By most measures, private equity has held up remarkably well during the economic downturn. But, it looks like it could be the calm before the storm for private equity. Thanks to the global credit crisis and deep worldwide recession, experts predict a shake-out, especially for the buyout segment of the private equity world.
The Boston Consulting Group and the IESE Business School of the University of Navarra in Spain predict at least 20 percent—and possibly as much as 40 percent—of the 100 largest buyout fund companies could go out of business in the next two or three years. “It all depends on investor asset allocation,” says Heino Meerkatt, a Munich-based senior partner at The Boston Consulting Group (BCG). Credit terms, integral to the private equity model, are unlikely to return to the favorable conditions that fueled the last private equity boom anytime soon.
What’s more, BCG and IESE, which recently published a joint, comprehensive report detailing their findings, believe many private equity firms’ portfolio companies will default on their debts, currently estimated at $1 trillion.
As a result, more than half (54 percent) of private equity firms say they havewritten down the value of their portfolio companies in the last quarterwhile 57 percent have portfolio companies in covenant default with theirlenders, according to a recent survey conducted by the Association forCorporate Growth (ACG) and Thomson Reuters. In fact, 41 percent reported thatup to one quarter of their portfolio companies are in default while 14 percentreported one quarter to one half in default.
So far, at least one private equity firm seems to be struggling. According to published reports, European-based Candover said earlier this year it had received offers to buy either part or all of the firm.
Like the global stock markets in general, fund-raising boomed from 2003 through 2007 for the entire private equity market, which includes leveraged buyouts, venture capital and real estate. In 2007 alone, 415 U.S. private equity firms raised $302 billion, up 19 percent from $254.7 billion raised by 404 funds in 2006, according to Private Equity Analyst. The PE sponsors benefited from cheap credit, swelling asset prices, strong and growing corporate profits, and an increased willingness among institutional investors to allocate money to alternative investments in general.
However, the global economic crisis has sent all of these factors in reverse, points out the BCG/IESE report, which only analyzes buyouts. Corporate earnings as well as price-to-earnings ratios have come way down even as debt has swelled. As a result, the debt of many leveraged companies is becoming much riskier.
Standard & Poor’s recently noted that as of May 13, the number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—surged to 293 from just 100 at the end of 2007. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. Most of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months, S&P points out in a report. “Some of these entities were even previously rated investment grade,” the report adds.
As a result, more than half (54 percent) of private equity firms say they have written down the value of their portfolio companies in the last quarter while 57 percent have portfolio companies in covenant default with their lenders, according to a recent survey conducted by the Association for Corporate Growth (ACG) and Thomson Reuters. In fact, 41percent reported that up to one quarter of their portfolio companies are in default while 14 percent reported one quarter to one half in default.
Of course, the general partners themselves can’t go bankrupt. However, if many portfolio companies go bankrupt, investors in a fund would wind up losing money or not get their money back, let alone make much less than they had hoped. This would impact investors’ willingness to pony up for the next PE fund in general and make it much more difficult for the sponsor to raise money for a new fund. “The moment of truth for a fund manager is the next fund raising,” warns Meerkatt.
He says the two biggest factors in determining which companies survive the shake-out are the timing of their next fundraising and their historical performance.
A PE firm seeking money now would most likely have a terrible time. For example, in the first quarter, 78 funds worldwide raised just $49 billion, down 62 percent from $129 billion raised by 203 funds during the fourth quarter and down 55 percent from the traditionally strong third quarter, according to London-based Preqin, a major industry scorekeeper. This includes buyout funds, real estate funds and venture capital funds. The first quarter total was also 70 percent less than the aggregate value of closed funds in the first quarter of 2008 and marked the lowest total in five years, the firm said.
Meanwhile, Preqin counts 1,673 private equity funds currently passing the hat around in the fundraising market, 48 more than in the fourth quarter. The funds currently in the market seeking capital are targeting a total of $879.9 billion. “The problem is that investors don’t have capital for even strategies investors are keen on, such as distressed or mezzanine financing,” says Tim Friedman, head of publications and marketing for Preqin.
At the same time, there is a lot of dry powder. Preqin estimates there is currently $1.15 trillion in committed capital, or the total amount of capital that each fund has yet to call up. The average size of funds on the road in the first quarter was $526 million, a 5 percent decrease from the preceding quarter, when the average fund size stood at $556 million.
As a result, Meerkatt says historical performance will play a critical role in determining which private equity firms are able to raise money for their next fund and therefore survive. “Private equity is one of the asset classes that has stickiness of performance,” he insists. “If you are in the top quartile, it is likely the next fund will be in the top quartile.”
Meerkatt says two other factors will determine whether a firm survives the shakeout—those that divested much more than they invested before the crisis hit and those that are heavily exposed to non-cyclical companies will fare better. “Firms that put emphasis on leverage will also have a tough time,” he adds.
Indeed, PitchBook, a private equity-focused research firm points out that these days PE funds are using more cash and less borrowed money to do deals. The typical buyout deal in the fourth quarter used 52 percent equity, way up from just 13 percent in the middle of 2007.
Will the PE market come back to life? Eventually. In the next 12 months, limited partners will have more visibility about performance and the managers will need new funds.However, much will also depend upon the hospitality of the credit markets. “Confidence is a tricky thing,” says John Gabbert, CEO and founder of PitchBook. “I’ll bet there will be more deals in the latter half, and more on the buyout side.”