The Eurozone crisis is on a longstanding run at high alert with a continuing focus on a series of negative sub elements that clouds investors’ visibility, raises the levels of pessimism/concern and reduces appetite to invest. Notwithstanding, Europe offers very attractive, select corporate investment opportunities. However, thoughtful sourcing of opportunities, an established investment screening process, and capital with long term staying power are essential.
In advance of considering corporate investing in Europe, one must consider the dynamics affecting three key participants today: sovereigns, banks and private equity.
The Eurozone became the focal point of the global financial crisis when some of its member states required foreign assistance to refinance their debt. Initiatives to assist focused on providing liquidity which initially came from the European Central Bank and then from the European authorities through the European Financial Stability Facility (EFSF) issues backed by guarantees given by member states.
The Eurozone constitutes both the debtors and lenders. Over 60% of the exposure to peripherals (Greece, Ireland, Italy, Portugal, Spain) is owned by France, Germany and the UK; and just under 90% of this total exposure is owned by all of Europe – so this is a European issue to solve and not one that is easily separable away from Europe.
Solutions to improve the financial condition of the Eurozone are difficult to implement; and virtually all proposed put pressure on GDP or put further strains on balance sheets in the near and medium term.
Those in debt can address by: increasing receipts/taxes tied to GDP; austerity measures, sale of assets (privatizations) or by assuming further leverage. Indebted peripheral countries can only push so hard before social unrest precludes the execution of their programs. Europe’s ability to resolve the crisis is complicated by having so many parties at the decision making table. While there are wonderfully talented people continuing to work on solutions, sovereign dynamics should create sustained downward pressure on the Eurozone economy – an important factor when thinking of corporate investing.
Banks also play a leading role in the corporate investing dynamics. In an effort to decrease the chances of another crisis like in 2008, Basel III was created requiring increase capital requirements. To achieve this, banks must do one (or more) of the following:
* Sell assets (we are witnessing the asset disposal programs);
* Raise equity (this is unlikely given the difficult economic conditions currently);
* Generate income (this is most unlikely to contribute adequately in near term); and/or
* Tighten financing standards.
One should expect that disposition of assets and tightening of financing standards will continue for the foreseeable future. These will continue to put downward pressure on GDP in Europe making it more difficult to find companies with adequately attractive projected growth for corporate investing. However, since default rates correlate to tightening of financing standards, there should be an increasing number of opportunities as companies seek alternatives to lack of available refinancing.
To more completely understand the dynamics affecting the environment for corporate investing, one must also assess the asset flows of private equity participants.
1. PE firms’ dry powder (uninvested capital) is at 90% of their all-time highs. This is because ’06-’08 were huge fundraising years and PE firms were not able to deploy as usual due to the lack of financing in the market.
2. PE backed deal volumes decreased since the crisis. For example, over the past year, Europe has experienced a 50%+ decline in deal volume to $12 billion.
3. A record number (1,800+) of funds are attempting fundraising of almost US$ 1 trillion.
Capital committed to investment in corporates in Europe typically has five years (plus select opportunities to extend depending on limited partnership agreements) to invest. Therefore, there should be large willingness to deploy of capital over the next three years. This factor demands caution over the next couple years.
However, if the current conditions continue, it would be difficult to imagine market dynamics changing to facilitate deployment. This, in part, is why so many are fundraising now as their deployment performance is unlikely to materially change in the near term. It is also difficult to see how it is possible to raise such amounts. A potential counter to this is that relatively attractive private equity returns may create allocation shifts to the asset class as investors seek returns. However, if that doesn’t happen, we may well see a reduction in the number of private equity participants. This means that corporate investing will likely get advantaged with time.
However bearish the picture may continue to be painted by those analysing and describing events, differences of opinions creates opportunity.
Interestingly, a high level comparison between the European and the US economies shows that the European Union is a $17 trillion economy, slightly larger than the US with $15 trillion. Also, while comparability of data is challenging, the Euro area has debt to GDP of
88%, below the US which is at 103%, and is running at a deficit of 4% of GDP compared to the US at 10%. Additionally, the U.S. is arguably experiencing the slowest economic recovery in over 50 years of recessions based on cumulative GDP growth and job creation. Therefore, dismissing Europe based on the volume of negative attention is short sighted.
While one may invest predicated upon the continuing fall or near term rebound of the Eurozone, we believe that it is more prudent to invest on opportunities without requiring such risk. There are a range of specific targeted strategies; two examples of such opportunities include:
1. Recession advantaged industry segments. For example, in the UK, there are a number of very high quality participants in highly fragmented sectors of the education space that are well positioned to capitalize on strong international appetite. This creates both organic and add-on acquisition growth possibilities.
2. Companies domiciled in Europe without dependence on the European economy. There are a number of participants that benefit from well-established and advanced technology or processes but whose principal markets are outside of Europe.
Europe is the largest economy in the world with a strong and reliable framework for investors. It has stood the test of time and will continue to do so. Corporate investing has slowed to a trickle, yet, the timing is right with an understanding of the market and asset class dynamics, thoughtfulness in sourcing and discipline in assessing opportunities. While corporate investing in Europe can be very interesting in this environment, many factors indicate that it will get increasingly attractive.
* Chief Executive Officer, Europe for Investcorp.