Buyouts: Courage of conviction

Nord Anglia Education didn’t come cheap. Baring Private Equity Asia and Canada Pension Plan Investment Board (CPPIB) privatized the US-listed K-12 school operator last year at a valuation of $4.3 billion, or approximately 20x adjusted EBITDA for 2016.

The company educated more than 37,000 students during the year across 43 sites globally. China is home to eight of its schools and more than 6,300 of its students. The country accounted for 23% of revenue in 2016 and 41% of adjusted EBITDA. The EBITDA margin for China was 43.5%, 11 percentage points ahead of second-placed Southeast Asia. 

Yet Baring believes there is even more growth to be realized in China. According to Jean Eric Salata, the private equity firm’s CEO, 2-3x of the return multiple underwritten into the deal on the upside would come from the China expansion strategy. This thesis is based on a belief in the potential for further growth and consolidation in such a large market.

Baring entered into the investment with more than just due diligence behind it: the private equity firm had been the majority owner of Nord Anglia since privatizing it, for the first time, in 2008. Following the re-listing in the US, Baring still held a 66% stake through its third and fourth funds. These positions were taken out by Fund VI and CPPIB.

In an environment of abundant capital and elevated valuations, conviction is critical when making investments. A buyout firm must be able to do something transformative to a portfolio company – and ideally sufficiently complex that it is hard for others to replicate – in order to justify the asking price. 

Buy and build strategies are popular because add-on acquisitions tend to involve smaller companies that command lower multiples, bringing down the overall cost. Beyond that, GPs must come equipped with plans for aggressive post-investment value creation, whether that means trimming costs, rejuvenating product lines, or entering new markets. 

Advisors say private equity firms are seeking a higher level of due diligence that allows them to commit capital confident in the knowledge that there are half a dozen areas in which they can potentially bring about meaningful change. Not all of these initiatives are expected to pay off, but investors want to map out bullish upside scenarios and base cases that offer more than just the status quo.

In this context, greater emphasis is placed on sector knowledge to help provide that conviction when paying up for an asset. Operating partners are also becoming more important for their role in executing value creation strategies.

Sector focus comes into play at the portfolio level as well. While a GP might be more aggressive post-investment due to rising valuations, sector selection could go defensive. Assets in areas where demand tends to be non-cyclical – such as aged care or essential consumables – are prized. Exposure to sectors across the portfolio is scrutinized so as not to leave the fund vulnerable in the event of a downturn.

Leverage is the other tool in the kit. Private equity firms are being conservative about the amount of debt they take on compared to the pre-global financial crisis period. They are also using more flexible structures such as covenant-lite loans. In addition, companies with strong free cash flow are prioritized because it means they can be de-risked in a few years despite a relatively high entry multiple. 

What investors want to avoid is a combination of earnings contraction and multiple contraction: picking the wrong company, industry and debt package and being undone in a downturn. No one wants to call a market top but they all know it will come eventually. And in the event of an asset price correction, conviction will be important in terms of identifying long-term opportunities amidst short-term volatility.

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• Topics
• Buyouts
• Financing
• Asia
• Operating partners