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Analysts predict new era for private equity
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WASHINGTON, D.C., Nov. 5, 2008 – Successful private equity managers of the future will be those that can remain disciplined through this uncertain period by carefully getting transactions done while avoiding strategy drift, according to Watson Wyatt, a global consulting firm.
These managers will also succeed if there is an understanding that financial engineering has become a commodity and that multiple expansion* is no longer a return driver that private equity managers can rely on to generate returns.
“In the recent past, cheap and readily available debt combined with rising prices and an accommodating exit environment created an ideal environment for private equity managers to generate strong returns for investors without needing to exercise particularly high levels of skill and investment judgement," said Jane Welsh, global head of private markets research at Watson Wyatt. "That era is over and the new world will reward those long-term and selective managers with strong track records of creating value through accelerating the earnings growth of their portfolio companies.”
In a research paper, the firm makes a number of assertions about the private equity industry and its future shape:
- Banks will remain very cautious in underwriting new debt packages: Credit markets changed dramatically in the second half of 2007 with banks left holding huge amounts of unsyndicated debt. This precipitated a large fall in deal volumes, with US LBO transactions falling around 70 percent from the second quarter of 2007 to the corresponding period in 2008, according to some sources.
- Increases in required equity to finance transactions could decrease returns: Unwillingness from banks to provide debt to finance transactions means an increase in equity contribution from private equity sponsors. This could result in a decrease in the expected returns of a deal due to managers being required to finance deals with more of their own capital.
- Exit routes blocked: Between 2005 and 2007, leveraged recapitalisations provided liquidity to private equity investors in exchange for an increased interest burden for the underlying businesses. This option no longer exists and many portfolio companies that underwent leveraged recapitalisations find themselves hindered by this increased debt burden and consequently their medium-term prospects have become more challenging. It is expected that managers will continue to find near-term exits for these businesses particularly difficult.
- Deployment dilemmas: Large and mega-cap managers, who raised unprecedented pools of capital through 2006 and 2007, are now facing capital deployment challenges. This is giving rise to style drift, meaning managers are pursuing strategies that are largely inconsistent with their previous funds and in which they have little or no track record of success. While imagination and innovation from private equity managers is welcome, there is a fine line between innovation and desperation and investors must be aware of this.
“In spite of these challenges facing the private equity world, it is not all doom and gloom and long-term investors might find now a good time to selectively invest, acknowledging that trying to time the market is not a good idea," said Welsh. "As the pricing environment is expected to soften, skilled managers will be well positioned to buy good quality businesses at more attractive valuations than have been available over the past few years. In addition, skilled managers with a proven ability to turn poorly performing businesses around and selectively invest in distressed situations will generate attractive returns over the medium-term. It is worth remembering that it is during periods of adversity that private equity managers have made significant money for investors in the past, and could well do again.”
The publication can be found here.
* Whereby the value of their investments increases due to increases in the value of market comparables.
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