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How can you tell when a private equity dealmaker walks into the room? He will start looking for the best exit almost immediately.
This old joke, told by one of the speakers at last month’s SuperReturn International conference in Berlin, emphasises how asset sales are the central focus of all private equity bosses. Even before private equity groups buy a company, using a mixture of their own investors’ money and loans from banks, they start planning how to sell it for a profit.
Rarely have profitable exits been more important than they are today, as the private equity industry is facing some of its biggest challenges yet. After a “golden age” of steady economic growth, buoyant markets, massive deals and big profits, the financial crisis has brought the private equity bosses – once dubbed “the masters of the universe” – crashing back to earth.
As debt has dried up, so have the deals. From roughly $500bn (£330bn) of buy-outs a year in 2006 and 2007, there were only $81bn-worth in 2009, according to Thomson Reuters. Returns at private equity groups have turned sharply negative as many of the “mega buy-out” deals from the credit bubble struggle under their heavy debts. Investors that gorged on private equity during the credit bubble are now suffering from indigestion. Fundraising, the lifeblood of the industry, is down from a peak of $646bn in 2007 to just $248bn in 2009, according to Preqin, the research house.
In these grim conditions, a key factor in deciding which private equity groups will be able to raise a successor fund from choosy and cash-strapped investors is how many successful exits they can deliver.
Jeffrey Montgomery, founding partner of GMT Communications Partners, a UK-based private equity company, says: “This climate will separate the sheep from the goats. Private equity firms need to achieve some profitable exits if they are to raise another fund.”
Yet, David Rubenstein, co-founder of the US-based Carlyle Group, says distributions from private equity exits to investors have fallen from an average of $15bn a quarter in 2004-07 to roughly $3bn a quarter in recent years.
Already, the much-hyped initial public offering window looks in danger of closing early this year, after two large private-equity-owned companies – travel group Travelport and clothing retailer New Look – were forced to put off planned London listings in February.
At the same time, there has never been more money sloshing around the private quity industry. At the end of 2009, private equity had $1,071bn of committed capital that was still to be invested, of which roughly $500bn was for buy-outs.
Bain & Co, the consultancy, said in a recent report this overhang of capital was driving up prices artificially, making it harder for private equity to pick up bargains during the downturn. “Competitive dynamics among buy-out funds are helping to keep multiples high,” said Bain. “Many firms are bidding up prices and settling for a lower target internal rate of return in order to win investments.”
The clock is ticking on this unspent capital, as many buy-out funds were raised in 2006-07 with five-year investment periods, which start expiring next year, pushing them to find new deals quickly. An example is BC Partners of the UK, which has a €5.9bn (£5.3bn) fund with its investment period expiring in November. After that, it will be unable to spend any money left in the fund on new deals unless two-thirds of investors grant an extension.
This means there is huge competition between private equity groups for any deals that banks are prepared to finance and where there is no obvious trade buyer. “Leverage is coming back and we have not yet seen prices come down, especially for quality assets,” says Fotis Hasiotis, head of financial sponsors in Europe at Bank of America Merrill Lynch. “They rationalise this by saying to themselves that they are capitalising it conservatively, and if financing markets continue to improve, they could refinance it in a few years and take some money out that way.”
While the proportion of debt used to finance buy-outs has fallen sharply, from three-quarters to less than half, purchase multiples have fallen more modestly, from 9.7 times earnings at the peak in 2007 to 7.7 times last year, according to Standard & Poor’s.
Many buy-out bosses say the combination of the need for exits and the large overhang of unspent capital looking for deals risks creating “a mini bubble”, as private equity groups fish in each other’s portfolios for deals.
“The mini bubble is going to be the story of 2010, with funds approaching the end of their investment periods, facing pressure to deploy capital and do deals, which will help others find an exit route,” says Mr Montgomery at GMT.
Already, there are signs that secondary buy-out deals – in which one private equity group sells a company to another – are becoming more commonplace. “There are an increasing number of secondary buy-outs happening, but the real question is: where are the new assets for private equity to purchase?” says Nick Jansa, head of European leveraged debt capital markets at Deutsche Bank.
There have been 14 so-called “pass the parcel” deals, worth $5.2bn, so far this year, compared with 43 deals worth $5.9bn all of last year, according to Preqin.
Guy Hands, founder of Terra Firma, says pass-the-parcel deals are unpopular with investors, which are often invested in both the buyer and the seller. They end up owning the same asset with 30 per cent of fees and carried interest – a profit share – taken out in the sale.
So, apart from secondary buy-outs, where will the private equity deals of the future come from? Bain’s report identified four promising areas for new investments: energy, healthcare, the Asia-Pacific region and distressed investing.
There are signs that disposals from big corporations may be increasing, after the UK’s CVC Capital Partners bought the central and east European brewing assets of Anheuser-Busch InBev, the world’s largest brewer, for $3bn last year, and US-based Bain Capital bought Dow Chemical’s Styron plastics unit for $1.63bn this month.
Others, such as Michael Queen, chief executive of the UK’s 3i, have predicted they would do more deals with governments, taking minority stakes in part-privatisations of assets to allow states to raise much-needed cash without having to sell out completely.
Partners Group, the Swiss fund of funds, has forecast that a third of buy-out groups “will be unsuccessful in raising meaningful amounts of additional capital for future funds and will eventually dissolve”.
Faced with an uncertain environment, established names in private equity will need to adapt to show investors, through successful exits and innovative deals, that they still deserve to exist.