Kirkland Ellis: Deal flow is resilient

Private equity practitioners need to work with and educate policymakers on how the industry can create a solid platform for growth


The private equity industry has faced testing times in the last few years. Following the era of the mega-buyout in the mid-2000s, the ability for large buyout houses to generate returns, coupled with the reduced availability of debt, led to a fall in the number of leveraged transactions and asked questions about many firms’ ability to create real value in their portfolios. Today, however, it would seem that to a large extent private equity houses have adapted to these challenges and the industry as a whole has grown stronger as result.

One of the most reliable bellweathers of the health of an alternative asset class is its ability to secure funding from institutional investors. Whereas it is fair to say that, during the crisis, some funds with a poor track record were forced to withdraw from the market, this can be seen as a natural consequence of an economic downturn, and one which left behind those players with a more established pedigree. These funds have continued to secure institutional funding.

Kirk Radke, Partner in the New York office of international law firm, Kirkland & Ellis LLP, says, “The predicted wholesale withdrawal of Limited Partners (LPs) from the asset class has not materialised, since the returns generated from portfolios, whereas in some cases were lower than in previous years, have nonetheless been consistently positive, and have outperformed those of the majority of other types of alternative investment.”

That is not to suggest that the industry has not had to make changes in the way it has done business. Far from it, on the General Partner (GP) side, investors have had to spend more time on due diligence in identifying the potential upside in new investments and also monitoring and working with their existing portfolios, to ensure that they can generate consistently robust returns to their investors. Similarly, LPs have also placed far more scrutiny on the nature of their GP relationships and have begun asking far more taxing questions of those to which they entrust their capital.

These developments, however, do not detract from the fact that fundraising has remained high principally because distributions to LPs have continued to be lucrative.

Another positive indicator for the market is the fact that deal flow has remained resilient. Looking first to the US, in spite of the crisis the ability to leverage a transaction never completely disappeared. Growth in underlying portfolios also remained, albeit at a more modest pace. But this is reasonably positive news, considering that the country is currently emerging from the effects of one of the worst recessions in its history.

“The best news coming from the US is that, historically, the bottom of the cycle is the best time to invest, as businesses can be snapped up at discounted prices and the potential upside for investors is at its greatest,” Radke says.

However, these positives are counterbalanced by some market realities. Firstly, there is a disconnect between the value expectations of buyers and sellers. Owner-managers are mindful of the valuation of their business five years ago and are extremely reluctant to accept a severely depleted price today. Whereas there is some indication that there is some traction on the part of vendors, deal flow is still sluggish in this segment of the market.

Also, whereas the depleted public markets will mean, on the one hand, that owner-managers may look more favourably on private equity if they are looking to raise funds, on the other hand if a PE house is looking to sell an investment it will not be to turn to the stock markets for the best price. The knock-on effect of this is that GPs with maturing portfolios may have to look within their own community to achieve exits. Whereas secondary buyouts do offer convenient liquidity solutions, they often do not attract the best price for the vendor and can leave the buyer with a headache in terms of creating additional value in an already well-oiled business.

Regional differences
In Europe there are other considerations. The main one, of course, being the willingness of banks to lend. In 2006 banks were only too happy to lend cheap debt in large quantities. Whereas today many claim to be open for business, their selection criteria is so stringent that only the most sturdy of counter-cyclical businesses pass the test. Having said that, in recent months we have seen the first trickle of new loan financing coming to the market, albeit mostly taking the form of club deals where a syndicate of lenders can share the risk.

And whereas private equity investment has been largely put on hold until the crisis in the eurozone has been resolved one way or another, even from this state of transition we can draw on some positives. Radke says, “Private equity by its very nature is dependent on change situations, and there is no greater change going on in Europe right now than the discussions surrounding the future of the eurozone. Even if the outcome is not necessarily ideal for certain individual member states, there will undoubtedly be opportunities for private equity investors to help companies across the region.”

In recent years, the developing markets of Central and Southern Asia have prospered, as investors have migrated to, most prominently, India to take advantage of the multitude of high-growth infrastructure projects. However, as the market has matured the potential for making quick returns has cooled, leaving a more measured investment approach. The flavour of the moment for now, however, is China, and the more emerging regions of South East Asia, where the growing affluence of the expanding middle classes has the attention of both new domestic and established international players.

But there are some considerations to take into account when approaching unfamiliar territories. Radke says, “In emerging markets it is vital for private equity houses to tap into the existing advisory infrastructure in a region in order to help navigate unchartered waters. By drawing on the expertise of established support networks and corporate finance advisory communities a private equity house stands the best chance of seeing the right deal and making the best investment decision.”

One of the principal issues that the private equity industry needs to handle carefully is the way in which it addresses the requirements imposed by the regulatory authorities as a response to the economic turmoil created by the banking crisis.

In the US, the Volcker Rule that came into effect in 2010 imposed restrictions on banks in relation to their allocations to alternative assets, including private equity and hedge fund investments. As a result, US banking institutions are considering carefully their private equity portfolios. In the meantime, in Europe, Basel III requires European banks to comply with new capital adequacy rules, which set a cap on their permitted assets they can hold in relation to the value of their portfolio.

Radke says, “As a result of the crisis there has been a wholesale change in how policy makers view the private equity industry. This affects not only LPs but also the GP community. Whereas institutions are being encouraged to reduce the number of perceived ‘risky’ investments they make, leading them to re-shuffle their allocations pack, GPs are also under scrutiny. This is largely due to the fact that governments have become more aware of the pure size of the industry, both in terms of the number of transactions and the capital available for investment.”

The role of private equity practitioners needs to be one of working with and educating the policy makers on how the industry works with individual companies to achieve their best potential and establish a solid platform for future growth. But more importantly, it creates jobs, encourages industry and, as a result, stimulates economic growth – something that is vital to economies that need all the boost they can get when emerging from the most challenging of economic times.