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The return of PE doesn’t necessarily secure the future of PE

Private Equity | The return of PE doesn’t necessarily secure the future of PE Anthony Harrington

The global credit crunch that led to the recession of 2008 to 2009, and whose consequences global markets are still struggling to shake off, killed off the kind of highly leveraged PE mega deal that had characterized the boom years. That whole model was based on using financial engineering to secure returns of the order of 30% for investors in PE funds.

That model was predicated absolutely on the idea that banks would be prepared to put up large chunks of senior debt to support a modest equity investment from a PE house. If you buy a company with 100% of your own money and sell it three years later for a gain of 15%, then that’s what you’ve made. If you only put up 20% of the purchase price and the bank lent the company the remaining 80%, the percentage return on your investment is vastly improved.

The more senior debt you can persuade a bank to put up, the better your rate of return. At the height of the boom the banks would look at deals based on multiples of six to eight time earnings, or even higher. Today, when they do deals, the multiples are down to between 2.5 and 4 times earnings, with 4 being a rarity rather than the norm. At that level there is no way for a PE house to achieve returns of 30% unless the target company’s value in the market rockets upwards.

PE and VC

Given that the target companies in the mega PE deals were usually mature, established businesses, that kind of upward surge in value in a developed market is itself a rarity. This is where PE differs from venture capital (VC). A VC firm’s model is absolutely predicated on buying into immature or early stage companies that have the potential for stellar growth. That is a different model entirely, and the VC company is risking vastly less per deal than a PE house.

So without extremely high leverage, what is left for PE? The answer that seems to be emerging is a composite one. A part of its returns will continue to be based partially on whatever leverage the PE house can get from a participating bank or group of banks. Another part will be based on growth, which the PE house will now be much more active in pursuing (probably to the chagrin of the incumbent management). And a third part will be based on driving efficiencies.

Of course, there probably never was a deal where PE didn’t want growth plus efficiencies, but what is different today is that these are now vital components of the mix and have become essential to the continued survival of PE. As an asset class it has to generate stellar outperformance by comparison with liquid asset classes like equities and bonds, or few will invest in it.

One way of achieving this is the buy-and-build strategy, where a PE house acquires an interesting, modest sized company, then uses it as the core and builds it up through a series of additional acquisitions of similar companies. The aim is to make the whole considerably greater than the sum of its parts. Again, this is a far more demanding and skill-intensive model than mere financial engineering, but it is doable. Whether it is scaleable and sustainable as a model remains to be seen. Which brings us to the other part of the story...

Future prospects

In general, PE is having to manage investor expectations downwards as far as returns are concerned. In a world where returns on cash are negative, and where growth in developed markets is down to one or two percent, promising investors returns in the low teens, instead of the high twenties or early thirties, can make a saleable story. PE  will always, however, have against it the fact that investor funds are locked up. As a limited partner in a PE fund, you hand over your money and then you wait until the fund achieves a successful exit and returns funds to its partners, which, in today’s climate, might take seven years or more, rather than the three to four years it was taking when PE was flying high.

Nevertheless, a January 2011 survey from the Centre for Management Buyout Research at Nottingham University suggests that PE is making a significant comeback.  The highlights make encouraging reading for PE, though the latest report from CMBOR does highlight a slight pullback in European PE-led deals. According to CMBOR:

  • Private equity-backed European buyouts in 2010 more than doubled in value to €49bn from €18.3bn in 2009. By volume, European buyouts rose by 17% from 433 to 505.
  • The European exit market has rebounded strongly with the overall value of businesses sold totalling €55.7bn (2009: €9.3bn), outstripping the total value of investments for the first time (€49bn). The IPO market showed the biggest recovery of all exit routes (14 IPOs in 2010 compared to only one in 2009).
  • The total number of secondary exits in Europe in 2010 more than doubled to 102 deals compared to only 49 in 2009. The overall value of European secondary exits rose by around eight times to €18.8bn from just €2.3bn in 2009. Secondary exits reached a high in 2007 when 238 deals were recorded with a total value of €56.8bn.
  • European buyouts in the fourth quarter have reached the highest quarterly value since the collapse of Lehman Brothers in Q3 2008, totalling €16bn (Q3 2008: €19.4bn). By value, European buyouts in Q4 represent more than 87% of 2009's total buy-out value (€18.3bn), but only 13% of 2005's 'pre-boom' annual total value of €126bn.
  • The average deal size has more than doubled in 2010, reaching €97m compared to just €42m in 2009. The average deal size peaked in 2006 at €175m.
  • Today, across the UK the bulk of corporate M&A transactions are trade sales, and management buyouts remain difficult to get off the ground. We are still some way from the heights achieved in the boom years but things are certainly looking better for PE. The big question, however, is whether the revamped underlying models for PE are strong enough for this upward trend to be sustainable.

    Further reading on private equity and funding:

    Tags: alternative asset class , buy-and-build , Centre for Management Buyout Research , CMBOR , credit crunch , illiquid assets , investment model , investment returns , Nottingham University , PE , private equity , risk , University of Nottingham , VC , Venture Capital
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