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
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
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
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.
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)
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.
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
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.