Friday Letter Heads up, seven up

Problems are plentiful these days for some private equity firms. But one firm’s misery may be another’s gain.  

There’s a 60-year-old children’s game prevalent in US primary schools – Heads up, seven up – that has at its roots a truism with modern implications for private equity firms.

To begin play, a teacher will call out “Heads down, thumbs up!” All the children in the classroom, save for seven that were preselected, will put their heads down on their desks with thumbs outstretched. The seven quietly go about the room, each pressing down the thumb of one classmate. The teacher then calls, “Heads up, seven up!” and the seven children whose thumbs have been pressed must try to guess which of the original seven kids selected them.

The game, of course, is based on the fact that it’s impossible to know exactly what’s going on around you when your head is down.

And as one London-based general partner pointed out recently, quite a lot of firms are simply forced to have their heads down at the moment. Any GP with more than a couple of active portfolio companies must fluctuate between offensive and defensive measures to keep businesses from succumbing to the global financial downturn. Many firms with listed vehicles are battling sinking share prices, hefty net asset value discounts and liquidity problems. Those on the fundraising trail have to knock on more doors than ever before. And even firms that have recently closed funds aren’t necessarily on firm ground: LPs whose over-commitment strategies have faltered as distributions slowed aren’t simply at risk of default, but of causing drastic fund size cuts – and resulting strategy shifts – if they were allowed to commit a substantial proportion of the fund’s total capital raised.

It’s natural that private equity firms plagued by any of or all of the above would concentrate on assuaging these situations – indeed, their LPs would expect them to – but it subsequently creates a unique window of opportunity for others.

For the past several decades, competition among private equity firms has got stiffer each year. “This is the first year that there is less competition because people are distracted,” said the aforementioned GP, who added with a smile: “We’re heads up, looking for deals.”

The “heads up versus heads down” phenomenon is likely to be a prominent theme in the industry shakeout most general partners are now publicly predicting. Bain Capital managing director Stephen Pagliuca is one of the most recent figureheads to forecast the disappearance of some firms going forward. He said during a keynote speech earlier this month that the number of private equity firms has nearly doubled from the 950 that were counted in 2000.

“Going forward in the brave new world, profit improvement, better strategic positioning and sales growth are going to be the key levers,” he said. “The private equity firms that are structured to enhance and support that are going to be the ones who succeed.”