The road ahead

After the challenges of recent years, the late-stage private equity industry has turned the corner. In 2004, while venture capitalists continue to work through the legacy issues of the technology bubble, buyout investment is enjoying much success. The relevant indicators suggest that on several distinct levels, the global LBO business is performing strongly.

First, new investment is taking place at a steady and rapid pace, as evidenced by the steady string of large transactions, such as Celanese in Germany, the Spirit Group in the UK and PanAmSat in the US. Private equity sponsors are benefiting from an exceptionally benign financing environment, and the large amount of equity capital being deployed worldwide means that the hangover of uninvested capital is finally abating. As a result, in terms of funds raised versus funds invested, the buyout market is returning to a state of equilibrium, with less than two years of late-stage capital available at current run rates.

Second, with M&A activity beginning to approach levels of the late 1990s and the number of IPO filings rising, the exit market is open for business, and private equity firms are able to take advantage. Those who wondered whether deals like Kinko's or Shinsei would deliver returns to investors have seen how these and other investments turned into major success stories. In addition, the recently launched structured equity, or IDS, market has delivered a potentially powerful additional exit route.

What is most remarkable about the current exit environment is the speed with which the market is accepting the return of capital at this point. The 2003 LBOs of Nalco Chemical and Warner Music Group in the US and Seat Pagine Gialle in Europe are examples of recent private equity deals that were favourably recapitalised or able to pay dividends to shareholders less than a year after first being acquired. Average holding periods of private equity investments have shortened, with return of initial capital approaching 1.5 years, which is having an extraordinary effect on the IRRs they generate.

Third, 2003 represented a reversal year in the financing of leveraged transactions. Available debt levels relative to cash flow or equity increased for the first time in nearly four years. Perhaps most importantly, the average interest cost of buyouts decreased to approximately 7 percent versus historic levels in excess of 10 percent. The result was transactions financed with greater leverage but more long-term low-cost capital to increase equity returns.

Finally, as a result of deals being brought to successful conclusions, cash flow back to private equity fund investors has been strong. Sizeable distributions of cash returns have enabled limited partners to balance their allocation models and have freed capital for new commitments. Recently the industry has generated distributions greater than new commitments for nearly the first time since the beginning of the 1990s.

To be sure, the average size of both buyout and venture funds has dropped significantly over the past three years, but fundraising, which had been moribund in 2001 and 2002, has shown new signs of life. Recent results achieved by some of the leading fund managers show that along with overall market sentiment, institutional appetite for quality private equity funds has improved also. Moreover, the swift rise lately of the business development company model in the US, most notably the $930 million BDC vehicle closed by Apollo Management in April, indicates that private equity firms are finally getting serious about tapping the public markets for capital as well.

ACTIVIST CAPITAL
The question is, how long will these good times last? There are signs that 2005 may be a more difficult setting to operate. Interest rates are beginning to show the first stage of their expected rise. Currency fluctuations are a cause for concern. A hike in global commodity prices is already having an adverse affect on market sentiment. And interest rate and emerging market challenges have already begun to weigh on the leveraged finance market.

Forthcoming political events such as the US presidential election later this year as well as regulatory changes in the world's capital markets such as Basel II are also shaping expectations. Recent jitters in the public markets have shown that these prospects are already looming large on participants' minds.

Given this outlook, the private equity business is likely to get tougher, too. Funding for new investment won't be as cheap; exit routes may narrow. However, I also believe that these are short-term challenges that the industry's best performers are well equipped to deal with. The private equity model that has evolved over the past three decades will ensure the long-term viability of this asset class.

Today, private equity combines elements of financially driven buyout investing, early- stage-style investment techniques and activist operational management. This blend has created a method of control investment that allows managers to impact value in many different ways.

Numerous exit routes are available – trade sales, flotations, recapitalisations. Add-on acquisitions can be made to enhance value. Management can be changed as and when required. In other words, the private equity investor is in a position to directly alter the outcome of an investment strategy by way of drawing on a multitude of mechanisms. This does not just help increase returns: control also serves to reduce risk.

This is why private equity in effect maintains a control premium over other asset classes. Specifically, this form of activist capital is replacing the value-driven public equity index investment model of old. It has taken a leadership role in the space of corporate restructuring and corporate divestitures. It has a definitive position in the asset management industry and a definitive role in the corporate finance life cycle.

The built-in optionality of the private equity investment process also means that the business is relatively market independent, even though its effectiveness may be enhanced or diminished depending on the specific market conditions prevailing at a given point in time.

The more sophisticated players have the ability to use this optionality to alter their investment models and to adjust to these conditions. They can extend their focus in distressed investing during a down cycle for example; they may temporarily extend their reach into one geography and scale back in another; they can concentrate on companies that have greater early-stage refinancing requirements or higher growth potential.

This flexibility is fundamental to the strength shown by the industry's largest and best-capitalised participants. There are of course strong performers that are smaller and focused on a more narrowly defined investment strategy. But by the same token, market events have shown that scale does provide significant benefits over the longer term: it guarantees access to transaction flow across markets, consistency of capital raising, better terms of financing and an edge in attracting and retaining talent.

OUTPERFORMANCE VS DILUTION
Those houses that have built out their platforms most successfully have developed beyond deal shops or large funds to brand name asset managers offering investors a consistent investment model and an ongoing rationale for best performance. In some cases, these firms have delivered two to three decades of audited performance with consistent top quartile returns.

Their emergence is also one of the main drivers behind the continuing bifurcation in private equity performance. According to statistics compiled by Venture Economics, the top quartile performers in the industry have accounted for practically all the returns generated since 1996. The remaining 75 percent of market practitioners on the other hand have experienced negative cash flows.

From a limited partner perspective, the implications couldn't be clearer: a portfolio with an extended list of funds in a similar asset or size class brings with it the risk of performance dilution rather than statistical diversification. A private equity investment programme needs to be built around the top performers, and manager selection is the paramount challenge facing investors today.

As the market downturn of the past three years has shown, late-stage private equity is not immune to adverse changes in market conditions. But the activist investment model that the industry has moved to is providing the leading operators with enough flexibility to invest successfully throughout the cycle.

At this point in time, the tailwinds of a strong economy, low rates and attractive acquisitions at reasonable prices have been at their back. As headwinds are inevitably building, success in private equity will become more difficult to achieve. This challenge is one that the leading houses have been preparing for. Expect them to continue to create value for themselves and their investors.