Zig when others zag in private equity
To source more potential deals, some leading private equity firms have narrowed the aperture to focus on an investment “sweet spot.” They look only for assets that live in the realm where they have already executed successful deals. Contours of the sweet spot are defined by variables such as the firm’s geographic footprint, target ownership and primary investment thesis. Deals within a firm’s sweet spot, we have found, consistently and significantly outperform opportunistic deals that stray from it.
We see several basic approaches PE firms are using to develop a sharp point of view on attractive potential deals, as described in Bain & Company’s newly released “Global Private Equity Report 2017.” Some PE firms have a well-defined playbook that they use for specific types of assets, often in one or two vertical industries. Others become expert in a macro topic such as demographics, China’s economy or new forms of business models, which allows them to develop investment ideas by anticipating second- or third-order effects that the market has not yet fully priced. And some firms cross-pollinate, taking investment theses that work well in one geography or market and playing them out in other areas.
A fourth interesting approach is contrarian investing. This involves a willingness to zig when the rest of the pack zags—investing in out-of-favor businesses or industries that are either due for a favorable turn of the cycle or can be fixed because they have valuable capabilities locked inside an outwardly ugly shell. The strategy requires a deep understanding of what drives demand in the target asset’s industry and when the recovery will occur. Investing in broken businesses also requires a high degree of self-awareness regarding the PE firm’s abilities to fix what’s broken, perform rigorous due diligence and capture value after the close.
TPG adopted a contrarian strategy for many years. For example, it scooped up computer chipmaker MEMC in 2001, right after the technology bubble burst and at the bottom of the semiconductor cycle. MEMC was hemorrhaging cash and rapidly declining. But TPG spotted an opportunity to dramatically reduce the cost structure, and it expected the semiconductor business to recover. Through due diligence, TPG was able to drive down the purchase price to a symbolic $6 by identifying aspects of MEMC’s underperformance and including debt financing options. Four to six years later, TPG sold its interest in MEMC for a huge sum. (In fact, TPG’s founders started their firm with the proceeds from an early contrarian deal, Continental Airlines, which they bought in 1993 for $66 million, resurrected and exited in 1998 for $780 million.)
Apollo made one of the biggest gains in private equity through a contrarian bet on LyondellBasell, a Dutch chemicals and plastics company. At the time of Apollo’s investment, LyondellBasell was hobbled by billions of dollars of debt, a sharp increase in oil prices and falling demand for its polymers and chemicals in the wake of the global financial crisis. Apollo bought more than $1.4 billion in bonds to become LyondellBasell‘s largest creditor, and after LyondellBasell filed for bankruptcy in 2009, Apollo emerged with a 25% equity stake. “We seek to buy when the world appears to be very, very cheap,” Apollo cofounder Joshua Harris told Bloomberg Markets. The company went public in 2010, and Apollo made its final exit in 2013. The $2 billion that Apollo sank into the company turned into a $9.6 billion profit.
The crowded deal marketplace today requires PE firms to put their best foot forward, actively looking to enhance the quantity and quality of deals entering their funnel. Contrarians do that by plying murky waters where others fear to swim.
Grégory Garnier is a partner in Bain & Company’s Dubai office. He is the leader of Bain’s Private Equity and Digital practices in the Middle East and a core member of the firm’s Telecommunications, Media and Technology practices.