pedudeAs I indicated previously, I have been talking to a number of private equity pros about the future of their industry.  With the election of Barack Obama as President of the United States some additional implications are surely to arise (carried interest as ordinary income anyone?).  What I have been trying to glean is how will private equity cope with a lack of cheap money to finance a transaction and how will they convince sellers to take lower purchase prices or structured deals.  I have also been asking about what private equities legacy will be when the dust settles with the financial crisis.

Here are some of the early returns:

How Will Private Equity Cope With a Lack of Available Debt

“The sunny side of the street says that good deals will continue to get funded. If debt costs continue to increase, you will find [private equity groups] holding more parts of the balance sheet, either because the returns on senior and mezzanine debt are too high or unavailable. The hold could be short term until markets thaw, or could be long term if necessary.  For those who seek an exit, I am sorry. If debt costs remain high for the long run, and liquidity remains low, valuations will drop. You might want to also consider seller finance and earn outs. We had not used seller paper in five years, but we have put it into our last three LOIs.”

“This is a time when firms that have been in business for a long time can rely heavily on solid lending relationships. As Warren Buffett said: ‘When the tide goes out, you see who’s been swimming naked.’ We are seeing a number of firms and lenders who have been swimming naked because the tides have been high. Also, in a market like this, I take some comfort knowing that some of our best lenders are also LP’s in our firm. We can fall back on these partnerships, and they provide good sources of debt financing along side our equity.”

“History is a good indicator of the future in this regard.  During the last credit crunch, after the collapse of the dot-com bubble, equity contributions to transactions rose from the low-30’s as a percentage of total purchase price to the mid 40’s.  During the transition from low equity contributions to high equity contributions, few transactions were completed.  Once the transition had occurred, however, deal flow began to emerge once again, albeit it at higher required equity contributions and lower purchase multiples.

“In our view, these cycles are painful but could present a win/win for the equity sponsor, the business owner and his/her team.  So long as the seller is rolling over equity into the new entity, the business owners will benefit from the second bite at the apple, when markets ultimately recover; and, with a more conservative capital structure in place, the management team will be able to more aggressively pursue its goals along the way.”

“The near-to-medium-term unavailability of cost-effective debt capital will, among other things, drive the private equity industry to meaningfully over-equitize transactions as compared to historical levels, where acceptable returns are still perceived to exist. It will also refocus efforts on growth investments less dependent upon debt. And finally, it will slow the pace of investment.”

“To truly understand how private equity will cope this time around, we need to know whether 2009 will bring at least some liquidity to the debt markets so that multiples and pricing become the ‘only’ challenges. If liquidity returns, will warehouse lines be available to those new lenders who want to enter the market? And how will mezzanine lenders and other debt providers working from committed funds (versus their own balance sheets and the capital markets) react in terms of creating – perhaps – one-stop-shop structures priced attractively enough to drive transaction volume? Finally, how rapidly will sellers adjust to the new realities of pricing?  Even with some or all of the ‘adjustments’ – and even with meaningful improvements in the debt markets – the economy (whether it’s in a recession or something worse) will still be the primary driver of transaction volume over the next 12 months.”

What Will the Private Industry Look Like in 2 Years? In 5 Years?

“Predictions at the time of the last slowdown earlier this decade failed to play out. People said there would be meaningful consolidation, structural changes and a step-function in regulation – but, for the most part, it never happened. As a result, this time around, I would only cautiously predict that LP’s will continue to improve their ability to back the higher-quality private equity funds, which will drive some level of consolidation. I also think hedge funds will still be involved, but they will find it increasingly difficult to play effectively in private equity investments. And, finally, I see regulation being increased for private equity – but in a rational manner.”

“There will be ample capital for high quality companies for many years to come.  In the end, our view is that the private equity industry is no different than Main Street industries insofar as competitive forces driving innovation, improvement and differentiation.  Emerging from these more challenging times will be a wider spectrum between high quality private equity firms and low quality firms.  As our industry matures, private equity firms with industry focus, value-added capabilities and cultures focused on the customer (the management teams of the portfolio companies) will thrive.  As this process unfolds, business owners will more easily be able to identify the high quality private equity firms from the others.”

“We might have some quiet times at the beginning, but after two years, this will all be behind us, and credit will be flowing again. In all probability, though, we won’t see levels like 2006-2007. It will be a slow return to some level of normalcy within our industry. Long term, without a doubt, there will be a shakeout. It will be tougher for first-generation funds to raise money, and some firms are just not going to make it. There will also be rough times for businesses with lots of leverage in a deep recession. It’s going to be hard for them to raise money.”

“In two years, I think private equity will be viewed as opportunistic capital. Our equity will be used in different structures and in different parts of the capital structure – not just in plain-vanilla buyouts. In five years, I would expect private equity to be an integral part of the investment landscape and proportionally larger than it is today. There will continue to be a real role for private equity.”

“Lower middle market focused private equity group (those with $10-200 mm worth of enterprise value) will be more important to investors than ever.  The larger deals with the big fund returns between 2005 and 2007 were dependent on junk bonds and club deals, as well as the ability to go public and take out debt-based dividends.  Those options are gone. Middle market deals allow room for operational improvements, value creation through M&A, and commodity pooling (especially in healthcare, shipping, office, telecommunications and property casualty insurance); and these deals will create higher value than mega transactions.”

What Will Private Equity’s Legacy Be Post Crisis?

“Thus far, private equity has been relatively unscathed in the recent financial meltdown.  As the economic downturn shifts from the capital markets to the real economy, however, you will see many of the large levered transactions completed in the 2006-2007 period encounter challenges.  While many of these transactions were completed with favorable debt terms and flexible covenant packages, eventually these transactions will suffer along with their private equity sponsors.  That said, private equity portfolios will rebalance over the next 18 months with lower purchase price investments, and cash-on-cash returns will likely be okay, but not great.”

“Private equity will be viewed as having made some industries much more efficient and some even stronger. In other situations, people will see that it has helped entrepreneurs and family owners get access to growth capital or transfer wealth on a generational basis. Overall, it will be seen as an important tool. And with the dislocation in the public markets, I believe private equity will become even more valuable.”

“I don’t see a change in legacy.  A proven asset class continues to be important to investors; this is an important way to create wealth for shareholders, and it creates more efficient growing companies.  It’s been said that the PEG process has become commoditized, but the ability to attract investors, lenders, intermediaries, management and sellers, in addition to handling deal selection smartly, are not part of a commodity process. The hard times ahead will test the constitutions of those involved.  Those that will flourish will show that it takes special abilities to be a great private equity investor; and I believe those groups will be rewarded.”

“Unfortunately, there will be lots of finger-pointing. Some people will say that private equity is responsible for some of the ills that have come upon us. But I think, at its essence, private equity is good for the economy. It provides capital to the economy that’s important. It’s also been proven – and there’s tons of data that show – that private equity-managed companies are operated better. Management has incentives to perform better. It’s not all just financial engineering.”

“Thus far, private equity has been relatively unscathed in the recent financial meltdown.  As the economic downturn shifts from the capital markets to the real economy, however, you will see many of the large levered transactions completed in the 2006-2007 period encounter challenges.  While many of these transactions were completed with favorable debt terms and flexible covenant packages, eventually these transactions will suffer along with their private equity sponsors.  That said, private equity portfolios will rebalance over the next 18 months with lower purchase price investments, and cash-on-cash returns will likely be okay, but not great.

A more interesting debate, in my mind, is the extent to which the rising tide of increasing purchase price multiples over the last decade hid poor investment and management performance.  By one firm’s estimation, approximately 80 percent of their returns were generated by purchase price expansion.  Was this because the sponsor actively created a higher quality business or because of purchase price inflation?

As we enter a period of increasing risk premiums and commensurate lower valuations, this question will likely be answered.  Again, high quality private equity firms will distinguish themselves and others will not – just like more conventional Main Street companies.  This is a good thing for good private equity firms.”

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