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Industry Viewpoint - Fall 2009

What Next for Private Equity? - continued

THE FINANCIAL AND TRANSACTION ADVISOR

Anuj Bahal

Private equity has matured as an asset class over the years but like other industries, it experiences cyclical fits and spurts in growth and is subject to certain market, credit and regulatory forces beyond its control, as was the case beginning in 2007 / 2008. The marquee private equity firms – like the Apollo, Blackstone, Carlyle and KKR’s of this world – have emerged from the credit crisis with some bruises, but they will weather the storm. They have adapted by operating like diversified alternative investment funds; they are active in distressed debt, real estate, mezzanine financing and financial and capital advisory services in addition to traditional leveraged buyouts. They have also expanded geographically to adopt a worldwide focus. These moves position them to pursue attractive opportunities at reasonable prices. Not all private equity firms are as fortunate, especially with investment capital increasingly flowing to perceived winners.

Ultimately, private equity firms are only as successful as the people running them—in many cases, among Wall Street’s most talented minds and managers. It will be up to these individuals to envision, adapt and implement ideas that generate high returns for their investors. It is inevitable that in a contracting business environment there will be some casualties. Given the reduced deal flow and struggling performance of many private equity-backed companies, the number of private equity firms is likely to decline going forward. The survival of smaller funds, which represent the majority of the 2000+ private equity funds in the United States, is being debated given the challenging business climate. The firms which survive and thrive will be those that recognize today’s LBO market is less about the “L” in LBO and more about generating and implementing smart ideas and strategies and defending and creating value from operating decisions at portfolio companies.

In the near term, private equity firms of all sizes will continue to actively nurture portfolio investments in order to ensure preservation and future growth of equity value and to meet the challenges of refinancing maturing debt on workable terms over the next few years. But the real challenge for sponsors will be generating sustainable top-line growth and improved working capital at portfolio companies, because much of the easiest cost-cutting has already been carried out. Fund managers will also be looking to make opportunistically priced tuck-in acquisitions to complement their existing operations and drive scale.

Given the vast amounts of capital at the disposal of private equity firms, look for them to invest in areas where capital is sorely needed: the banking, real estate and mortgage industries. One potential obstacle, though, will be formidable regulatory and execution hurdles.

Private equity firms are also likely to pursue more minority interest investments and private placements in public entities (so-called ‘PIPEs’) – more than 50 U.S. deals involving $14 billion of capital have already been done in the last 18 months. And there has already been an acceleration of private equity activity in distressed M&A. About $80 billion of distressed debt deals have been done in 2009, and more may be on the way, given the onerous debt maturities on the horizon – analysts forecast another $300-400 billion dollars of debt is likely to default over the next three years. Regardless of what happens, traditional buyouts will eventually return, but initially they will be smaller deals with lower thresholds on internal rates of return, less reliant on leverage and heavily dependent on more conservative forecasting and financing than in prior years.

History reminds us that some of the best private equity fund vintages were created amid adverse conditions akin to what we are experiencing today. This asset class is here to stay – it will evolve and adapt as necessary to meet the challenges and seize the opportunities that cyclical industries inevitably encounter.

Anuj Bahal is a Senior Managing Director at FTI Consulting in the Corporate Finance/Transaction Advisory Services Segment.