Last year was a difficult, but surprisingly active, year for the
private equity market in the US. By the end of the third quarter,
fundraising by buyout, venture capital and other private equity
funds in the US had dropped to a level not seen in almost a decade.
Full year 2003 numbers are not yet in, of course, but it seems
likely that the total capital raised by private equity funds in
2003 will be down to near 1995 levels. If this is so, total capital
raised by private equity funds in the US in 2003 will be down
roughly 80% from the record setting year 2000, and down about 35%
from 2002.
As of September 30 2003, US private equity fund sponsors had
raised only about $30 billion. Although it is difficult to
estimate, it appears that even with a more active fourth quarter,
no more than $40 billion will have been raised. Not since 1994 and
1995 (when $34 billion and $45 billion, respectively, were raised
and the private equity market was far less developed) have such
small sums flowed into private equity funds. The low fundraising
total for 2003 follows two years of steep fundraising falls in the
US market, where capital raised by private equity funds in 2002 was
down about 50% from the 2001 level, and capital raised in 2001 was
down just under 50% from the heyday of 2000 when about $218 billion
was raised. Figure 1 highlights these trends.
Figure 1: US private equity
fundraising
As of September 30 2003
($ in billions) |
 |
| Source: Thomson Venture
Economics |
The decline over the past few years in the amount of capital
raised was not the same for all types of private equity funds. Not
surprisingly, the decline in the amount of capital raised by
venture capital funds in 2002, as compared to 2000, was much larger
in percentage terms than the fall off in fundraising by buyout
funds. (There were also marked differences based on geography; the
fundraising trends for private equity firms based in Europe have
been much more encouraging than for US-based private equity
firms).
There is some good news, though, for venture capital funds.
After the calamitous decline in fundraising since 2000, venture
capital fundraising seemed to stabilize in 2003. A number of high
quality venture capital firms raised new funds in 2003, although in
many cases the funds were substantially smaller than the funds
those firms raised when they last went to market. Nevertheless, in
absolute dollar terms, it appears likely that venture capital funds
will raise about 20% less capital in 2003 than they did in
2002.
While modest improvements can be seen in percentage terms,
venture capital fundraising remains at its lowest level since 1993.
Through the third quarter of 2003, about 18% ($5.2 billion) of the
private equity money raised went to venture capital, while 15% of
capital raised in 2002 ($9.1 billion) was venture capital dollars.
Figure 2 illustrates these trends.
Figure 2: US venture capital
fundraising
As of September 30 2003
($ in billions) |
 |
| Source: Thomson Venture
Economics |
Perceptions of overall market difficulties and of too much money
chasing too few deals, which contributed in part to such weak
fundraising, contrasted with the surprising statistical evidence of
increased private equity deal activity in 2003. The prevailing view
that deals were few and far between was belied by statistics that
showed a surprisingly strong deal activity throughout the first
three quarters of 2003. The first half of the year was particularly
strong, with one industry publication noting that the six month
deal volume of $33.2 billion in the first half of 2003 was
surpassed only by the $44.1 billion of deals announced in the
second half of 1999. Although it may be true that these numbers
reflect a small number of mega deals completed while a large part
of the market remained dormant, there is no doubt that deal
activity is up sharply.
Still, much of the industry focused on weak economic
fundamentals and other troubles in the market. These concerns
included the dearth of initial public offerings (IPOs), the absence
of corporate buyers, and the difficulty in obtaining acquisition
financing. The terms of acquisition financing (if it could be
obtained at all) were viewed as too restrictive, with stubbornly
low debt to equity ratios. These views did not seem to give way to
an optimism that more closely mirrored the deal making activity in
2003 until the fourth quarter of this year, when many began to
speak of a nascent economic revival, often noting an awakening IPO
market and the availability of more flexible high-yield financing
terms.
Exit and liquidity strategies
In this challenging climate, partial exits through leveraged
recapitalizations increased in popularity and often provided what
many viewed as the sole source of liquidity and return of capital
for private equity funds, and thus their limited partners, in a
marketplace where IPOs were rare, strategic buyers were scarce and
acquisition financing was available only episodically. Recaps grew
in size as well as number, with deals exceeding $500 million and
reaching up to $1.5 billion.
In the search for liquidity by private fund investors, activity
in the secondary market for interests in private funds increased
dramatically. A number of funds of funds focused on secondary
acquisitions were raised in 2003. A sizable number of banks and
other financial institutions sold their private equity portfolios
in 2003 to such funds of funds, or to other secondary players, to
reduce the volatility of their earnings and obtain regulatory
capital relief. Pension funds and endowments also sold to rebalance
their portfolios. Some limited partners sold simply to raise cash
or because they had lost confidence in certain types of private
equity funds. As part of this search for liquidity, 2003 saw the
completion of several large and novel structured secondary
transactions and securitizations of private equity portfolios,
notwithstanding the complex legal issues that such transactions
raise.
Other developments
Club deals continued to grow in popularity, especially in deals
with enterprise values in excess of $1 billion, as funds reached
for larger transactions. At the same time, interest in the middle
market grew, with many private fund sponsors perceiving market
inefficiencies that would enable them to obtain favourable terms
and avoid auction situations in which they would need to pay
premium prices. Interest in Europe was also high. Indeed, in the
first half of 2003, deal activity in Europe reportedly exceeded
that of the US for the first time ever.
Other developments included the appearance of income deposit
securities (IDS), which are units of common stock and debt modeled
on the popular securities issued by Canadian income trusts. These
new securities were intended to bolster the ability of companies
with a perceived lack of growth potential, but stable cash flows,
to access the capital markets. Conceptually, an IDS issue is akin
to a leveraged recapitalization in that it creates value for
investors by monetizing a company's ability to generate stable cash
flow. In the case of an IDS, the coupling of a debt component with
an equity security was intended to provide an attractive feature to
investors in an environment of reduced returns. The popularity of
convertible debt offerings in the US capital markets in 2003
reflected a similar investor desire to hedge equity risk with a
coupon-based return.
Disclosure and transparency
Private equity did not escape the impact of the corporate and
accounting scandals of 2003. Although the number of going private
deals in response to the Sarbanes-Oxley legislation was small
compared to the dire predictions made when the law was enacted, the
industry faced increasing demands for transparency and disclosure
of information. In fact, at least one pension fund has begun
publicly rating private equity firms on corporate governance
standards.
Governmental pension plans experienced a growing volume of
requests, from newspapers and others under state freedom of
information acts or open record laws for disclosure of documents
concerning the plans' investments in private equity funds. While
some resisted making such disclosures (sometimes resorting to
litigation), they were generally unsuccessful. A number of
governmental plans now disclose internal rate of return and other
information regarding their private equity investments. Many in the
industry expressed concern that such disclosure would extend to
competitively sensitive information regarding portfolio companies,
and in turn generate a backlash of reduced disclosure from funds to
their limited partners in an effort to protect portfolio company
value. Thus far, however, portfolio company information has
generally not been required to be disclosed. Concerns about public
disclosure, however, led at least one prominent venture capital
firm not to admit a state pension plan to its newest fund.
In a related trend, concern over the thorny issue of the
valuation by private equity funds of their holdings grew, and the
lack of industry standards in the US became increasingly
troublesome to some investors. A number of industry groups have
been working to develop valuation guidelines. In December, the
Private Equity Industry Group, an ad hoc group of limited
partners and general partners, released proposed guidelines for
portfolio valuation. It is too early to tell whether these
guidelines will be met with wide industry approval.
Private fund marketing materials became a hot topic in October
when the National Association of Securities Dealers (NASD)
restricted the use of predecessor fund performance information
(so-called "related fund information") by NASD members
(broker-dealers) in sales materials (other than private placement
memoranda) for hedge funds and, it appears, private equity funds.
Because track record information has been considered so important
in marketing private funds, this position created significant
concern on the part of placement agents, private equity firms
wishing to engage placement agents, and private equity groups
within financial institutions with broker-dealer affiliates, that
their ability to market private funds would be impaired.
Return of public company investments
Last year also saw a revival of interest in transactions
involving private investment in public companies (PIPEs). This
trend occurred despite recognition by private equity sponsors that
the regulatory regime imposed by Sarbanes-Oxley made it more
difficult to exercise the type of governance rights that they would
customarily receive in private deals. The new rules impact
principally on rights regarding the composition of board committees
and the ability of directors affiliated with private equity firms
to serve on such committees.
Managing exit from a public deal become more complicated in 2003
after the divided Delaware Supreme Court decision in
Omnicare. The court held that deal protection devices such
as lock ups may be void if they effectively preclude a board of
directors from exercising its continuing fiduciary obligation to
negotiate a sale of the company in the best interests of all
shareholders.
Author biography
Marc Kushner
Debevoise &
Plimpton
Marc Kushner practises in the private equity group at Debevoise
& Plimpton. The firm has offices in New York, Washington DC,
London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.
Debevoise & Plimpton
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