We believe European Private Equity can augment investors’ broader Private Equity allocation due to its distinctive and varied composition, demographic drivers and quality.
Over the next 10 years, we believe there will be two key challenges for investors. The first is that we expect economic growth to be uneven globally, and dependent on local dynamics. The second is that we expect the trend toward de-globalisation – which took root in the US-China trade standoff but accelerated with Covid-19 – to persist.
It is an environment that will cause problems for some conventional asset types and strategies. However, we believe it is an environment for which European Private Equity (“PE”) is very well positioned. This is based on three characteristics:
- European PE market’s fragmentation
- The number of family and founder owned businesses and the opportunity arising from generational transfers
- The high quality of goods and services produced and supplied in the region
When considering European PE we believe it is crucial that investors view Europe as a collection of markets, as opposed to one homogenous market. If growth drivers become increasingly localised, Europe’s inherent fragmentation is an attractive characteristic, providing geographic, and sector diversity. That family and founder-owned businesses make up 60% of all companies in Europe also presents a compelling investment opportunity, especially in the case of generational transfers. Family owned business often display operational inefficiencies that offer strong upside for investors, without the use of leverage. Lastly, goods made in Europe are associated with quality and, even with the trend of de-globalisation, we believe European products will remain sought-after exports.
2. Fragmentation in European Private Equity
The European PE market can be broken down into six main geographies that account for 95% of the market.
- The UK
- The Nordics
- DACH (German speaking Europe)
- Southern Europe (Spain and Italy)
Each region is subject to different dynamics, meaning access to local teams to source and execute the best deals is paramount. The level of international interest in European companies is clear, but we believe investing with the best local managers has never been more important. In a post-Covid world, where de-globalisation accelerates, regional industries consolidate and consumption patterns change through new technologies, specialisation by geography and by sector becomes vital.
Europe’s industries are also characterised by “horizontal” fragmentation. The unconsolidated markets are divided among many small businesses, and the number of companies per industry in Europe far exceeds the equivalent number in the US. What this means for Private Equity investors, is the opportunity to deploy “buy-and-build” strategies to unlock value.
European Private Equity managers often identify local champions: good businesses which serve only one local home market. Private Equity investment enables them to launch regional, domestic and cross-border activities. PE firms can provide such businesses with the necessary capital to roll-out and open new branches or subsidiaries. Geographical expansion is often pursued by intensifying trade connections and increasing exports through new distribution channels. To achieve this, Private Equity firms introduce companies to a specialised network of other businesses and investors, both domestically, and within Europe.
Source: Statista, Made in country index
3. The importance of generational transfers
Demographics are very predictable. As a consequence, we think it is safe to assume that the demographic trends over next 10 years will look rather similar to the last, albeit with existing trends reinforced.
Europe has a reduction in its workforce (given its aging population), and lacks the US’s offset of migration, or the growth in population of Asia, excluding-Japan. Given the high number of family and founder owned businesses in Europe, the aging population presents an opportunity, as founders sell businesses in generational transfer. To many business owners who are planning to step down, the question of their succession is a major challenge. While the first choice typically is to introduce another family member as a successor, the descendants, if there are any, might not be interested (or qualified) to take over such a leading function in the family business.
Family- and founder-owned businesses are often attractive acquisition targets because they are less intermediated and often sourced directly from the seller, giving local Private Equity investors strong negotiation power and attractive entry prices. Furthermore, price is often not the only consideration for founders and families when choosing to whom to sell. If the company is a solid business, employees could be interested in taking over through a management buyout, but usually cannot finance a buyout with their own means. In all these cases, a management buyout that is supported by a Private Equity fund provides a good solution for privately owned businesses. In Europe over 50% of small buyout transactions are sourced from families.
Private Equity provides capital, improves structures and processes, but also incentivises managers in order to achieve growth. Firm roll-outs, geographical expansions and new distribution channels are used for companies with inherent growth potential, and capital is invested to enhance and expand production facilities.
4. Europe’s sustainability and quality
The continuation of low growth across Europe means Private Equity in Europe has been focused on export-oriented businesses that can take advantage of growth elsewhere. Given Europe’s fragmented nature, there are numerous well run businesses, at reasonable valuations, with sound governance.
Furthermore, consumers associate goods made and produced in Europe synonymous with quality. The Made-In-Country-Index (MICI) showcases the reputation of products produced across 49 countries (including the EU). European countries dominate the index, representing seven of the top 10 and 15 of the top 20 countries. Europeans like to buy local, but we believe high quality European products will remain attractive exports even in an environment of increasing deglobalisation.
Furthermore, the European Commission has launched a “Made in Europe” partnership between industry and academia to enhance manufacturing. The partnership will focus on contribution towards sustainable advantages such as better productivity, enhanced job quality and reduced carbon footprint.
As Europe’s population is aging, industrial innovation and competitiveness must be rethought and invested in. From product ideas, to R&D, technology needs, factories and supply networks, logistics and end-of-life approaches, businesses will see overhauls throughout product cycle. The partnership will require investment from the private sector, and local European Private Equity firms should benefit from the initiative.
5. Well versed in slow growth
As we touched on earlier, many of the current dynamics were already at play before Covid-19 and the virus has intensified them. Lower GDP growth was perpetuating low real interest rates and continued quantitative easing (QE). This, in turn, was driving asset inflation.
Europe has been in a low growth rut for many years, and European PE has still performed well. Many sponsors and business owners have been prepping for a downturn, especially in Europe, given the low-to-no-growth environment. As a result, we believe European PE is better positioned than others to take advantage of today’s environment.
Inorganic growth, in the short-term, will centre around investment opportunities in businesses struggling through the Covid crisis by means of rescue or bridge financing, or buying outright as add-ons. Add-ons are a good way to consolidate industries and a good opportunity for businesses to acquire weaker competitors. Acquisitions increase scale and stability through valuable geographic, customer, product and supplier diversification. Bolt-ons accounted for over 60% of deals done in the first half of 2020, 10% higher than the first half of 2019.
6. Unlocking growth requires the right key
We believe European Private Equity’s fragmentation – both geographically and by sector – coupled with the stability and transparency of the underlying markets represents an enticing opportunity set. However, while the opportunities are numerous, it is clear that unlocking growth requires local expertise coupled with deep sector knowledge. For those with the right footprint, network and skillsets, we believe European PE adds a differentiated set of value drivers to a broader Private Equity portfolio.