Between 2002 and 2007 private equity (PE) experienced what has been called a "golden age", characterised by multi-billion dollar deals, easy credit and substantial profits. Worldwide private equity transaction activity increased from $111 billion in 2002 to a peak of $659 billion in 2006. Nine of the ten largest private equity buyouts of all time were undertaken between 2005 and 2007, capped by the record-breaking, $45 billion purchase of energy producer TXU Corp. (now Energy Future Holdings) by US private equity groups KKR & Co. and TPG. As the decade drew to a close, however, TXU was attempting to negotiate with its lenders for relief on its crushing debt load. Many observers have predicted a long winter for the private equity industry. Activity has fallen to pre 2003 levels and several prominent boom deals seemed poised for bankruptcy. "Everybody made mistakes, some people lost fingers; some people lost whole arms," said Hardy McLain, the founding partner of CVC Capital Partners. However, many leading PE firms have already begun to adapt to the new climate, raising funds and investing in new deals. The future for private equity therefore looks brighter than it did just eighteen months ago.
Whilst deals on the scale of those witnessed between 2005 and 2007 (when a mega-deal was anything upwards of $20 billion) are unlikely to be seen for some time, there has been a substantial increase in the number of deals around the $1bn mark - the recent buyouts of Pets at Home by KKR, and of Marken by Apax as well as the current bidding activity around both New Look and Kabel Deutschland are all notable examples.
Since most PE firms intensified their fundraising during 2006-07, the industry as a whole is estimated to be sitting on over $500 billion of dry powder, that must be invested at some point. Indeed, some argue that now would be the perfect time to begin deploying this capital, as market prices remain depressed. Opportunism is the key. Leon Black founder of Apollo Management LP, recently predicted that whilst conventional (or "vanilla") leveraged buy outs would not recover for years, there would be an increase in idiosyncratic deals, such as debt for equity swaps and turnarounds.
Although they are often disliked, the leaders of the largest private equity firms have demonstrated their adaptability in previous crises, such as the 1987 crash, the Asian Bubble and the fall of Drexel Burnham Lambert in 1990. Highly adept at making money, leading firms have been quick to shift their activities into potentially profitable sectors. Several firms have adopted a merchant banking approach over the last twelve months, demonstrating a willingness to broaden their strategies to include minority investments (where the firm does not seek to buy out the target company), growth capital (a form of lending) and partnerships. KKR, for example, recently provided growth capital for mature businesses such as Far Eastern leasing and Eastern Resources in exchange for a favourable equity stake. It has also been buying debt instead of purchasing entire companies. As the big banks have lost their appetite for making risky loans, some PE firms have spotted a gap in the market. The Carlyle group, for example, has expanded its mezzanine financing operations, offering unsecured loans at high rates of return. Firms which specialise in distressed assets (a strategy which involves taking over or turning around struggling companies), such as Apollo and Lonestar, have been extremely active in purchasing both debt and equity securities, which have declined substantially in value. They hope to profit from the market's revival and to purchase sound businesses at a discount. Whilst the current market conditions remain testing, the ability of leading PE firms to develop new strategies should serve them well.
However, the current political climate could have a significant detrimental impact on the PE industry. Whilst its leaders protest that they are job creators not cutters, and that they should be rewarded for their long-term investment strategies, there appears to be a political will to impose higher taxation on capital gains in both the US and the UK. Compared to activities in other markets, however, this talk has been relatively mild. South Korean tax authorities are poised to increase capital gains on US firms exiting investments in the country, whilst Indian legislators are talking about modifying the law to increase the tax burden on buyouts. The Australian government recently imposed a $1.4bn tax bill on TPG after its divestment of the department store, Meyer, which, as Steve Schwarzmanm, the founder of Blackstone, recently suggested, may make it difficult for the country to attract new investments. Despite this, the industry is likely to remain flush with funds. PE firms in the US are likely to escape the strict restrictions which appear to be descending on the investment banks. They may even benefit from the Volcker rule, which would ban the banks from owning their own private equity funds and therefore reduce the competition for the PE firms.
PE returns have consistently outperformed those of the public markets for the last fifteen years. Pension funds, college endowments and insurance companies struggling to meet future obligations will want to take advantage of the superior returns PE firms promise. There are also growing opportunities in the emerging markets, as companies become more transparent and legal regimes more developed. PE has plenty of room to expand its horizons.
Therefore, whilst political risks remain, the outlook for the PE industry is positive. The financial crisis caused serious damage but it has also thrown up new opportunities. With credit still restricted, firms will need to focus on improving operational performance and purchasing businesses with growth potential, since leverage alone cannot be relied upon to produce returns. In other words, PE firms must actually improve the companies they buy in order to post a profit - which is what they've always promised.
Private equity firms purchase companies using a mix of their own capital (equity) and debt borrowed from banks (loans) and the capital markets (bonds). Historically debt has formed between 40 per cent and 60 per cent of the total purchase price but reached as high as 85-90 per cent on some deals at the peak of the credit bubble. Private equity investors seek to generate superior risk adjusted returns through a mix of purchasing companies at attractive valuations, financial leverage and improving operating performance. Typically, investments are held for several years before being divested either via an initial public offering (taking the company to market), or through a sale to another private equity company or to another corporate. Firms typically target at least a 20 per cent return on the equity invested.
Leading PE firms
- The Blackstone Group
- The Carlyle Group
- Goldman Sachs Capital Partners
- Apax Partners
- CVC Partners