Private equity takes stock for 2008

James Mawson looks at some of the subjects that came under scrutiny, and how much agreement there was as to their likely outcomes


Last month’s 2008 Super-Return conference in Munich was a chance for the industry to take stock of the impact of the credit turmoil, and to predict how things might look in the future. With more than 1,000 delegates sharing news, gossip and their hopes and fears, there were few areas of agreement, but several topics were at the front of people’s minds.

Will fundraising hold up?
The delegates were relatively optimistic. Those agreeing it would hold up pointed to Vitruvian, which announced at the Super-Return conference it had closed Europe’s largest debut fund at €925m. Investors were also impressed by mid-market buyout firm Advent International raising its upper limit by 10 percent to €6.6bn.

And new investors, particularly sovereign wealth funds, were seen as important sources of money.

The more pessimistic delegates included David Bonderman, co-founder of TPG Capital, who said fundraising “will be tight this year”. Delegates also warned that the large, often public, pension funds that allocate a proportion of their assets to private equity could see this absolute sum of money shrink if other asset classes and their overall wealth falls with the equity and debt markets.

However, Joseph Dear, executive director at the Washington State Investment Board, said many, including his retirement scheme, would maintain their long-term, patient approach through any turbulence.

What is going to happen to buyout debt held by syndicating banks, and when will liquidity return?
The liquidity crunch has lasted longer than many delegates had expected, with part of the concern surrounding the lack of transparency over problems in the broader debt capital markets spilling over to leveraged finance, and bank liquidity stretched by the need to support hung loans from previous buyouts.

Euan Hamilton, global head of leveraged finance at Royal Bank of Scotland, said “greed across the market” had contributed to the difficulties. Carlyle Group said there was about $200bn of leveraged finance held by syndicating banks, which was down by $75bn from last July.

Of the leading US investment banks, David Rubenstein, co-founder of Carlyle, quoted Wall Street Journal and Morgan Stanley figures which showed Citigroup with $43bn of hung loans, JP Morgan with $26.4bn, Goldman Sachs with $26bn, Lehman Brothers with $23.8bn and Morgan Stanley with $20bn. Delegates said the crunch was likely to last the rest of the year, at least.

Are there going to be major defaults from Golden Age-vintage deals?
A feared recession was a talking point with Jonathan Nelson, chief executive of Providence Equity Partners, who said the US was already in one and the number of blow-ups was likely to increase from a current default rate of less than 1 percent.

However, defaults were seen as the last stage for companies in trouble as earnings fell and debt costs increased. Joerg Alting, head of leveraged finance in parts of continental Europe for Mizuho Corporate Bank, said a larger number of companies it tracked were behind their earnings plans, although still growing.

Jon Moulton, founder of Alchemy Partners, said that in the UK the most prominent exit route for private equity deals was bankruptcy, with 106 last year compared with 70 in 2006. Moulton said other signs of distress, such as equity changes by buyout firms to cover interest costs or financial restructurings, were also increasing.

This followed average leverage levels hitting 6.2 times a portfolio company’s earnings before interest tax depreciation and amortisation last year, up from 4.1 times in 2001. Ebitda minus capex divided by cash interest charges fell to 1.7 times from 2.5 times in this period.

Has the industry hit its high water mark?
Rubenstein said it was always darkest just before dawn. He added: “Deal volume will rebound and yesterday’s records will be left far behind.” However, this was for the longer term, delegates said, with the Golden Age of positive record-breaking finished in the current economic cycle.

Where will firms get their returns? And will they converge into alternatives/merchant banks?
TPG’s Bonderman said the preponderance of US deals compared to the value in the rest of the world seen in the past few years would reverse, with European and Asian deals taking precedence. Rubenstein agreed emerging markets would drive industry dealmaking and said eastern Europe had the lowest proportion of private equity dollars per GDP of almost anywhere in the world.

According to the Emerging Markets Private Equity Association, eastern Europe and Russian fundraising hit $14.6bn last year compared to $3.3bn in 2006 while deal volumes were $5.3bn and $4bn respectively. The other areas of high interest were minority investments, such as into telecoms company Sprint Nextel, Dutch cable operator Numericable, bond reinsurer MBIA, Chinese hotel chain Galaxy and foreign exchange service provider Moneygram International.

In the first half of last year there were 252 deals worth $25bn compared with 84 worth $5.8bn in the first two months, according to data provider Dealogic. Distressed debt fundraising in the first half of last year hit $25bn versus a 2008 leveraged loan maturity schedule of $175bn this year and $200bn next year.

Will returns fall?
Data provider Thomson Venture Economics found the top quartile US buyout funds returned 32.1 percent in the past year and an average of 21.8 percent over each of the past 10 years, while in Europe the figures were even higher at 78.6 percent and 37 percent respectively.
Almost all delegates expected returns to fall from these highs.

Can the industry improve its image?
The industry was too sanguine about the pressures facing it from politicians, trade unions and the media, panellist said in a discussion led by Carol Kennedy, senior partner at Pantheon Ventures. Rubenstein said the perception of the industry within the industry was better than the views held by those outside of private equity.

He said the solution was to continue to produce hard data; engage industry critics in debate; consider factors other than just returns when assessing or overseeing investments; involve portfolio companies directly in the effort; enhance transparency and their public focus; and recognise that some changes could and should occur.

Otherwise delegates feared the markets that already limited investment activity, such as in China, or had more onerous tax and regulatory rules would be joined by others which were considering changes.

Is the time right to strike deals?
Rubenstein was optimistic the deals being struck now would generate strong returns. He said in previous slowdowns, such as 1981, 1991 and 2001, US deals returned 14.8 percent, 19.5 percent and 15.3 percent respectively, while European returns were more modest at 9.2 percent, 18.8 percent and 3.4 percent.

What is the competitive threat from sovereign wealth funds?
Four of the top 10 SWFs have an active investment strategy, according to Citigroup, including Abu Dhabi Investment Authority, Singapore’s Government Investment Corporation and Temasek, the China Investment Corp and Qatar Investment Authority. But these active investors did not so far include wealth funds run for Norway, Saudi Arabia and Kuwait. Last year, SWFs bought 250 companies, up from 200 in 2001, but the deal values climbed to $69.8bn from $13bn respectively.

However, there was hope of a fruitful partnership between the two classes of investors. Rubenstein said: “In the future, sovereign wealth funds and private equity firms are likely to pursue large investment opportunities through joint ventures. Sovereign wealth funds will benefit from private equity firms’ deep pools of investment talent and deal expertise.”

Will US firms dominate the global industry in the future?
US private equity firms dominate the top 10 by assets, according to Rubenstein, but he predicted firms from other countries would break into the list over time.

The large US limited partners investing in private equity firms would also struggle, according to delegates discussing the list of most influential European investors, published for the conference by Private Equity news, the sister publication of Financial News.