Friday Letter After all this pain, things will get better

The past 12 months have brought unprecedented turmoil to markets everywhere, and the private equity industry suffered profound ripple effects from many of the year’s most dramatic events.  

Here’s our selection of the 10 most memorable private equity stories of the year:

1. Debt markets collapse. When the music finally stopped, the silence was truly deafening. Ever since leverage has disappeared, sponsors have struggled to get financing for deals, with the rule of thumb being the bigger the buyout, the rarer the term sheets. GPs went to extraordinary lengths to fund investments, such as using their own debt affiliates to finance deals, or fighting legal battles to force lenders’ hands. Yet another prevalent trend among large LBO firms was to move strategically to capitalise on credit opportunities. Apollo, Carlyle, TPG, Oaktree and others have raised funds dedicated to buying loans. “Traditional private equity is dead and has been for a year,” Apollo chief Leon Black recently told The New York Times. “We’ve totally turned into a bond house.”

2. The ‘smartest’ shops catch falling knives. One of the biggest bank runs on record also caused some of the largest and most rapid losses in private equity history. TPG alone lost more than $1 billion in its gamble on Washington Mutual. Other brand-name sponsors including JC Flowers and Warburg Pincus have presumably had to have some testing conversations with investors over losses.

3. Mega-deals fall apart. Large, high-profile buyouts that had been agreed at the height of the last market cycle – at high multiples with large leverage components – unravelled. The reasons ranged from GPs invoking material adverse change clauses to beleaguered lenders looking to wriggle free of obligations. In December, Canada’s BCE became the latest victim added to a long list of lost LBOs that also includes Sallie Mae, Huntsman and Penn National.

4. LP liquidity evaporates. You might not have thought it possible a year ago, but some private equity investors, especially those with leveraged overcommitment programmes, literally ran out of money as private equity realisations slowed. Others started to suffocate as the denominators grabbed their throats. To get themselves out of trouble, some LPs began writing smaller tickets to fewer managers, or turned to selling fund interests in the secondaries market. Still others begged GPs to delay capital calls. And in the most striking development yet, Permira revised the terms on its €11.1 billion Fund IV, allowing struggling LPs, notably its largest investor SVG, to reduce their original commitments to the fund by 40 percent.

5. Fundraising falters. Organising a new private equity fund right now is no picnic. Some GPs, like Madison Dearborn and Blackstone, have already reduced their fundraising targets. Others will delay closings and GPs will be less likely to return to market as quickly as they have in past years. And some market observers expect all of these factors to cause LPs to negotiate tougher terms and conditions.

6. Bankruptcies proliferate. A global economic downturn puts the screws on many industries and companies, and private equity portfolio companies are no exceptions. Already there have been some high-profile defaults, such as KKR-backed Masonite, and several staggering bankruptcies. US newspaper publisher Tribune, acquired last year by Sam Zell in an $8 billion LBO, collapsed last week under its $13bn debt load. Other notable casualties have included Apollo’s Linens ‘n Things; Madison Dearborn’s Pierre Foods and Hines Horticulture; Sun Capital-backed Mervyns; Carlyle’s Hawaiian Telecom; Tom Hicks- and Investcorp-backed Greatwide Logistics; Capricorn-backed Mrs. Fields; TA Associates-backed Steve & Barry’s; and MatlinPatterson’s ATA Airlines.

7. Write-downs plague portfolios. Fair value accounting applied to private equity portfolios walloped them across the board, causing consternation on the part of an increasing number of GPs. “The idea that all of our nation's assets should be priced based on the level at which a few bearish hedge funds can jam transactions through the market in the last few moments of the trading day is ridiculous,” Castle Harlan chief John Castle recently said.

8. Publicly listed funds get a thrashing. Wild stock market swings have done no favours for the publicly trade private equity posse. Financial services stocks have been battered, with groups like Fortress and 3i hitting record lows and others suffering analyst downgrades. The sector as a whole is trading at hefty discounts to net asset value, and at least two proprietors of listed funds have decided to throw in the towel: both American Capital and Kohlberg Kravis Roberts were so disheartened by their Euronext-quoted vehicles’ performance that they opted to de-list them.

9. GPs streamline operations. Unprecedented job cuts came crashing down on private equity across the globe. American Capital, and affiliate European Capital, sacked 19 percent of its workforce and closed two offices. The Carlyle Group cut 10 percent of its staff, closed its Silicon Valley and Warsaw premises and let go its Asian leverage finance team. 3i reduced its global team by 15 percent, eliminating mostly back-office functions, and shuttered its offices in Shanghai and Hong Kong. Blackstone eliminated 70 jobs, or 5 percent, of its team, while UK firm Cognetas cut 12 percent, Investcorp trimmed 20 percent across its offices in Bahrain, London and New York and Dubai-based Shuaa Capital sacked 9 percent. Similar measures at other houses seem likely.

10. Captive groups hang in limbo. In-house private equity arms and their assets at Merrill Lynch, Lehman Brothers and Bear Stearns were put in play as their parents dissolved. Meanwhile the big investment banks left standing have restructured and drastically reduced head counts. This has left fewer bankers pitching potential deals.

So where does all this leave private equity for next year? To be sure, some of the pain the industry has felt this year will continue, and in some cases even deepen. But equally certain is that some savvy investors will capitalise on falling valuations, contrarian bets and companies in need of turnaround expertise.

Private equity now has a great chance to prove its prowess as an active participant in reconstructing the world’s economic health. The industry is well-equipped to grab it. And however bold a prediction it may seem right now, after all the disasters of 2008, things can only get better in 2009.