE investors may not be able to renew existing leases in jurisdictions where leases do not benefit from statutory or contractual rights of renewal
- Obtaining and maintaining permits or certificates to operate schools – Any failure to maintain relevant standards could result in the loss of required accreditations and ultimately the closure of schools
- Managing privacy issues, particularly personal information of students – If security measures were to fail, or an employee or third-party contractor misuses personal data fraudulently or otherwise, aside from the reputational damage, liability and/or financial fines may arise
Private equity goes green
In December 2015, world leaders met to negotiate the Paris Agreement. Setting aside whether the Paris Agreement goes too far, not far enough or is just right, one cannot dispute that government commitments to limit an increase in the global average temperature to well below two degrees Celsius will almost certainly impact private equity funds. In particular, regulatory and investor demand are likely to change the way climate-related risks are assessed. As Blackrock notes, “…carbon-heavy industries are not immune from disruption, nor are asset prices from regulatory efforts to mitigate climate change risk. We believe investors should thoughtfully consider these dynamics in order to build sustainable portfolios and take advantage of investment opportunities as we move towards a low-carbon economy”.
The private equity sector is in general paying closer attention to Environment, Social and Governance (ESG) issues throughout the investment cycle, whether voluntarily (for example, KKR’s Green Solutions Platform) or in response to investor pressure. French private equity firms Apax Partners, Ardian, Eurazeo, LBO France and PAI Partners committing to reducing greenhouse gas emissions across their portfolio companies is perhaps the most recent illustration of this shift in focus.
Going forward, we anticipate further tightening of existing laws and also the emergence of new controls
While the Paris Agreement clearly sets governments’ aspirations and goals, the real key to climate change risk mitigation will turn on implementation. To date, the EU has been a leader in terms of regulation in this area with the EU Emissions Trading Scheme and Article 8 of the Energy Efficiency Directive (requiring non-SMEs to undertake energy audits). The UK has also been proactive, with national goals set out in the Climate Change Act 2008 and the implementation — through the CRC Energy Efficiency Scheme and climate change levy — of a tax on UK businesses’ carbon footprint (the UK will abolish CRC from 2019 as the government seeks to simplify carbon-related regulation). Going forward, we anticipate further tightening of existing laws and also the emergence of new controls, particularly in jurisdictions that have previously been less proactive (including China, which will in 2017 launch the largest emissions trading scheme in the world).
This rapidly changing regulatory landscape is also impacting investment behaviour with carbon-intensive assets increasingly considered stranded assets. The World Bank, along with analysts at Citigroup, HSBC and the Carbon Tracker Initiative have all warned of the financial risk that climate change poses to such assets. Indeed, the Portfolio Decarbonization Coalition, a coalition of institutional investors committed to mobilizing financial markets to drive economic decarbonization, is overseeing the reduction in carbon emissions across US$600 billion in assets under management.
Other investors see stranded assets as a significant opportunity, particularly given concerns over the lack of capacity in the energy market. Whatever your view, there will likely be more volatility in this sector. The question yet to be answered is whether these are ‘stranded assets’ or ‘undervalued assets’, or perhaps a combination of both.