The Golden Age of private equity is truly over – despite brave assertions to the contrary.
After the latest boom and bust cycle, the private equity game has fundamentally changed. Today's winners will have to return to the basics: buying and building companies. Trying to juice investor returns by piling on debt and using fashionable financial engineering is no longer viable.
In today's challenging political and economic climate, private equity must be seen to be part of the solution. It must be an industry that fixes companies, makes them globally competitive and creates jobs. It must also be seen as an industry that treats its investors with respect by providing better and more transparent terms and conditions. Nothing less will do.
Headline grabbing mega deals, staggering leverage, paper performance and lightening quick exits via rocket ship initial public offerings are out. In are smaller and less frequent investments, conservative deal structures, higher-priced debt and, most importantly, a laser focus on creating long term value in an increasingly competitive global marketplace.
Do not be fooled by those who say capital is scarce. Syndicated bank loan departments may be timid, but there is no shortage of firepower on the sidelines. The industry has $1 trillion of uninvested commitments. The flip side, of course, is that purchase price multiples, while having come down from the stratospheric heights of three years ago, still rank as historically bloated at just under nine times EBITDA, according to a Standard & Poor's report, making them the third highest since 1997.
To succeed, private equity firms will need to invest in industries they know and understand. Firms will need to focus on improving their existing portfolio companies, particularly the so-called “zombies” which are loaded with quickly maturing debt, have no traditional sources of funding and no viable exit route.
Private equity firms will also need to tread carefully as they ponder new acquisitions, which will have less debt, more equity and perhaps less risk but also less margin for error. With leverage levels in the last 18 months at some of the lowest seen in the past decade and equity checks climbing north of 50 percent, the investor returns of 30 to 40 percent seen in the prior downturn will be increasingly difficult to match.
The best portfolios will be characterized by companies across diverse industries and geographies, with market leadership, strong cash flow characteristics and significant value creation opportunities. These value creation opportunities can drive meaningful performance upside through, for example, geographic unit or bolt-on acquisitions; or operational upside through increased management resources and improved operating processes.
The mid-market so far has shown the best returns, down only 17 percent as of June 2009, compared with mega funds that were down 31 percent on average.
The mid-market clearly offers some of the most promising opportunities in today's environment. There are more exits available to mid-sized portfolio companies and more ways to achieve genuine value creation – up and down economic cycles.
Most private equity firms – big and small – tout operational prowess. The coming months will be illuminating as the real operators are separated from the pretenders. Bring on the Real Golden Age.
Steve Puccinelli is head of private equity in the US and Europe for Investcorp, the alternative investment manager.