Invesco Canada blog

Insights, commentary and investing expertise

Patrick Machir | December 6, 2017

2018 Investment Outlook: Looking for opportunity in private equity and stressed credit

The overall global macroeconomic picture saw gradual improvement in 2017, aided by continued supportive monetary policy from central banks throughout key economic centers. We entered the year expecting volatility, in part due to the implications of the U.S. presidential election. However, lower volatility took hold as markets grew comfortable with a range of uncertain issues, including potential policy changes from Washington, China’s economy and the overall interest rate and commodity environment. We expect that 2018 may see an increase in volatility as the economic expansion in the U.S. enters its ninth year.1 While our base view is for a continuation of the current economic expansion, there is a higher degree of uncertainty beyond 2018. We are monitoring several key themes that each play an important role in the private equity and stressed credit universes.

Valuations and leverage

In parallel with the public equity and credit markets, valuations in the private markets have also reached lofty levels, with multiples for middle and large corporate leveraged buyouts now eclipsing those witnessed prior to the financial crisis. Specifically, large leveraged buyouts in the first three quarters of 2017 averaged an enterprise value to EBITDA purchase multiple of 10.5x.2 Receptive financing markets and a continued flow of capital into private equity funds have been key factors supporting valuations as private equity dry powder has grown to a record level of $942 billion as of September 2017.3 The combination of synchronized global monetary stimulus, significant availability of credit and the large amount of dry powder has created a receptive climate for growth in leveraged buyouts in recent years. However, as purchase multiples have moved up, average equity contributed to transactions has remained at higher levels than prior to the financial crisis. Further, increasing participation from sovereign wealth funds, family offices and other new pools of capital has resulted in more deal competition for traditional private equity investors. These factors, combined with a rising interest rate environment, serve to put downward pressure on the implied return potential of the traditional leveraged buyout and limit the ability for returns to absorb unanticipated risks. The volume of leveraged buyouts and expansion of the leveraged credit markets in recent years should provide an increased opportunity set for distressed and special situations private equity, particularly as economic growth and credit availability slow.

Company-specific opportunities

The current backdrop would also suggest limited opportunities for investing in systemically distressed credit. However, several factors underlying the broader market continue to produce a growing number of company-specific opportunities, especially among small- and mid-cap issuers undergoing some level of underperformance. As dry powder has risen, the volume of private equity investment with more aggressive financing structures has also increased. Total leverage levels within the small- and mid-cap universes are approaching 6x, and first lien levels now exceed those achieved during 2007.4 This heightened risk profile is illustrated by the distribution of leverage in today’s market – over one-third of small- and mid-cap transactions completed in 2016 (and close to 40% completed in the first three quarters of 2017) were leveraged at 6.0x or greater.5 Small- and mid-cap companies that have financed themselves at aggressive leverage levels will be vulnerable to reduced cash flows and/or more limited availability of capital as interest rates rise or sentiment shifts. In addition, these smaller companies are often more ill-equipped to deal with other unexpected developments that adversely impact performance. We believe these dynamics create opportunities in situationally specific, non-control stressed and distressed credit investments and special situations private equity.

The impact of China

China continues to be an important driver of the flow of goods and commodities worldwide and plays a prominent role in the global economy. The Chinese government’s implementation of economic and social policies can have wide-ranging implications, both domestically and abroad. An example is the Chinese government’s current effort to address overcapacity and excess debt in the steel industry and certain other industrial and manufacturing sectors. As these efforts are implemented, the Chinese government will look for partners with operational and restructuring expertise. This will create unique investment opportunities. In addition to steel, industrial sectors such as coal or cement could be targeted for similar supply-side reforms.

Outbound merger and acquisition activity in China should also continue to be active and influence the broader private equity landscape. Although China has put certain restrictions on capital outflows, we believe its government will continue to be supportive of transactions that provide Chinese strategic acquirers access to new technologies, markets or avenues of growth.

Conclusion

The current investment landscape leaves little room for error, making due diligence rigor and a discerning approach to deal selection critical. As we look to 2018, we believe the most attractive opportunities in stressed/distressed credit and private equity will emerge from idiosyncratic issues that impact companies across a range of industries, providing potential entry points at discounts to intrinsic value. Our focus will remain on identifying particular situations that present identifiable and correctable company-specific issues, bring strong and defensible business models and provide adequate downside protection.

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1 Source: National Bureau of Economic Research.

2 Source: S&P LCD, Quarterly Review as of Sept. 30, 2017.

3 Source: Prequin, as of September 2017.

4 Source: S&P LCD, Quarterly Review as of Sept. 30, 2017.

5 Source: S&P LCD, Quarterly Review as of Sept. 30, 2017.

This content is intended for informational purposes only and does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. Past performance does not guarantee future results.

Intrinsic value refers to the value of a company or stock determined through fundamental analysis without reference to the market value. If the market price of a security is less than it’s intrinsic value, it is said to be trading at a discount.

Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV/EBITDA) is a valuation tool that allows investors to compare the value of a company, including debt, to the company’s cash earnings less noncash expenses.

Small-cap is a term used to classify companies with a relatively small market capitalization, which is the market value of its outstanding shares. It is generally a company with a market capitalization of between $300 million and $2 billion. A mid-cap is generally recognized to be a company with a market capitalization between $2 billion and $10 billion.

Distressed securities are financial instruments issued by a company that is near to or currently going through bankruptcy.

A first lien is a type of priority debt which ranks ahead others in the case of default. If a property or other type of collateral is used to back a debt, first lien debt holders are paid before other debt holders.

Leverage refers to the amount of debt used to finance assets.

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