Covered Investors
The Final Policy Statement does not cover all potential investors in a failed depository institution. Rather, it applies only to:

1. Private investors in a company, including any company acquired to facilitate bidding on a failed depository institution, that is proposing to, directly or indirectly, including through a shelf charter, assume deposits, or deposits and assets, from a failed depository institution.
2. Applicants for deposit insurance for a de novo depository institution chartered to acquire a failed institution.

Significantly, the Final Policy Statement excludes from its reach:

1. Acquisitions completed prior to the FDIC’s approval of the Final Policy Statement.
2. Upon application and approval by the FDIC, investors in a depository institution (or depository institution holding company) after the institution has maintained a Camels 1 or 2 rating continuously for seven years.
3. Investors in partnerships or similar ventures with depository institution holding companies or in such holding companies (excluding shell holding companies) where the holding company has a “strong majority interest” in the resulting depository institution and an “established record for successful operation” of insured depository institutions.
4. Investors holding 5 percent or less of the total voting power of an acquired depository institution (or its holding company), absent any evidence of such investors acting in concert.

(Investors that are subject to the Final Policy Statement are referred to in this memorandum as “Covered Investors.”)

Capital Commitment
Under the Final Policy Statement, depository institutions acquired by Covered Investors will be required to be initially capitalized at a minimum 10 percent common equity to total assets ratio for at least three years and at a “well capitalized” capital adequacy level thereafter. This requirement has been substantially eased from the initial proposal in several ways.

First, the 10 percent level is substantially lower than the original proposal of at least a 15 percent Tier 1 leverage ratio for at least three years. Although the Final Policy Statement did revise the test from a Tier 1 leverage test, which permits the inclusion of cumulative perpetual preferred stock, to a common equity test, which does not, the 10 percent common equity leverage test is at least comparable to the 8 percent Tier 1 leverage ratio that newly chartered depository institutions and those that are subject to a change in ownership are typically required by the FDIC to maintain.

Under the Final Policy Statement, depository institutions acquired by Covered Investors will be required to be initially capitalized at a minimum 10 percent common equity to total assets ratio for at least three years and at a “well capitalized” capital adequacy level thereafter.

Second, in contrast to the proposed policy, the FDIC did not retain in the Final Policy Statement the authority to extend the term of this requirement beyond three years (and potentially indefinitely).

Third, where the proposed policy statement provided that the investors would have to agree to maintain the capital of the depository institution at this level, the Final Policy Statement merely provides that the acquired depository institution must maintain the required capital ratio.  As in the proposed policy statement, if the depository institution fails to maintain the required capital levels, it would be deemed “undercapitalized” for purposes of the Prompt Corrective Action rules.  In that case, the depository institution would be required to submit a plan to restore its capital to the required level and, in order for that plan to be accepted by the regulators, the holding company for the depository institution would be required to guarantee the plan in an amount not to exceed 5% of the assets of the depository institution.  (The holding company cannot be required to provide such a guarantee, although the regulators may take other actions against a depository institution that does not submit a capital plan that includes such a guarantee.)  However, it is important to note that the Final Policy Statement does not contemplate that either the holding company or Covered Investors will be required to enter into agreements with the FDIC in which they are legally bound to maintain the capital of the depository institution at a particular level.

No Source of Strength Requirement
The Final Policy Statement does not contain a requirement that Covered Investors agree to serve as a “source of strength” to any failed depository institutions in which they invest—a vague but potentially unlimited obligation to support the depository institution.  Under current law, the source of strength obligation only applies to companies that acquire control of a depository institution.  The FDIC had proposed that such a requirement would generally apply to investors’ organizational structures, but eliminated it in recognition of the fact that private equity funds generally would be prohibited by their fund documents from making an investment on such terms.

Cross Support Liability
The Final Policy Statement requires Covered Investors holding an 80% or greater interest (as opposed to a majority interest, as contemplated in the proposed policy) in two or more depository institutions to pledge their interests in each of the institutions to cover any losses to the FDIC’s Deposit Insurance Fund as a result of a failure by either institution.  This provision, which allows the FDIC to seize shares pledged by Covered Investors in a healthy depository institution if the FDIC incurred costs assisting a commonly owned depository institution, differs from the statutory commonly controlled liability rule, which allows the FDIC to assess a healthy depository institution (not its owners) for the costs of assisting a commonly controlled depository institution.  In the Final Policy Statement the FDIC retains the discretion to waive the pledge requirement if it determines that exercising the pledge would not result in a decrease in the cost of the failed depository institution to the fund.  While the Final Policy Statement does not indicate when a waiver would be given, we would expect that a waiver would occur at the time bids are submitted so that a determination of whether or not a pledge will be made can be factored into affected bidders’ financial proposals.

Transactions with Affiliates
Under the Final Policy Statement, a depository institution acquired by Covered Investors is prohibited from making extensions of credit (as defined in Regulation W) to such investors, their investment funds, if any, and any affiliates (defined as any company in which a Covered Investor owns, directly or indirectly, 10% or more of the equity for a period of at least 30 days) of either.  Covered Investors will be expected to make regular reports to the depository institution identifying all of their affiliates.  Existing extensions of credit made by an insured depository institution prior to its acquisition are exempt from the prohibition.

Bank Secrecy
The FDIC will deem Covered Investors ineligible to own a direct or indirect interest in an insured depository institution if they employ ownership structures “utilizing entities that are domiciled in bank secrecy jurisdictions,” unless they are part of a group subject to comprehensive consolidated supervision, as recognized by the Federal Reserve Board, and satisfy certain other requirements.  Private equity investors are not subject to comprehensive consolidated supervision and the definition of “secrecy law jurisdiction” in the Policy Statement is extremely broad.  Under the Final Policy Statement, a secrecy law jurisdiction would include: a country that applies a bank secrecy law that limits U.S. bank regulators from determining compliance with U.S. laws or prevents them from obtaining information on the competence, experience and financial condition of applicants and related parties, lacks authorization for exchange of information with U.S. regulatory authorities, does not provide for a minimum standard of transparency for financial activities, or permits off shore companies to operate shell companies without substantial activities within the host country.

The Final Policy Statement does not list or provide examples of countries that would satisfy the FDIC’s definition and this restriction would appear to implicate a range of tax and other issues for potential bidders that frequently use common off-shore jurisdictions at some level of their ownership structures.

Minimum Term of Ownership
Unless the FDIC gives its prior approval, Covered Investors that have acquired a failed depository institution are restricted from selling or otherwise transferring their securities for at least three years.  The Final Policy Statement provides that the FDIC will not unreasonably withhold its consent to a sale or transfer to an affiliate if the affiliate also agrees to be subject to the same conditions applicable to the selling or transferring investor under the Final Policy Statement.  The Final Policy Statement also provides that the holding period requirement does not apply to open-end mutual funds registered under the Investment Company Act of 1940 that issue redeemable securities capable of being redeemed by investors on demand.

Prohibited Ownership Structures
The Final Policy Statement also considers “complex and functionally opaque ownership structures” to be ineligible bidders for failed depository institutions.  Such structures exist where “beneficial ownership is difficult to ascertain with certainty, the responsible parties for making decisions are not clearly identified, and ownership and control are separated.”  The Final Policy Statement describes structures of this type as typified by “organizational arrangements involving a single private equity fund that seeks to acquire ownership of a depository institution through creation of multiple investment vehicles, funded and apparently controlled by the parent fund.”  Thus, the prohibition appears to apply to so-called “silo” structures in which private capital sponsors form new funds to make investments in failed depository institutions without causing their existing funds to be subject to regulation applicable to depository institution holding companies.  Although reasonable persons may differ on the virtues of “silo” structures, the Final Policy Statement is nonetheless an improvement over the proposed policy in that the Final Policy Statement more clearly describes what structures would raise objections from the FDIC.

Special Owner Bid Limitation
A 10 percent or greater shareholder of a depository institution that fails would not be permitted to bid for the assets or deposits of that institution.

Required Disclosures
Covered Investors in a failed depository institution are expected to provide the FDIC with information about themselves and all entities in the ownership chain, including the size of their funds, diversification, return profile, marketing documents, management team and the business model, as well as other information that the FDIC may request.  Any such information would be submitted on a confidential basis.

As investors and corporations try to emerge from the global credit crisis, the PE funds have moved from the fund-raising stage to the investing stage. And experts say there are more than enough deals to go around.  “It is a phenomenal time to invest,” says Marc Lasry, co-founder of New York City-based Avenue Capital, which manages more than $17 billion, 90 percent of it in private equity or lock-up vehicles. “There are a lot of distressed opportunities.”

Of course, it is not surprising that fund-raising tailed off late last year as the credit crisis intensified. This year, just seven funds raised a mere $1.1 billion, according to Preqin. However, PitchBook Data, a Seattle-based private equity research firm, recently noted that Oak Hill Capital is seeking $1 billion to invest in distressed debt. It added that the new fund, OHA Strategic Credit Fund, would continue the firm’s strategy of investing in nonperforming and distressed loans, high yield bonds and other securities.

Most of the investors in the distressed private equity funds are institutions and endowments, which, like most other investors saw the value of their portfolios deteriorate last year. “Institutional investors don’t have money,” says Kelly DePonte, partner at Probitas Partners, a placement agent for alternative investments. “All areas are down about 60 percent from where they were in 2008.”

As global economies recover in general and the credit environment begins to ease somewhat, experts expect these private equity investors to return to the market later in the year as they become less concerned about liquidity. And they will especially look to those funds that specialize in the securities of, or the acquisition of, troubled companies. In fact, at least 54 funds are currently on the road seeking to raise as much as $52 billion, according to Preqin. “I think [fund raising] is likely to go back up to levels we saw a couple of years ago,” says Tim Friedman, head of publications and marketing at Preqin.

“It is a phenomenal time to invest. There are a lot of distressed opportunities.” -Marc Lasry, co-founder of Avenue Capital

Why is Friedman so confident? He cites the historic track record for distressed private equity funds. Investors are mindful that distressed PE funds with vintages from 1999 through 2004 racked up double-digit returns, including 30 percent for the 2002 funds. That year’s first-quartile performers generated, 46 percent returns on average. (There is no performance data for funds created after 2006.) Since many distressed asset funds operate on a  J-curve, with most deals in private equity losing value initially, Preqin won’t typically start looking at performance until around three years into the life of the fund at the earliest.

Indeed, in a recent survey of institutional investors, Preqin found that about one-third believe small- to mid-market buyout funds are particularly appealing, followed by 31 percent, which singled out distressed private equity, including distressed debt, turnaround, and other special situations funds.

DePonte, however, says it typically takes five to six months to get to the first close and 12 to 18 months in total. These days, funds are looking at the longer end of that range and are raising less than they had hoped. In fact, he says many funds that planned 2009 fund raising are pushing back the timetable to 2010.

While investors have taken a pause, the PE fund managers haven’t. “All distressed funds are incredibly active,” says Jonathan Henes, a partner in the restructuring group at the law firm Kirkland & Ellis LLP. He says earlier this year managers were mostly loading up on senior secured debt as asset values were falling and companies were increasingly filing for bankruptcy. “That was the in-the-money security,” he says. Now, as asset values have moved up, distressed funds are looking at high-yield bonds.

PE managers are not so much looking at specific industries for value. Rather, they are looking for what they deem to be an inherently good company with a bad balance sheet that they can fix and then grow in value. Then they are going after the capital structure they believe could give them control of the company. “The goal is to find the fulcrum—the instrument that converts to equity,” Henes stresses. “The downside is we get par and the upside is we get substantially more than par by converting a portion of our bank debt to equity,” Lasry says.

In the past, Lasry says the fulcrum was in the unsecured or subordinated debt. However, these days he is finding it in bank debt because companies are still having trouble refinancing their debt. So, he is buying bank debt and being paid off at par or getting equity, which enables him to wind up owning the company.

Currently, he sits on the creditor’s committee of four companies, including: Six Flags, which runs amusement parks; casino operator Trump International; Spectrum Brands, a global consumer products company; and Ion Media Networks, a network television broadcasting company that owns and operates 63 broadcast television stations.

Altogether, more than $5 billion of completed and announced bankruptcy acquisitions have occurred since July 2008, according to Adley Bowden, managing editor of PitchBook. While 2008 saw just $875 million of completed bankruptcy acquisitions, there have already been $4 billion worth so far in 2009—a 350 percent increase.

There is also another $750 million of pending bankruptcy acquisitions. “There are no other investors right now providing nearly this amount of capital to these distressed and bankrupt companies,” says Bowden. “I believe as the economy continues to stabilize the number will only increase.”

And Lasry reasons there are more than enough deals to go around given the amount of capital recently raised in this space. For example, the American Bankruptcy Institute (ABI) shows that the number of businesses that filed for bankruptcy in the first half of this year totaled 30,333, a 64 percent increase over the previous year’s total of 18,456. Chapter 11 business reorganizations increased 113 percent to 7,396 during the first half of 2009 from 3,470 in the same period of 2008. Chapter 7 business liquidations increased to 20,375 in the first half of 2009, a 57 percent increase over the 13,002 business Chapter 7 filings during the same period in 2008.

Meanwhile, the number of companies with deteriorating financials has surged in the past year. So far this year, at least 205 global corporate issuers have defaulted—that’s four times the 54 defaults reported at this time in 2008, according to Standard & Poor’s. The number of bankruptcy filings has also surged to 53 issuers so far this year, exceeding the full-year 2008 total of 49 bankruptcy-related defaults. More than half of the defaulters this year either had or continue to have private equity involvement, S&P points out.

Meanwhile, the number of fallen angels—entities that moved to speculative-grade territory—has topped 62 affecting rated debt worth nearly $222 billion, according to S&P. In all 0f 2008, the fallen angel total came in at $226.42 billion. Says Lasry: “The amount of supply dwarfs the amount of demand.”

The SEC’s proposal, if adopted, would forbid private equity funds from using third-party placement agent services to solicit investment dollars from state and municipal pension plans, thus bringing to a halt the widely practiced use of such agents. The proposal would also block political contributions from parties seeking investments from those government entities, a shadowy, but not altogether uncommon, practice among private equity firms. “There are just a few small players in the country that have the political connections to do this,” says Charles Eaton of placement house C.P. Eaton Partners. “If the SEC bans political contributions, we would be happy to see these two-bit finders go away.”

The use of placement agents has become commonplace in private equity, with 54 percent of PE firms using their services in 2008, up from just 40 percent two years previously. The agents, who deduct their fees from the firms themselves, are responsible for a large portion of the investment that has flowed through private equity in recent years—illiquid “alternative assets,” which include PE deals, composed about 18 percent of U.S. pension fund assets at the end of last year.

The SEC’s major objective in its controversial proposal is to staunch the prevalence of “pay to play” tactics that have marred the PE landscape in recent years, with the ban on placement agents a largely secondary, but no less crucial, aspect of the proposal. “Pay to play” refers to the use of political donations (or, as in some notable cases, even more blatant financial offerings) on the part of third-party solicitors to curry the favor and investment dollars of state and municipal pension funds, which, nationally, hold $2.2 trillion in assets.

“Private equity is already laying lifeless as it is. If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities.”  -Paul Denning, private equity firm Denning & Co.

The SEC reasons that by stopping third-party placement agents, as well as explicitly forbidding political contributions within the investment advisory sector, there will be less of an opportunity for the kind of shady politically linked financial deals that have as late been an embarrassment for the private equity industry. As the SEC announced its proposal, “Investment advisers that seek to influence the award of advisory contracts by public entities, by making or soliciting political contributions to those officials who are in a position to influence the awards, compromise their fiduciary obligations.”

The most infamous breach of such obligations between funds and the solicitors that seek to win their business is that which was uncovered earlier this year in relation to the New York state pension fund. A pair of aides to former New York Comptroller Alan Hevesi are alleged to have funneled millions—including $30 million straight to the pocket of Hevesi consultant Hank Morris—in fees from companies that won pension investment from the state fund. “Morris was essentially masquerading as a placement agent,” says Paul Denning of private equity firm Denning & Co., who notes that Morris’s standards of professional conduct were much lower than industry standard. “Our hit rate is like 7 or 8 percent, whereas Morris’ guys were at 100 percent. There were no standards.”

The SEC’s reasoning in its efforts to stomp out pay to play is multifaceted, and largely supported by the private equity community. The effects of pay to play are harmful to pension funds and independent brokers alike—and are more a matter than mere reputation. Qualified advisors and the advisory community at large are hurt when certain parties can simply buy the business of those funds whose investment dollars they seek, leading funds to invest in companies that may not be an ideal match. The pension plans themselves will pay higher fees to compensate for the corrupt advisor’s expenditures—and the advisor has a greater ability to squeeze other monetary rewards out of the pension fund. And, of course, the actual beneficiaries of the pension fund—state and municipal workers—aren’t happy to know that their retirement dollars were pushed in inappropriate investments, especially if these investments underperform.

“The important thing from the funds’ point of view is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”  -Charles Eaton, placement house C.P. Eaton Partners.

“The ultimate goal of the SEC’s proposal is to protect public funds from abuse,” says Richard Marshall, counsel at Ropes & Gray. “But the question is whether the approach that they’re taking with this proposal will help public plans or hurt them.” Indeed, the critics of the SEC proposal have come out in droves during the document’s 60-day comment period, with many claiming that such changes will damage an already-fragile private equity climate. “Private equity is already laying lifeless as it is,” says Denning. “If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities. It’s also going to hurt those newer funds that don’t have the access to capital that the big guys have.”

Many critics have pointed out that the banning of placement agents is going to have a disparate effect across the PE field, with smaller firms bearing the brunt of the damage. Because the proposal allows a loophole—placement agents are allowed if they have an exclusive relationship with the capital-raising firm—it will be those smaller firms, who cannot afford in-house fundraisers and must outsource, that will suffer. “The rule has an asymmetry,” says Marshall. “And the question is, does this give an unfair advantage to the largest entities?” There is also the fact that placement agents do indeed offer a valuable service to smaller private equity or venture capital groups that don’t have the necessary professional contacts to get an audience with large pension funds, all of which are constantly besieged by deal proposals. “The important thing from the funds’ point of view,” says Eaton, who has spurred a Washington lobbyist group to attempt to stymie the bill, “is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”

But the regulatory proposal, however unpopular, isn’t without precedent. A similar pitch, made under Arthur Levitt’s SEC in 1999, would have placed a two-year ban from accepting pension fund fees on investment firms that used third-party placement agents. The 1999 proposal died, but, ten years later, numerous pay to play scandals have forced regulators to consider the harsher measures of its latest proposal. Though the egregious abuses allegedly committed in New York were the most highly publicized, they were by no means singular, with similar cases having been brought to trial in New Mexico, Connecticut, Illinois, Ohio, Florida, Alabama, North Carolina, and other states. The sheer volume of wrongdoing mandates some degree of policy change, says Marshall. “There have been a number of speeches that have been given that have identified this issue as a priority for the SEC. Clearly, the SEC will adopt something.” What remains to be seen—and what depends highly on the influence exerted by private equity groups and their attendant lobbyists—is just what kind of balance can be struck between fair play and a balanced, self-correcting market. The risk of overreaction, says Eaton, could wreak havoc within the industry: “We’re praising the SEC for coming to grips with pay to play, but we’re saying that if you go so far to ban the entire industry, you’re going to have a lot of unintended consequences.”

That’s welcome news for private-equity firms. While the IPO window may be just inching open, the prospects look enticing enough that a number of companies are taking the opportunity to move into the public markets, including a few firms held in private equity portfolios. Over the past several months, Dollar General, Rosetta Stone, and Avago Technologies, among other PE-backed ventures, have completed initial public offerings.

Between July 2008 and June 2009, only 58 companies filed to go public with the Securities and Exchange Commission, according to information from Renaissance Capital, a Greenwich, Conn.-based IPO research firm. That compares with 108 in just the first half of 2008, and 21 in July and August of this year.

To be sure, even with this increase, the current rate at which companies are going public doesn’t compare to the headier pace of IPOs prior to 2008. In 2006, for instance, 293 companies filed to go public. That number jumped to 373 in 2007, according to Renaissance.

“The concern with IPOs has always been that you’re really at the mercy of the overall market.”  -Michael Laveman, partner, Eisner LLP

“The IPO market is intensely cyclical,” says Josh Lerner, professor of investment banking at Harvard Business School, Boston, and private equity-backed offerings aren’t immune to larger market forces. If the IPO market remains open, it’s likely that more private equity firms will take advantage of public offerings as an exit strategy for some of their portfolio companies, he adds.

Does this represent a shift in strategy for private equity firms? After all, most private equity investors prefer to sell their portfolio holdings to a strategic buyer, rather than take their chances on a public offering. “The concern with IPOs has always been that you’re really at the mercy of the overall market,” says Michael Laveman, partner with accounting firm Eisner LLP. “Privately negotiating with a strategic buyer offers sellers a greater level of control.”

In fact, private equity investors have targeted IPOs as exit strategies for only about 13 percent of their investments, according to an analysis of some 21,000 private equity transactions between 1970 and 2007 by the World Economic Forum, “The Globalization Impact of Private Equity Report 2008.” Selling to another company was the most common exit mechanism, accounting for 39 percent of exits.

At the moment however, finding buyers has become more difficult, says Jeremy Kloubec, senior client partner for private equity at Infosys Technologies Ltd., a business solutions provider. Private equity mergers and acquisitions in the U.S. this year totaled $13.6 billion through July, or less than one-fourth the amount for the same period last year, according to Thomson Reuters.

The drop-off in deals is due to a mismatch between sellers’ and buyers’ expectations, Kloubec says. In addition, potential buyers aren’t able to use as much debt to carry out acquisitions, which means their purchases are going to be smaller.

The current jump in PE-backed IPOs also reflects the skill of private equity fund managers in timing the market, says Steven D. Dolvin, Ph.D., and associate professor of finance at Butler University in Indianapolis. “They’re very good at coming to market at the best time for a particular sector.”

“When the window is closed, you build up a backlog, and have to release it at some point.”  -Jeremy Kloubec, senior client partner for private equity, Infosys Technologies Ltd.

A case in point is Dollar General. On August 20, the operator of 8,600 discount stores filed form S-1 with the Securities and Exchange Commission to go public. Dollar General is owned by Buck Holdings, a limited partnership owned by Kohlberg Kravis Roberts & Co., L.P.  The proposed offering totals $750 million. “In the case of Dollar General, you can’t be better primed for a down economy,” Kloubec says.

Even as private equity investors decide it’s a good time to wade into public waters, they can’t guarantee that investors will be receptive. Some are going to be concerned that at least a few of the firms are coming to market simply because the fund managers want to get their money out while they can. If that’s the case, they may be bringing companies public that should remain private a while longer. “When the window is closed, you build up a backlog, and have to release it at some point,” Kloubec says.

Others express more confidence that the firms coming to market will succeed. For starters, IPOs really aren’t the most effective way for fund managers to cash out, says Scott Perricelli, partner with private equity group LLR Partners in Philadelphia. Even once an initial public offering is completed, the owners can’t sell a significant portion of their holdings until the lockup period expires. Instead, an IPO really is a way of valuing a business and providing it with capital for growth.

Moreover, private equity firms want to avoid a repeat of the kind of experience that Rosetta Stone, Inc., is having. The language software company went public in April, and got off to a great start, with its shares rising from about $18 to $25 on the first day of trading. For a time, it traded at over $30.

Things aren’t quite as rosy now, however. In August, after the company cut its third quarter forecast, the stock fell to about $21 and management pulled a planned secondary offering. As of late August, Rosetta’s stock was trading at about $22.

The challenge facing VC at the moment is twofold: excess capital commitments and investments have clogged the market; and extremely limited returns on this capital have punished investors for their patience. Since 2000, there has been approximately $250 billion in committed capital circulating through the market, with around $25 billion to $30 billion invested during each year in the past five years. These figures dwarf the ten-year period leading up to the dot-com explosion, when total capital commitments hovered around $50 billion, with annual investments not breaking $20 billion until 1998.

The inflated investment figures have only led to trouble, says Steve Dow, a general partner at Sevin Rosen Funds: “Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” Indeed, the number of participants in the game—all $250 billion worth—has remained relatively stable since 2001, while the number of winners has dramatically decreased—five-year returns have rotated around the zero percent axis since 2004. When compared to the years leading up to the dot-com revolution—during which investment figures were low, but returns were high—the last five years have marked a remarkable depression from VC’s former profitability. “Before the dot-com bubble, the ratio of winners to losers was such that the winners were making much more than the losers lost,” says Dow. “Now, the sector isn’t so consistent.”

“Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” -Steve Dow, general partner, Sevin Rosen Funds.

The poor returns for VC stem from a remarkably poor exit market, during which IPOs and M&A transactions have netted very little for the industry’s investors, with the average exits steadily decreasing. “We haven’t had a normal IPO market in a while,” explains Paul Kedrosky, senior fellow at the Ewing Marion Kauffman Foundation, which released a report in June pointing to the need for a “right-sizing” of the VC industry. “Without a solid IPO market, returns in venture are horrible; the exits have been terrible in the public markets and the private markets can’t compensate.” “You’re essentially taking one of two exit routes and shutting it down,” says Matt McCall, co-founder and managing director at Draper Fisher Jurvetson Portage Venture Partners. “You lose half of your ability for liquidity.” While IPO market conditions look to be improving, it may be a case of too little too late for many venture capitalists.

Compounding the weak state of IPOs are tight credit conditions, which have made it more difficult for venture funds to raise money. “VC investors are now worried about the solvency of their backers; they don’t want to make capital calls and find that their investors are backing out,” says Kedrosky. “So, rather than making investments, the VCs are just holding off on the whole thing.”

Clearly, VC is in a perilous state. A poll administered by executive search firm Polachi found that 53 percent of respondents—the majority of whom were partners or managing partners of their VC funds—agreed that the industry as a whole was “broken.” The same poll found that 92.7 percent of these executives said they were concerned about the weak state of exit markets. The consensus view on how to fix VC is that the industry must undergo a real downsizing, with committed capital and new investments both declining to a manageable level.

According to “Right-Sizing the U.S. Venture Capital Industry,” Kedrosky’s report for the Kauffman Foundation, “whether it realizes it or wants to, the venture industry has to change…it seems inevitable that venture capital must shrink considerably.” Such a view is reinforced across the industry, with nearly all VC players gearing up for such a change. “Less funds will be raised,” predicts Dow. “And the venture firms, living off the fees from previous years, will slowly fade away as they fail to raise what they need.”

“Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.”  -Paul Kedrosky, senior fellow, Ewing Marion Kauffman Foundation

The general assumption across the industry is that VC needs to shrink to half its current size in order to remain viable. The Kauffman report concludes that VC investment will fall by half to around $12 billion annually, with committed capital under management dropping about $100 billion from its current level of about $250 billion. Draper Fisher’s McCall predicts that much of the fat will be cut from middle-sized funds of between $150 and $300 million, but that all funds will see their capital pools diminish.

The need for an adjustment in the size of the VC industry is not ignorable, says Kedrosky: “Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.” But, as is the case with most shifts within the greater capitalistic structure, an exit from the VC sector may be inevitable for many. “The dot-com boom was a distortion,” says Kedrosky. “Before long, we’re going to see an inflation-adjusted version of the period just before that.” McCall predicts that stabilization of the industry could take between five and eight years, but that IPOs will likely reinvigorate themselves before then—which means that VC funds will have to maintain a disciplined investing approach if they are to make it to greener pastures. “The industry as a whole fluctuates between fear and greed; when there’s greed, in a strong IPO market, that’s when people start acting unwisely.”

The Federal Reserve and Federal Deposit Insurance Corporation officials must issue forbearance in order for CIT’s long-term success to pull through. Right now the $3 billion injection from CIT’s existing bondholders should help the company with $1 billion in debt maturing in August.

Bondholders, such as Allianz SE’s Pacific Investment Management and Centerbridge Partners, have secured virtually of of CIT’s $30 billion in assets that aren’t currently tied to other loans.

As CIT awaits regulator decisions, competitors, such as Fifth Street Capital, are informing clients of capital infusion offiers of as much as $10 million within 48 hours.

“If CIT can’t provide the factoring, we will step in and replace it for our clients,” said Leonard Tannenbaum, Fifth Street Capital president. “In a market dislocation like this, it offers us tremendous business opportunities.”

Deutsche Bank and Credit Suisse withdrew $15 billion of funding for the leveraged buyout of Huntsman Corp. by Apollo Management when the U.S. economic decline took hold, according to a report by Bloomberg. The banks were concerned the new company would be insolvent while Huntsman was reassured by “rock solid” financial statements of Apollo.

Each bank has agreed in the settlement to pay $316 million immediately and an additional $550 million each in senior debt over seven years.

Generally, banks can be expected to write these deals more carefully in the future, reported Bloomberg. Other investment banks were left with similar private equity obligations totaling $230 billion in August 2007. By December 2008, $105 billion worth of deals had collapsed. In addition, boards of directors will likely be more wary of leveraged buyout offers and their risks.

Private equity firms are learning to adapt in the new environment. Several are using their investor’s funds to purchase equity stakes in public companies. Others are investing in distressed banks. According to Bloomberg data, the total nominal value of leveraged loans by banks is down 81 percent from 2007. The nominal value of announced private equity transactions are down 60 percent over the same period.

Stanford and his associates at the Stanford Group are accused of selling certificates of deposit, while claiming the money would be used in simple financial instruments; instead, the firm invested the portfolio in risky private equity and real estate transactions. The bank then claimed “improbably, if not impossible” returns, according to the Securities and Exchange Commission.

Also implicated in the case are Stanford CIO Laura Pendergest-Holt and CFO James M. Davis. Pendergest-Holt was arrested in February.

Stanford, who was rated as the 605th richest person in the world in Forbes’ last rankings, has asserted his innocence in the matter. “I’m not a damn swindler,” he said in an interview with Bloomberg in April.

Stanford Group was placed under receivership in February.

“The impact of the financial crisis has been profound,” says Sacha Ghai of the McKinsey Group consultant/data firm. “Private equity lives off of the availability of credit, and until capital becomes available, it’s difficult for deals to go through.”

Canadian private equity, however, is at a relatively healthy point compared to its counterparts around the world, largely due to the health of Canadian banks. “[Banks] have weathered the crisis far better than they have in the United States, and there haven’t been any that have gone under,” says Ghai. “There is still capital to lend and this has to an extent muted the negative effects on the PE market.”

“The two strengths the market has are its focus on mid-market buyouts ofbetween $30 and $100 million and that buyouts aren’t leveraged asdramatically as they are in the U.S.” –Greg Smith, President, CVCA

Jacques Foisy, president and managing partner of Quebec-based private equity group Novacap, agrees. “When you come up with a good deal, the banks are still there to play,” says Foisy. “It gets more complicated with the larger deals, but overall there is still good banking support for private equity.”

Because of their stable banking network, Canadian private equity, particularly buyouts, suffered less through the crisis than the rest of the world. Canadian buyout and other PE fund managers disbursed a total of $6.7 billion to 562 deals in 2008, down 57 percent from the figures in 2007. This normally would not be perceived as good news, but compared to the losses suffered on a global scale—buyout activity dropped 71 percent from $590 billion in 2007 to just $170 billion last year—it demonstrates that Canada’s PE markets are relatively at ease.

Canadian Venture Capital & Private Equity Association (CVCA) President Greg Smith agrees that the Canadian private equity climate is healthier than some would fear. “The two strengths the market has are its focus on mid-market buyouts of between $30 and $100 million and that buyouts aren’t leveraged as dramatically as they are in the U.S.” Smith says that this more conservative approach has taught PE managers to be able to work within the confines of constrained credit conditions far better than they would be able to otherwise.

As the recession tapers off, many predict that PE will enjoy a quick recovery, largely due to the much-touted $1 trillion in unused investment capital that has accumulated in global PE fund coffers. “The money is still there,” says Foisy. “It’s just not being invested, but it will return to the market.” Moving forward, however, PE companies would be advised to look to operate differently than they did in the boom leading up to the financial crisis, says Ghai: “Investors should look to new markets and new types of investments.”

Ghai points in particular to private investment in public equity (PIPE) transactions, in which private funds look to take large stakes in public companies. “The PE firms need to bring the same virtues to public firms that they would to a private firm,” says Ghai. He also points to the opportunities provided by foreign investment groups, which made up an astounding 54 percent of Canada’s new PE commitments in 2007, and can be expected to resume such activity in the post-recession market.

Though buyouts may appear poised for a comeback, the same cannot be said for Canada’s venture capital industry, unfortunately, which suffered significantly in 2008. While $1.5 billion was disbursed to VC transactions in 2007, 2008 saw this number decline 20 percent to $1.2 billion. By comparison, VC investment in the United States suffered only marginally, dropping from $30.8 billion in 2007 to $28.2 billion in 2008. The losses, according to the McKinsey Group’s year-end findings, “[suggest] more than just a cyclical change in response to broad economic retrenchment,” and “systemic challenges.” “VC is running into a huge capital shortfall,” says Smith, who points to a meager $149 million invested in the first quarter of 2009 that suggests the climate is only worsening.

Canada’s VC field has in the past shown its value in sponsoring innovation across a number of industries. Highlights include the triumph of Research in Motion, the Ontario-based wireless developer responsible for the ubiquitous Blackberry wireless devices—a technological success only made possible through significant fundraising in the late 1990s. Canada currently has almost 1,800 companies vying for an increasingly scarce amount of funding. Returns, however, seem not to justify such investment—Canadian VC investments post 10-year returns of negative 2.8 percent, compared to 10-year returns of 16.6 percent for their U.S. counterparts. “Canadian VC is sub-scale,” says Ghai. “The funds are smaller, the capital commitments are a fraction of what you’d see in the U.S., the hold period is shorter, and it’s a pretty weak venture industry overall. This has a lot of implications, as VC is responsible for sparking innovation and industries, and it’s a bit of a millstone around the neck of Canadian innovation.”

Ghai points out that weak VC performance leads quickly to “death spiral,” in which the worse venture investments pan out, the less likely they are to earn future funding. Smith acknowledges this danger, but points to the government as a possible source of assistance. “People are recognizing that the administration has a role to play in sparking the VC market; the government needs to provide funds, and that’s what they’re starting to do.” Recently-launched government funds such as the $250 million Ontario Emerging Technologies Fund and the $825 Quebec Venture Capital Fund hope to drive start-ups in spite of the tightened investment climate and look to bring Canadian VC back to an even keel. “If the money is there to support a temporary situation, a cash-flow crisis, it’s good for start-ups,” says Foisy. “But it can’t be a long-term solution.” Indeed, Canadian VC is going to have to determine its own path to financing if it wants to continue as a proud pillar of the Canadian marketplace.

About half of sovereign wealth funds are estimated to invest in private equity, according to Preqin. Over the past twelve months, that proportion has remained steady, says Tim Friedman, head of publications and marketing with Preqin. Private equity investing is more prominent among the larger funds, as they tend to have more sophisticated asset allocation strategies and can include riskier assets, like private equity, within their portfolios, he adds.

Going forward, sovereign wealth funds’ interest in private equity is likely to continue, says Michael Laveman, partner with Eisner LLP. Their recent losses notwithstanding, the sovereign wealth funds still have massive pools of cash. Moreover, investing via private equity, rather than taking direct stakes in public companies, allows the funds to “fly below the radar,” and hopefully avoid some of the controversy that’s ensued when the funds have taken direct stakes in companies, he notes.

One reason for the funds’ more circumspect approach is the drop in theprice of oil, Cox says. In 2008, the price of a barrel of crudeaveraged nearly $100; in 2009 to date, it’s at $71, according to theU.S. Energy Information Administration.

However, their investment approaches likely will shift, experts say. The large deals of several years ago, such as the Chinese government’s $3 billion stake in Blackstone, probably won’t recur for a while, says Michael Maduell, president of the SWF Institute in California. “We haven’t seen anything like that on the radar.”

Thus, while sovereign wealth funds will remain a source of capital for private equity, their share of the funds may be smaller than in the recent past, says Donn Cox, managing director and founder of LP Capital Advisors in Sacramento. “The imbalances in the amount of capital (from sovereign wealth funds) versus, say, pension funds, seems to have abated.”

Oil revenue accounts for about 60 percent of all sovereign wealth funds, estimates Preqin. A case in point is the Abu Dhabi Investment Authority, considered the largest sovereign wealth fund on the planet. It boasts between $625 and $875 billion in assets, according to a September 2008 report by the U.S. Government Accountability Office (GAO).

For instance, in May the Government Investment Unit of Indonesia, a de-facto sovereign wealth fund, formed a private equity fund of its own, the Indonesia Clean Technology Fund. It will invest in alternative energy, water distribution and treatment and agriculture technology within Indonesia.

The losses, at least on paper, that sovereign wealth funds have experienced from some of their past investments – not necessarily in private equity – also is likely to alter their investment style going forward, as their stakeholders question previous decisions. For example, according to several reports in March, Singapore’s GIC wanted to move its investments to property and private equity, after its bank holdings dropped 25 percent.

One area of private equity investing that’s attracting more interest among various investors, including sovereign wealth funds, is the secondary market, Friedman adds. As many investors have watched the values of other holdings in their portfolios drop, some have found themselves over-committed to private equity. As a result, “there has been a flurry of interest on the secondaries market in the past few months,” as investors rebalance their portfolios, he says. “Sovereign wealth funds certainly have the potential to be significant players in this market.”

Monitor Group, in a study of sovereign wealth firms, also concluded that the funds are not investing based on political motives. To the contrary, sovereign wealth funds have taken on an important role in providing liquidity to the global financial system during the financial crisis, Monitor concluded.

These shifts should benefit PE firms, given that sovereign wealth funds likely will remain invested in private equity, even if their role going forward differs from that in the past. Many sovereign wealth fund managers “continue to see private equity as an important and integral part of their investment portfolio and it is likely that the proportion of SWFs investing in the asset class will rise over time,” Preqin’s Friedman says.

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.”

In the year to date, downgrades have vastly outnumbered upgrades by almost 15 to 1. This is about 3x worse than the previous high reached in 2001, when the downgrade-to-upgrade ratio was about 5 to 1. In 2008, the ratio was 3.4 to 1, and in 2004-2007, downgrades and upgrades were about equal. The bulk of the recent corporate downgrades were in the lower rating categories, and many were ratings lowered to ‘D’ or ‘SD’ as a result of either a missed payment, a bankruptcy filing, or a distress exchange. Private equity investors are significantly exposed to these downgrades, including defaults.

The explosion of buyout activity in recent years inevitably positioned private equity investors squarely in the speculative-grade segment. In their search for yield, sponsors typically targeted troubled entities, or at the very least ones that appear to be, and many of these companies are rated speculative grade. It is in this segment that sponsors are more likely to land an entity with much potential at an attractive price and then, they hope, sell it for a profit after some sort of restructuring or reorganizing. The expertise of private equity groups to identify and rehabilitate entities, at a time when liquidity was abundant and confidence was soaring, worked very well, which, in turn, fueled the use of this model even further.

Sponsors might offer some stability to target companies with their deeppockets and knowledge and experience in managing distressed companies.In fact, some companies may have even averted bankruptcy with the helpof their sponsors. However, some practices that private equityinvestors have adopted in recent years could also have exacerbated thetargets’ balance sheets, particularly if they underestimated theseverity and duration of the current economic and financial challenges.

However, the economic landscape has changed dramatically, and the current recession is bearing down on companies across the ratings spectrum, but is particularly harsh on entities at the lower end. Poor corporate earnings, an apprehensive consumer market, and reduced access to capital have significantly eroded credit quality. Entities rated speculative grade have less financial or operational flexibility and are therefore more vulnerable to further credit degradation.

This is evident in our ratings: speculative-grade-rated entities have not only been more volatile historically, but they also have been more likely to default. On average, during the period 1981-2008, 8.88 percent of entities rated ‘B-’ and 25.70 percent of entities rated ‘CCC/C’ defaulted within a year. This statistic even excludes entities that were downgraded to or were newly rated at the ‘B-’ and below level and that defaulted between calendar years. Although sponsors might have accounted for some of this credit erosion in their valuations, exit strategies (such as an IPO) are less feasible in the current environment, perhaps compelling sponsors to the engagement longer and deeper than they had originally planned.

The number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—increased dramatically to 293 as of May 13, 2009, from just 100 at the end of 2007. The erosion of credit quality leads to lower ratings and more entities with negative outlooks or negative ratings on CreditWatch as well as increased vulnerability to default. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. The vast majority of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months.

Some of these entities were even rated investment grade not too long ago. Weakest links are particularly vulnerable because they tend to have less tolerance for absorbing economic or market stress. Relative to the entire corporate speculative-grade population, it is not a surprise that weakest links would have a larger proportion of entities defaulting, particularly during periods of economic stress. In the 2001-2002 cycle, for example, more than half of the weakest links defaulted within 12 months, and nearly 65 percent defaulted within three years. We expect to see the same trend in the current cycle.

Corporate casualties in 2009 have already exceeded the total in full-year 2008. Similar to the pattern observed among weakest links, at least 79 of the 140 defaulters through May 28, 2009, (74 of the 126 defaulters in 2008) were involved in private equity transactions (see table 3). Sponsors might offer some stability to target companies with their deep pockets and knowledge and experience in managing distressed companies. In fact, some companies may have even averted bankruptcy with the help of their sponsors. However, some practices that private equity investors have adopted in recent years could also have exacerbated the targets’ balance sheets, particularly if they underestimated the severity and duration of the current economic and financial challenges. We forecast more than 200 defaults in the U.S. in the next 12 months, and we expect private equity exposure to these casualties to remain elevated.

The decline of asset valuations on the heels of the economic recession has hurt private equity investors to a certain extent. However, this may have also given sponsors a window of opportunity to further build up and diversify their portfolios. The improved risk-reward potential of some entities with sound business models makes them that much more attractive targets.

Diane Vazza is managing director, and Jacinto Torres is associate director in the New York office of Standard & Poor’s.

The established regulatory view is that private equity, with its risky plays, secrecy-at-all-costs culture, and vast pool of dollars, does not mix well with the staid thrift banks that are the humble base of the economic pyramid. The overarching rule, as enforced by the Federal Reserve—and as mandated by the Bank Holding Company Act of 1956—is that bank holding companies cannot engage in non-banking activities. “A conglomerate that owns a bank cannot be engaged in traditional commercial pursuits,” says University of Connecticut law professor Patricia McCoy. “The Fed’s concern here is that by allowing private equity into the banks, they’re eroding the traditional wall that exists between banking and commerce.”

PE firms, which generally have their eyes set on many industries beyond commercial banking, of course would prefer to run thrifts with the same iron grip they use on other riskier ventures. To prevent this, the Fed limits non-bank holding companies to controlling positions of under 25 percent, which requires the type of private equity group-deal seen in the BankUnited takeover. “Banking is a fairly high-risk venture these days,” says McCoy, “and being able to control management and make investment decisions and handle risk is essential for PE firms.” However, as is often the case, the promise of profit can persuade buyout firms to adjust their expectations.

Though the credit climate is gradually thawing, capital is stillrelatively scarce, and regulators would love to see some of the $1trillion in dry powder that global PE firms have collected inanticipation of a healthy investment climate, go into the banking sector.

“I’m not sure [PE firms] need control of the banks,” says Lawrence D. Kaplan, general counsel at Paul Hastings and a former regulator with the Federal Home Loan Bank Board (now the Office of Thrift Supervision [OTS]). “I think most firms view the banking sector as underpriced, and financial institutions now have terrific opportunities to get returns for investors.”

The introduction of PE firms into the banking sector is also advantageous for regulators eager to get commercial banks back on track. Though the credit climate is gradually thawing, capital is still relatively scarce, and regulators would love to see some of the $1 trillion in dry powder that global PE firms have collected in anticipation of a healthy investment climate. Says Walter J. Mix III, managing director of consulting firm LECG, “The size of the banking and savings and loan problem exceeds the FDIC funds’ capacity, and the banking sector will need private as well as government capital in order to improve credit availability.”

In order for that money to make its way through the thousands of U.S. commercial lenders, regulators are going to have to come to an agreement on just how PE firms interact with small banks. “The issue for the regulators is that they want a well-qualified board of directors and management with the requisite banking experience,” says Mix. “In this type of market, that especially means experience with credit and liquidity.” While the Fed has so far taken a hardline stance, the OTS has proven itself more willing to allow leeway among the approximately 800 thrifts it regulates. Earlier in the year, the OTS approved the takeover of thrift Flagstar Bancorp by distressed assets specialist MatlinPatterson Global Advisers. For $350 million, MatlinPatterson got a 70 percent stake in the Troy, Michigan bank, going against the Fed’s opposition to PE firms taking majority stakes.

The FDIC, too, has shown its willingness to cooperate with private money. Says Kaplan, “We may see a willingness of the FDIC to allow private equity buyout deals, and if this happens, it’s going to put pressure on the Fed to hammer out a deal with other regulators to determine when such buyout deals would qualify as sound.” Besides the BankUnited deal, the FDIC approved the sale of $13.9 billion worth of IndyMac assets to a group of private equity investors that included J.C. Flowers and Paulson & Co. Following the close of the BankUnited deal, the regulator pointed to an upcoming policy shift: “Due to the interest of private equity firms in the purchase of depository institutions in receivership, the FDIC has been evaluating the appropriate terms for such investments. In the near future, the FDIC will provide generally applicable policy guidance on eligibility and other terms and conditions for such investments to guide potential investors.”

Clearly, the tide is shifting in favor of more and more private equity firms that want a stake in the banking sector. With trillions in banking assets on its books, the Fed may need to reevaluate the merits of PE buyouts as apply to the heretofore sacrosanct area of commercial banking. Says Kaplan, “The Fed’s going to have to look at potential buyouts on a case-by-case basis, and to look through the legal precedents, but they can’t ignore that PE has the cash and because of that we can’t rule them out.” Mix says that it’s possible for private equity to make a bigger footprint in the banking industry without a complete overhaul of the rules: “I wouldn’t foresee a policy change unless Obama or Congress specifically directs such a change. Regulators are going to try and make it work with the tools they have.”

The Kauffman paper advises that VC companies—which invested almost $30 billion last year into start-ups—reduce their investment to the $12 to $15 billion range. Venture capital must “shrink its way back to health,” says the report.

VC spending increased by a factor of five between 1996 to 2001 in the midst of the Silicon Valley tech boom, leading to “a collapse in performance from which the sector has never recovered.” The flux of money has in turn led to overpriced valuations, which has itself led to lower profits.

Figures from the National Venture Capital Association show that VC contracted last year in the United States, with about 882 firms controlling $197 billion, versus 1,019 firms controlling $258 in 2007.

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 is 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 for the foreseeable future.

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%) of private equity firms say they havewritten down the value of their portfolio companies in the last quarterwhile 57% 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% reported thatup to one quarter of their portfolio companies are in default while 14%reported 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% 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 as 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%) of private equity firms say they have written down the value of their portfolio companies in the last quarter while 57% 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, 41% reported that up to one quarter of their portfolio companies are in default while 14% 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 is 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, just 78 funds worldwide raised $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 was reported 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% 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.”

In the year to date, downgrades have vastly outnumbered upgrades by almost 15 to 1. This is about 3x worse than the previous high reached in 2001, when the downgrade-to-upgrade ratio was about 5 to 1. In 2008, the ratio was 3.4 to 1, and in 2004-2007, downgrades and upgrades were about equal. The bulk of the recent corporate downgrades were in the lower rating categories, and many were ratings lowered to ‘D’ or ‘SD’ as a result of either a missed payment, a bankruptcy filing, or a distress exchange. Private equity investors are significantly exposed to these downgrades, including defaults.

The explosion of buyout activity in recent years inevitably positioned private equity investors squarely in the speculative-grade segment. In their search for yield, sponsors typically targeted troubled entities, or at the very least ones that appear to be, and many of these companies are rated speculative grade. It is in this segment that sponsors are more likely to land an entity with much potential at an attractive price and then, they hope, sell it for a profit after some sort of restructuring or reorganizing. The expertise of private equity groups to identify and rehabilitate entities, at a time when liquidity was abundant and confidence was soaring, worked very well, which, in turn, fueled the use of this model even further.

Sponsors might offer some stability to target companies with their deeppockets and knowledge and experience in managing distressed companies.In fact, some companies may have even averted bankruptcy with the helpof their sponsors. However, some practices that private equityinvestors have adopted in recent years could also have exacerbated thetargets’ balance sheets, particularly if they underestimated theseverity and duration of the current economic and financial challenges. 

However, the economic landscape has changed dramatically, and the current recession is bearing down on companies across the ratings spectrum, but is particularly harsh on entities at the lower end. Poor corporate earnings, an apprehensive consumer market, and reduced access to capital have significantly eroded credit quality. Entities rated speculative grade have less financial or operational flexibility and are therefore more vulnerable to further credit degradation.

This is evident in our ratings: speculative-grade-rated entities have not only been more volatile historically, but they also have been more likely to default. On average, during the period 1981-2008, 8.88% of entities rated ‘B-’ and 25.70% of entities rated ‘CCC/C’ defaulted within a year. This statistic even excludes entities that were downgraded to or were newly rated at the ‘B-’ and below level and that defaulted between calendar years. Although sponsors might have accounted for some of this credit erosion in their valuations, exit strategies (such as an IPO) are less feasible in the current environment, perhaps compelling sponsors to the engagement longer and deeper than they had originally planned.

The number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—increased dramatically to 293 as of May 13, 2009, from just 100 at the end of 2007. The erosion of credit quality leads to lower ratings and more entities with negative outlooks or ratings on CreditWatch negative as well as increased vulnerability to default. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. The vast majority of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months.

Some of these entities were even rated investment grade not too long ago. Weakest links are particularly vulnerable because they tend to have less tolerance for absorbing economic or market stress. Relative to the entire corporate speculative-grade population, it is not a surprise that weakest links would have a larger proportion of entities defaulting, particularly during periods of economic stress. In the 2001-2002 cycle, for example, more than half of the weakest links defaulted within 12 months, and nearly 65% defaulted within three years. We expect to see the same trend in the current cycle.

Corporate casualties in 2009 have already exceeded the total in full-year 2008. Similar to the pattern observed among weakest links, at least 79 of the 140 defaulters through May 28, 2009, (74 of the 126 defaulters in 2008) were involved in private equity transactions (see table 3). Sponsors might offer some stability to target companies with their deep pockets and knowledge and experience in managing distressed companies. In fact, some companies may have even averted bankruptcy with the help of their sponsors. However, some practices that private equity investors have adopted in recent years could also have exacerbated the targets’ balance sheets, particularly if they underestimated the severity and duration of the current economic and financial challenges. We forecast more than 200 defaults in the U.S. in the next 12 months, and we expect private equity exposure to these casualties to remain elevated.

Private equity groups will continue to be drawn to higher-risk assets in search of better returns.

The decline of asset valuations on the heels of the economic recession has hurt private equity investors to a certain extent. However, this may have also given sponsors a window of opportunity to further build up and diversify their portfolios. The improved risk-reward potential of some entities with sound business models makes them that much more attractive targets.

Diane Vazza is managing director, and Jacinto Torres is associate director in the New York office of Standard & Poor’s. 

]]> http://www.directorship.com/exposure-to-deteriorating-assets-increases-risks-to-private-equity/feed/ 0 http://www.directorship.com/north-of-the-border-canadas-divergent-experience/ http://www.directorship.com/north-of-the-border-canadas-divergent-experience/#comments Thu, 01 Jan 1970 00:00:00 +0000 News Editor http://www.directorship.com/?p=2438 As the recession continues to impair the movement of capital, and financial markets worldwide sit dormant, Canadian private equity suffers from a similar malaise, with buyout and venture activity at an almost dead halt. The robust flurry of asset movement within the Canadian buyout and venture capital fields that so energized the industry up to 2007 has been replaced by an uneasy standstill in which investors, entrepreneurs, and fund managers are faced with the rebuilding of the private equity marketplace.

“The impact of the financial crisis has been profound,” says Sacha Ghai of the McKinsey Group consultant/data firm. “Private equity lives off of the availability of credit, and until capital becomes available, it’s difficult for deals to go through.”

Canadian private equity, however, is at a relatively healthy point compared to its counterparts around the world, largely due to the health of Canadian banks. “[Banks] have weathered the crisis far better than they have in the United States, and there haven’t been any that have gone under,” says Ghai. “There is still capital to lend and this has to an extent muted the negative effects on the PE market.”

“The two strengths the market has is its focus on mid-market buyouts ofbetween $30 and 100 million and that buyouts aren’t leveraged asdramatically as they are in the U.S.” –Greg Smith, President, CVCA

Jacques Foisy, president and managing partner of Quebec-based private equity group Novacap, agrees. “When you come up with a good deal, the banks are still there to play,” says Foisy. “It gets more complicated with the larger deals, but overall there is still good banking support for private equity.”

Because of their stable banking network, Canadian private equity, particularly buyouts, suffered less through the crisis than the rest of the world. Canadian buyout and other PE fund managers disbursed a total of $6.7 billion to 562 deals in 2008, down 57 percent from the figures in 2007. This normally would not be perceived as good news, but compared to the losses suffered on a global scale—buyout activity dropped 71 percent from $590 billion in 2007 to just $170 billion last year—it demonstrates that Canada’s PE markets are relatively at ease.

Canadian Venture Capital & Private Equity Association (CVCA) President Greg Smith agrees that the Canadian private equity climate is healthier than some would fear. “The two strengths the market has is its focus on mid-market buyouts of between $30 and 100 million and that buyouts aren’t leveraged as dramatically as they are in the U.S.” Smith says that this more conservative approach has taught PE managers to be able to work within the confines of constrained credit conditions far better than they would be able to otherwise.

As the recession tapers off, many predict that PE will enjoy a quick recovery, largely due to the much-touted $1 trillion in unused investment capital that has accumulated in global PE fund coffers. “The money is still there,” says Foisy. “It’s just not being invested, but it will return to the market.” Moving forward, however, PE companies would be advised to look to operate differently than they did in the boom leading up to the financial crisis, says Ghai: “Investors should look to new markets and new types of investments.”

Ghai points in particular to private investment in public equity (PIPE) transactions, in which private funds look to take large stakes in public companies. “The PE firms need to bring the same virtues to public firms that they would to a private firm,” says Ghai. He also points to the opportunities provided by foreign investment groups, which made up an astounding 54 percent of Canada’s new PE commitments in 2007, and can be expected to resume such activity in the post-recession market.

Though buyouts may appear poised for a comeback, the same cannot be said for Canada’s venture capital industry, unfortunately, which suffered significantly in 2008. While $1.5 billion was disbursed to VC transactions in 2007, 2008 saw this number decline 20 percent to $1.2 billion. By comparison, VC investment in the United States suffered only marginally, dropping from $30.8 billion in 2007 to $28.2 billion in 2008. The losses, according to the McKinsey Group’s year-end findings, “[suggest] more than just a cyclical change in response to broad economic retrenchment,” and “systemic challenges.” “VC is running into a huge capital shortfall,” says Smith, who points to a meager $149 million invested in the first quarter of 2009 that suggests the climate is only worsening.

Canada’s VC field has in the past shown its value in sponsoring innovation across a number of industries. Highlights include the triumph of Research in Motion, the Ontario-based wireless developer responsible for the ubiquitous Blackberry wireless devices—a technological success only made possible through significant fundraising in the late 1990s. Canada currently has almost 1,800 companies vying for an increasingly scarce amount of funding. Returns, however, seem not to justify such investment—Canadian VC investments post 10-year returns of negative 2.8 percent, compared to 10-year returns of 16.6 percent for their U.S. counterparts. “Canadian VC is sub-scale,” says Ghai. “The funds are smaller, the capital commitments are a fraction of what you’d see in the U.S., the hold period is shorter, and it’s a pretty weak venture industry overall. This has a lot of implications, as VC is responsible for sparking innovation and industries, and it’s a bit of a millstone around the neck of Canadian innovation.”

Ghai points out that weak VC performance leads quickly to “death spiral,” in which the worse venture investments pan out, the less likely they are to earn future funding. Smith acknowledges this danger, but points to the government as a possible source of assistance. “People are recognizing that the administration has a role to play in sparking the VC market; the government needs to provide funds, and that’s what they’re starting to do.” Recently-launched government funds such as the $250 million Ontario Emerging Technologies Fund and the $825 Quebec Venture Capital Fund hope to drive start-ups in spite of the tightened investment climate and look to bring Canadian VC back to an even keel. “If the money is there to support a temporary situation, a cash-flow crisis, it’s good for start-ups,” says Foisy. “But it can’t be a long-term solution.” Indeed, Canadian VC is going to have to determine its own path to financing if it wants to continue as a proud pillar of the Canadian marketplace.

We used a unique sample of 288 exited transactions over a 20-year period across 19 industries from 13 buyout firms, based on confidential data from detailed interviews with the general partners of several leading private-equity partnerships in an attempt to answer these questions.

While prior studies have focused on whole company, going-private buyouts, our sample includes transactions with minority stakes, syndicate deals, and consolidating roll-up or add-on strategies, and we have detailed information on internal rates of return, leverage, equity stakes, and other deal characteristics.

We find that the pursuit of ancillary consolidating acquisitions is the biggest driver of post-buyout revenue and profit growth, that solo deals and deals with controlling stakes outperform syndicated or “club” deals, that rates of return have declined over time as buyout markets have become more competitive, that mitigation of agency costs is critical for deal success, and more generally, that private equity can improve the performance even of sound businesses by providing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition.

Mid-Size
Our focus is on small and mid-sized deals. This end of the buyout market features not only the investment goals found in larger public-company buyouts, which include cost elimination via consolidation and exploitation of scale and scope economies, but also a variety of strategies aimed at improved management coordination and control. The range of transaction rationales seen in smaller and middle-market buyouts forces PE investors to take on several roles including banker, operating executive, board member, strategist, headhunter, coach, union negotiator, and occasionally family therapist. There is thus perhaps a “fuller” view available here with respect to the manner by which PE professionals seek to create value in their deal-making.

Focusing on middle-market transactions highlights some interesting characteristics of the PE world that are hidden in studies of larger deals. Most prior work distinguishes between two types of buyouts: restructuring deals designed to mitigate agency costs in mature, low-growth, low-beta industries; and growth-equity transactions based on investments in high-growth industries. There is a third category as well, however, an intermediate type we might call coordination-improving deals. These typically involve sound businesses that can nonetheless benefit from PE firm ownership bringing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition. The intended result in these transactions is better coordination of deployment of a firm’s assets, often in recombination with market-based resources. These kinds of transactions occur often in our sample, and would appear to manifest a major benefit of—and under-reported storyline about—private-equity governance.

Conclusions
More generally, our preliminary analysis of this sample of middle-market transactions suggests that, fundamentally, growth is the ultimate driver of wealth creation for smaller companies. Over three quarters of our sample experienced increases in revenues and operating profits, and, not surprisingly, those transactions with the highest revenue and profit growth rates have the highest rates of return. The same applies to increases in employment. For these deals, PE was a catalyst for exploiting scale and scope economies and providing operating leverage.

Second, for this sample, return on equity for PE transactions is negatively (and significantly) correlated with exit year, suggesting a secular decline in returns (and, the increasing competitiveness of the PE industry), even for the lower middle-market arena for  small-cap transactions. This can be seen as part of the relentless Schumpeterian efficiency wrought from dynamic, innovative, and competitive markets.

Third, insights from agency theory (Jensen 1986, 1988) and transaction cost economics
(Williamson 1988, 1996) are substantiated in our sample transactions. The low-tech, slow-growth consumer-goods manufacturers have the highest-return transactions, highest average leverage, highest average levels of management equity and PE firm equity, and most of the controlling-stakes deals. More broadly, the slow-growth manufacturing businesses are more heavily leveraged and exhibit better returns than marketing and services businesses. Marketing and professional services firms have less average leverage, more syndicate club deals, more minority-stakes deals, and exhibit higher revenue and profit growth (and, more organic growth deals than those involving add-on acquisitions). IPOs have the highest returns as an exit type, followed in order by exit types characterized by progressively more knowledgeable buyers. These straight-line differences in results across exit types apply as well to leverage, holding time, revenue, profit and employment growth, capital expenditure growth, and management equity.

Fourth, controlling-stakes and solo deals are characterized by twice the return, one-third to one-fourth the size, shorter holding times, much higher leverage, and lower debt pay-down ratios than their counterparts. They are also far more heavily concentrated in slow-growth manufacturing industries. This is not to deny the growing importance of syndication in private equity. However, our data clearly show the long-term performance advantages of control transactions focused on low-beta industries that are amenable to leverage (and, the ability of the majority or sole owner to bring about a new, more focused, strategy).

In our sample, the pursuit of ancillary consolidating acquisitions is the single most important determinant of transaction IRR for equity. This shows the extent of available “slack” in fragmented industries ripe for exploitation by small- and mid-cap PE investors. Additionally, leverage affects equity IRRs positively and asset (or total firm) returns negatively, consistent with received theory. For improvements in operating performance, the presence of an add-on transaction and the amount of leverage are key to explaining revenue growth, and leverage is the main driver of growth in EBITDA. That is to say, the fastest-growing firms are burdened with the least amount of debt.

John L. Chapman, PhD is the NRI Fellow in Economics at the American Enterprise Institute. Peter G. Klein is Associate Professor in the Division of Applied SocialSciences at the University ofMissouri. The full paper can be downloaded from the CORI Working Paper Series Index.