UK: Sink or swim?

Author: | Published: 1 Oct 2010
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2010 is proving to be another difficult year for the private equity industry. Many well admired and dynamic private equity houses are suffering at the hands of changing Limited Partnership (LP) sentiment. Ongoing constraints in the availability of debt finance, a notoriously adverse fundraising climate and the continued threat of regulation internationally are all factors that have led to this challenging environment. But is the future of private equity all doom and gloom or does the current economic and regulatory climate bode well for savvy private equity houses?

Over the course of the past two years, the private equity industry has seen the biggest slump in activity in more than a decade. Private-equity backed deals generated 6.9% of global M&A volume in the first half of 2010, compared to 21% in the booming economy of 2006.

It seems clear that investors, like everyone else in this market, are trying to hang on to their money. Indicators for the first half of 2010 show that investment activity totalled $55bn with private equity firms continuing to focus on investments in small and medium sized companies; fulfilling the forecast that the mid market is the engine of the industry. This amount is marginally higher than this time last year but is still woefully short when compared to the same period between the years 2005 and 2008.

And private equity houses appear to have become increasingly sympathetic to investors' difficulties. Some large buyout houses, including Permira and TPG have returned uncalled capital to investors. Private equity houses have therefore found themselves behaving in a way that would have been previously unimaginable in a boom time economy.

The economic down turn is also having an impact on completed deals. With over $800 billion of private equity debt due to expire between 2010 and 2015, private equity houses are expected to renegotiate covenant resets or extend debt maturities on behalf of their underperforming and/or overleveraged companies in the course of the year. If financial conditions do not improve, it is clear that refinancing bad deals will be tough but refinancing over leveraged deals will form a central part of the industry's focus in Europe over the next 5 years. However, this will create further opportunities for the acquisition of distressed companies and hand the lenders a key role in shaping the medium term future of the market.

This difficult market has also had an impact on management fees. The regimented 2 and 20 model looks to be on its last legs. In a competitive environment, it's hard to justify a 2% management fee, just for sitting on limited partnership cash. A recent Mercer/CalPERS study agreed with this and concluded that management fees are too high. Some have questioned whether fees should be temporarily adjusted when deals are hard to come by. It is not so much the performance-related part of the fees that is the problem; it is the non-performance-related part that causes concern. LPs have more power now and will expect lower fees. The power shift to LPs from General Partnerships will have long lasting repercussions for all but the most powerful winners.

Fund raising

Funds raised fell by two-thirds in 2009 to $150bn, the lowest annual amount raised since 2004. These difficult fund raising conditions have continued into 2010 with a total of $70bn having been raised in the first half of this year, slightly below the amount raised in the same period in 2009.

The impact on private equity's access to leverage has been dramatic. Total loans extended virtually disappeared falling to less than $20bn at the end of 2009. Loan issuance is suffering due to banks' reduced appetite for risk, lack of institutional investor interest and a dearth of collateralised loan obligations activity. It appears that despite hopeful speculation from some commentators last year, banks have remained highly focused on credit risk and therefore standard documentation terms remain generally restrictive compared to the terms found in equivalent documentation in the boom years. In a nutshell, despite slight signs of improvement, debt is still expensive and banks are reluctant to lend.

An alternative route to raising funds is through the launch of initial public offerings (IPO's). However, it seems this route is unlikely to be the future of private equity for the time being given that the valuation divide between the private equity industry and institutional investors is currently unbridgeable. There is a perception that sponsor IPOs haven't been priced right in the past and confidence in them has consequently failed. IPOs will continue to get pulled and the net result will be that different methods of fund raising will need to be found. It is therefore predicted that private investment will be the way forward.

If debt is expensive and hard to come by and confidence has been lost in IPOs, what are the alternatives? Firstly, equity only deals are becoming more common and are likely to remain popular for the foreseeable future. A recent example of such a deal is Apax Partner's acquisition of drug development company Marken at the end of 2009. Around 40% of the buyouts taking place in the UK in the third quarter of 2009 involved no acquisition leverage at all and it remains likely that refinancing opportunities will increasingly be used to optimise capital structure. Secondly, mezzanine finance is coming back into fashion. When there was plenty of cheap capital, mezzanine debt couldn't compete. But now, as debt markets have closed, mezzanine has become more important. However, High Yield has finally emerged in the European market in the last 12 months and increasingly looks likely to become a much more common financing technique over the next 12 months as sponsors and borrowers alike crave its certainty and stable characteristics compared to traditional syndicated acquisition finance.


One notable response to the debt capacity restraints discussed above is the trend of partnering between companies wanting to sell, and private equity houses wanting to buy. There has been a recent emergence of deals involving private equity houses buying significant stakes in a company assuming management control but aligning themselves with the corporate seller by allowing it to take a significant retained stake. The corporate often receives an up-front cash payment, and the private equity house gains control of the business – it's easy to see why this staged exit over a longer period is a popular option with both parties.

For example, the US private equity group, Apollo Global Management, L.P. has recently made an offer to Rio Tinto to buy a 51% stake in Alcan Engineered Products' holding company (which specialises in aluminium products). Based on these terms, Apollo would become the majority and managing shareholder of AEP. Fonds Stratégique d'Investissement would hold 10% and Rio Tinto would retain a 39% stake under the proposed terms of the transaction.

This style of partnering between private equity and corporates is likely to become more frequent in an environment where leverage has dried up and private equity looks to align itself more closely with corporate sellers to go back to its roots and pursue primary buy outs, particularly on more complex or large divestments in the Financial Institutions Group (FIG) and Oil and Gas sectors.

Regulatory tightening

2010 is starting to reveal the exact complexion of the regulatory tightening that private equity has been facing since the onset of the economic crisis. Strict regulation in the EU and US could lead to an industry exodus towards more permissive global financial centres which can spark the spin out of the majority of captive funds.

One such piece of legislation is the Alternative Investment Fund Managers Directive (the Directive), which is due to come into force in 2011. The introduction of the Directive would be the start of a process that will introduce a common standard of regulation across the EU.

The Directive would have numerous practical implications for private equity firms. It will create wide disclosure requirements for portfolio companies that could apply as soon as a 10% investment is made in a company (according to the Parliament draft directive). The information that would have to be disclosed would include supplying information on portfolio companies and strategies – information which at the moment can be kept strictly confidential. The draft directive also grants the commission the power to impose EU-wide limits on the amount of leverage Alternative Investment Fund Managers (AIFMs) can employ.

Arguably, the timing of the Directive could not be worse. Although the Directive is being introduced in response to concerns about the systematic risk to the EU economy that AIFMs are posing, it is potentially going to be introduced at a time when private equity backed companies should not be subject to greater administrative burden. Continuing business viability is, in many cases, a serious concern. Critics argue that the Directive poses a threat to the UK's economic recovery and is more generally, anti-competitive.

It is estimated that annual compliance costs would be material for European companies owned by private equity houses. There is also a concern that as the EU is the first jurisdiction in which concrete proposals for the regulation of private equity have been introduced, AIFMs may relocate. It is currently unclear where this relocation would take place as the US is also looking to impose new stricter regulations.

Add this additional regulation to the other factors that private equity houses are attempting to deal with and you can see the problem.

Future predictions

It's not all doom and gloom though. Private equity firms are surviving the multiple challenges of today's economy. One thing that is becoming clear is that a strong track record, adaptability and resourcefulness will be the key aspects to success in the future. Historically, the best vintages have been invested during recessions. There are good vintages coming, and if private equity houses are resourceful, they should be in a strong position going forward when compared to their faltering competitors.

Recently announced fundraisings, like BC partners, will provide a litmus test of LP sentiment. BC are launching a £5bn ($7.7bn) fund to invest in European buy-outs, one of the largest to see the light of day since the collapse of Lehman Brothers 2 years ago. BC argue that their track record (on average returning 3.8% of the cost of investor's money) will help to attract investors.

Another success story is that of mid market private equity firm, Triton Partners. In February, Triton beat its initial fundraising target by raising €2.25bn ($3.1bn), which meant the Europe-based firm, which initially sought €2bn ($2.5bn), more than doubled its previous fund's size of €1bn ($1.3bn). Mid-market specialist HgCapital also beat its target to raise £1.85bn ($2.84bn) earlier this year.

It's not hard to see then why private equity investors are gravitating towards midmarket institutions. Investors are tending to be of the view that the big buyout funds that dominate the industry are now facing prolonged agony and as a result are specialising in small buyouts. Mega funds have been criticised for using too much debt, overpaying for large companies and raising excessive funds that generate such big fees that their interests are no longer aligned with investors. The attractions of the midmarket include its lower debt levels and the cheaper prices paid for deals, even in the credit boom. These views, like the industry themselves are proving cyclical and are reminiscent of the pre mega fund era. The harsh prediction of winners and losers based on historic performance though looks inevitable.

As well as midmarket firms, the recent rise and prominence of US firms has been significant. Firms located in New York accounted for 36% of funds raised in the five years up to 2009 whereas firms in London accounted for 17%. Whereas UK Private Equity Houses were mainly established in the 1990s, those in the US started cropping up in the 1980s. The US private equity houses have therefore previously weathered more difficult patches in the economy and are likely to have become resourceful as a result. They have survived previous recessions and can rely on track record rather than recent boom and arguably a more resilient American LP base. It may be that midmarket and US private equity houses can offer us an insight into recession resistant private equity.

There is a clear feeling of insecurity within the private equity industry. However, the difficult market that we have found ourselves in may ironically provide excellent opportunities for those that are well placed to invest and attract investment. Although it is unclear quite what effect new laws and regulations are going to have on the industry, tentative investment is likely to pick up again with investors placing a strong emphasis on private equity houses' track records and ability to change performance in portfolio companies. Alternative methods of fund raising and the trend of partnering will remain firmly on the agenda for the near future. Based on recent months, midmarket and US firms look set to be best placed to ride this difficult spell.

Many private equity houses are struggling against the tide; it remains to be seen whether they will sink or swim but it is clear that innovation on financing, fundraising and ultimately deal making will be the industry's reaction to the changing landscape ahead as it attempts to prosper. Long may private equity remain at the forefront of innovation.