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June 17, 2009updated 29 Jan 2016 4:55pm

After the Fall

By Christopher Silvester

Christopher Silvester on how private equity is picking itself up, sorting itself out and getting back to basics

I t is no exaggeration to say that a ‘new world order of private equity’ is emerging. That is the title of an essay published in the 2009 Preqin Global Private Equity Review by Kevin J Conway, managing partner of the New York firm Clayton, Dubilier & Rice, one of the oldest private-equity firms in the world.

As the ‘Golden Era’ of private equity gives way to a new era of ‘responsible’ private equity, Conway argues, there will probably be fewer and smaller transactions and certainly less of ‘the financial engineering that was fashionable and gave private equity its public face and a measure of notoriety’. 

Already the giant players are in decline. According to the Financial Times, several major firms, including Terra Firma, Permira, Candover, Cognetas and Kohlberg Kravis Roberts, wrote down the value of recent European funds between 40 per cent and 70 per cent at the end of December 2008.

Terra Firma has written down 70 per cent of two investments in its 2006 fund, EMI and Awas, but one investor has marked down the latest Terra Firma fund 79 per cent. In March, Guy Hands stepped down as chairman and CEO of Terra Firma to become group chairman and chief investment officer, so as to concentrate on salvaging the company’s investments. BC Partners has seen its stake in Foxtons, the estate agency for which it paid £360 million at the top of the market, shrink to zero value.

‘They have eight managing partners and each one of them has a veto right on a deal,’ observes one private-equity executive. ‘They’ve done almost no investing over the last few years, but one of the deals they did was Foxtons. They were being so careful, they hadn’t done any investing at all because they knew there was trouble out there, and yet they did Foxtons… and all eight of them agreed!’ The banks that leveraged this deal have lost about four times as much as BC Partners. 

‘Half of all private equity ever was invested in the couple of years until the middle of ’07,’ says Jon Moulton, managing partner of Alchemy Partners. ‘Virtually all of that is now worthless. The majority of that money was put out by the large funds. Permira, BCG, Chris Flowers and Terra Firma are all trading at very large discounts; these were the heroes of not very long ago. These are spectacularly over-leveraged days, when a bank may well own over 400 per cent of a company.’

T he credit boom kicked off in 2003, with banks lending aggressively to private-equity companies. Since the megafunds had no trouble raising capital but a shortage of management capacity, they hired as many investment bankers as they could find in order to put this capital to work.

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‘If you look at Permira, Cinven, Candover, TPG, most of their staff are people who came out of investment banks, young and old,’ notes Jeff Montgomery, managing partner of GMT Communications Partners. ‘Their mentality is transaction-driven. It’s not about “I have to live with that damn thing I did”.’ 

Warren Hibbert, a partner at private-equity advisers MVision, concurs. ‘Arguably, any banker worth his salt could go and start a private-equity fund, because it was all financial engineering at the end of the day,’ he says. ‘Everyone in the market was an operational genius, everyone was top decile — despite that not making sense. It’s all come home to roost now. They were able to execute it because it was really just a buy-and-sell strategy. Buy, sell, and if you could engineer it intelligently you’d make money.’ 

At the same time, hedge funds started to compete with the banks, participating in private-equity structures at the senior and subordinate levels on the debt side. They would borrow money from banks, enter a private-equity structure as senior debt, and charge an uptick to the private-equity company. ‘They were trying to make an arbitrage play on the use of double leverage,’ says Jeff Montgomery.

  Taken together, these elements constituted a perfect storm. ‘You had people who didn’t really understand principal investing, you had easy access to credit, and you had people throwing money into private-equity funds, which wasn’t a good combination — which is why virtually every single fund of more than a billion in size will have lost some or much of the money given to it by investors.’   

The approach of the megafunds was to buy big, top-tier, high-quality companies, paying high prices through competitive auctions, then through the use of leverage and some minor modifications and efficiencies to obtain a little EBITDA growth (earnings before interest, tax, depreciation and amortisation).

As long as the exit multiples remained buoyant, this approach, with its velocity of entry and exit, was sufficient to generate spectacular returns in the order of 40 to 50 per cent. While the limited partners, led by the US endowments but also including pension funds and high-net-worth investors, basked in the warm glow of these returns, the general partners in the funds pocketed their ‘two and twenty’ fees, known as ‘carry’. 

‘That whole idea quickly became commoditised,’ says Montgomery. ‘It didn’t take long for people out of investment banking to understand and master the financial engineering. That whole model’s dead. That’s never going to come back.’ What was propping up a lot of the values of private-equity investments was not the underlying fundamental growth of the portfolio companies but the easy access to credit in a benign and growing business environment.

Again, Warren Hibbert agrees. ‘In the upper mid-market or mid-market, the model is broken for the time being. While the banks will return, they’re not going to return with the quantum of leverage they have provided in the past — certainly not the multiples of EBITDA in the seven and above range.’    

Apart from short-term opportunities in the distressed debt area, with companies that are over-leveraged, Hibbert believes that what will play out well in the years to come are specialist, sector-focused funds. ‘A lot’s been spoken about consolidation,’ he says. ‘But I think the reverse will happen: a de-consolidation, where money follows talent, not funds.

‘The best rainmakers within the funds will say, “Look, the model’s broken, particularly at the upper end where most of the experienced guys are, and we’re going to go back to what we used to do very well.” Growth is going to be vital, simply because there’s no debt. There’ll be spin-offs of groups doing smaller things, as long as the model remains broken at the top, in addition to the fact that there’s no “carry-out” because everything’s so far under water. There’s very little incentive within the industry.’

Over the next eighteen to 24 months the megafunds will be spending most of their time monitoring and sorting out their core portfolio, restructuring, and renegotiating bank covenants on almost everything. The ability of private-equity companies to call capital from limited-partner investors is severely compromised.

It is casually claimed that over a trillion dollars of committed capital is available to the general-partner community, but the reality is rather different, since the biggest writers of cheques for private equity, the wealthy US universities, were exposed to alternative assets, covering everything from private equity to hedge funds, in the order of 60 per cent. They may be nursing their wounds for some time.   

T o survive and prosper in the future, private-equity companies will need to have a broader investment philosophy than merely doing leveraged transactions. Indeed, private equity, which grew out of the venture-capital industry, needs to return to its true purpose of generating returns by building fundamental value in portfolio companies. With the leverage-finance model no longer viable, private-equity companies will have to focus on something else: the operational aspects of a business or consolidation of its market.    

‘These are things that take a lot more effort and a lot more skills,’ says Jeff Montgomery, whose company GMT specialises in the high-growth European media sector, ‘and there aren’t as many of those kind of opportunities around. There aren’t that many companies that grow fast in a global environment that is de-leveraging and where the spending patterns for businesses and consumers are changing.

Private equity will become much more competitive in terms of the ability to deliver returns to investors. The kind of strategies which will benefit will be understanding the products and markets, finding high-growth sectors, and maximising growth in those sectors. But it takes a fairly long time to build up an expertise level.’ 

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