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Hedge Fund Monthly
 
Coping with the Hangover

Joseph Mariathasan, IPA

May 2010
 

The private equity industry is currently experiencing an adjustment phase after a period of excess. For those who are able to recover quickly from the hangover, there are certainly opportunities that are worth considering, but many of the current generation of firms will find it difficult to survive in their current form.

Meanwhile, both investors and managers still need to grapple with fundamental questions: is private equity a distinct asset class separate from listed equities or merely an illiquid form of equity investment?; can private equity outperform the public markets?; what role should leverage play in the future?; and how will the industry fare in a still uncertain regulatory environment?

“A lot of people came into private equity because they saw it as a quick and easy way to make money,” says Colin Wimsett, CIO of fund of funds provider Pantheon Ventures. “It was for a few years, but that was an aberration”.

The economic and regulatory backdrop for the private equity industry in Europe will become more difficult. “I think there is a lot of stagnation on the side of financial legislation in Europe,” says Bruno Raschle, CEO of Adveq, another fund of funds provider. He sees this lack of direction at the policy level affecting allocations as investors face both uncertainties in their own cash flows and capital adequacy requirements. “In Europe, many institutional investors are not yet used to the idea that we live in a different world and do not know how to generate returns consistently from this new environment,” he adds. On the other hand, Wimsett argues that one of the key strengths of private equity is that it benefits from change: as the economies move out of a recession, he sees private equity-owned companies as better positioned than listed companies.

What seems certain is that firms will no longer be able to rely on leverage and rising private equity ratios in the listed markets to perform the simple arbitrage of buying companies, leveraging their balance sheets and then floating them at higher multiples. As Wimsett argues, many firms have been changing their strategy over the past 10 years to develop more operational skills, replacing accountants and investment bankers with people with real industry and sector knowledge. But there will be a shakeout as managers, who did not develop these operational skill-sets, find they cannot compete in a world of low leverage and static listed markets.

“The private equity industry is very diverse with many small players,” notes Patrick Reeve, CEO of Albion Ventures. “There is a real danger of consolidation”.

Choosing Firms

In the new world, finding managers who can truly add value is key to generating attractive returns. Mega funds which dominated private equity investment over the last decade no longer look attractive. “One has to question whether, on a risk-adjusted basis, the large-cap buyout deals can be handled in a rapidly changing macro environment,” says Raschle. “A maximum of 20% of private equity managers provide true value – and that may be too optimistic. It is not value defined historically that is needed but the wisdom and foresight to be at the forefront of a rapidly changing world”.

Given the demise of the mega funds, it is not surprising that everybody now favours the mid-market. It is also much easier to sell smaller companies to trade buyers, so exits are less reliant on IPOs. For example, managers in LGT Capital Partners’ European portfolios sold 33 companies to trade buyers in the year following the Lehman bankruptcy, according to partner Tycho Sneyers. At the very small end, where Albion operates with an investment size of £1-10 million, there is considerably less competition, according to Reeve, after 3i moved on to doing much larger deals, leaving a gap in the marketplace.

Different managers have different skills and it is important both for the managers and investors to be able to recognise where their real added value lies. But in a rapidly changing environment, as Raschle argues, each firm has to redefine itself and find its own way to differentiate itself when selecting business investment opportunities. But this transition creates a number of problems. Wimsett points out that private equity firms are typically small and mid-sized boutiques that are very dependent on key individuals. Firms need to ensure alignment of objectives for the staff to be able to survive long term.

When firms were making vast amounts of money, it was harder to tackle the issues. “There is now a lot of unease at the ‘marzipan level’ just below partners,” says Wimsett. “There is not a lot of hope for a great return where they are. Most of the senior partners have made enough money to retire but may decide to wait a long time and senior people are required to raise new funds”.

These issues over succession policies lead to new spin-outs: one of the key issues for funds of funds is to recognise that rather than investing in the third fund of an old private equity firm, it may be better to invest in the first fund of a spin-out firm where the founders have the experience and track record, combined with the motivation to be successful.

Adding Value

As Sneyers sees it, managers focusing on distressed companies have the greatest ability to make operational improvements – it is a lot easier to replace the CEO, for example, either with one of the manager’s own partners or with an outside expert. But there are few firms in Europe with a proven track record in doing this effectively.

Another strategy with significant operational value-add is “buy and build” or “roll-ups”, where private equity firms buy up several competing small businesses in a local area – funeral parlours or childcare centres, for example – integrate them with centralised management and information services, and generate economies of scale. Typically, such businesses can be bought at two to four times cash flow, and the newly formed local market leader can be sold to a European or global leader for seven to eight times.
 
Sneyers sees this strategy as sustainable and replicable, and it can be based around various themes, such as ageing populations, increasing participation of women in the workforce and more money being spent on leisure.

A third type of private equity investment is the typical buyout. Every private equity firm claims it adds operational value, but as Sneyers says: “It is our job to find out who is really operationally involved. We look at every deal they have done. If someone owns a business and the industry has done well but their company has not, it means that something is wrong and we would want to sit down and walk through what happened”.

Finally, there can also be value in some firms which just provide capital but are very good at sourcing deals: “There are cases such as a French fund that had a proprietary relationship with a credit agency and as a result, had access to good deals,” explains Sneyers.

Fundraising

As Sam Robinson, director at SVG Advisers points out, deal flow in Europe has been negligible since the Lehman collapse – virtually no funds have been raised since then. In the US, however, fundraising never really completely stopped. “There was a slowdown, but Americans, by nature, are optimistic, so there has been a reasonable flow of funds”. Asia has rebounded much more quickly in both the public and the private markets. In the secondary market, although Coller Capital partner Erwin Roex believes that this year will not be an easy one for fundraising, he notes that Lexington has just raised $3.1 billion for an interim close of its latest and expects next year to be much better.

As the world recovers, interest in private equity will certainly return but rather than just focusing on mega and mid-market buyouts, the issue might be how best should investment be allocated between Asia, distressed and secondaries.

 

 

This article first appeared in www.ipe.com/asia on 1 May 2010.

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