The first signs of stress

First, the good news: private equity is still enjoying an exit boom. According to the third Annual Exit Analysis produced by Swiss gatekeeper SCM Strategic Capital Management, the value of realisations achieved by 41 private equity firms globally (accounting for 171 partnerships) climbed 66 percent last year, while the number increased 15 percent (see graphs 1 and 2). The value gain is all the more impressive when you consider it had already shot up by 115 percent from 2003 to 2004.

The authors expect the boom in recapitalisations to founder during the second half of the year

Now the bad news: there are some signs just beginning to emerge that the ‘up’ cycle is on the turn. On the face of it, such talk appears unduly alarmist. After all, note the survey's authors, in the first quarter of 2006 “the exit drive…remains in full force” with a 12 percent increase in value compared with the opening quarter of 2005. Nothing to worry about there, until you go on to read that the authors expect the boom in recapitalisations to founder during the second half of the year as interest rate rises make re-financings less attractive.

This is a particular concern for the European buyout market, where recapitalisations have been more popular than elsewhere in the world. After the last global economic downturn stemming from the technology crash, US companies were “swifter [than companies elsewhere in the world] to get the poison out of their balance sheets and get back on the acquisitions trail”, says Stefan Hepp, CEO of SCM. In addition, they were encouraged to do deals by US stock markets, which have placed a premium on acquisitions recently. As a result of this acquisition hunger, 48 percent of exit value achieved by US buyout houses last year came in the form of trade sales. This contrasts with the situation in Europe, where companies have generally been slower to resume making acquisitions, and trade sales accounted for just 32 percent of total value.

In casting around for an alternative to trade sales, recapitalisations have been the obvious choice for European investors, particularly given the widespread availability of cheap debt. This meant that 30 percent of European exits by value last year came in the form of recaps, almost as high a share as trade sales (32 percent). In the US, the difference between trade sales and recaps was stark: 48 percent as against 13 percent (see graph 3).

European buyouts have outgrown US buyouts over the last five years by a significant margin

Stefan Hepp

Nor was it only in that respect that significant differences emerged with regard to the respective exit markets of the US and Europe in 2005. In Europe, distributions from private equity funds reached $14.5 billion during the year, representing a 32 percent increase compared with the previous year. While distributions from US funds were considerably higher at $54.6 billion, this reflected a relatively stagnant two percent year-on-year increase.

What is more, fund distribution was not the only area where US private equity contrasted strongly with its European counterpart in 2005. During the year the number of exits from US funds climbed by 17 percent compared with the previous year, outstripping the 11 percent increase in the value of exits. The picture in Europe differed enormously, with a 92 percent increase in the value of exits dwarfing a 9 percent increase in number (see graphs 4 and 5).

The reason for this was partly due to European stock markets taking longer than those in the US to slow down, giving European funds prolonged access to the IPO window. It also reflected the increasing heft of Europe's large buyout market. “European buyouts have outgrown US buyouts over the last five years by a significant margin,” says Hepp. He points out that the European buyout market has doubled in size over the last five years thanks to a growth rate of 20 percent a year, while the US buyout market has grown by less than 14 percent over the same period (and just ten percent last year).

A marked transatlantic dichotomy can also be identified when looking at venture capital exits. Last year, 84 percent of European venture exits by value were in the form of trade sales; while in the US the equivalent figure was 28 percent (see graph 6). Meanwhile, IPOs and sales of quoted equity accounted for just 8 percent of the value of European exits and 46 percent in the US (see graph 7).

However, these headline figures obscure some arguably rather more surprising findings. One is that the number of IPOs in the US declined in 2005, compared with an increase in Europe. The reason for the predominance of stock market exits in the US had much to do with the strong IPO market of 2004, which led to a large number of quoted equity sales last year as a result of listings that were undertaken during the previous 12 months.

Ironically, the stronger IPO market in Europe was largely the result of European stock markets (and particularly London's AIM market) being welcome recipients of US venture-backed companies. Says Hepp: “In the US, the bar has been raised for venture-backed IPOs to the extent that other liquidity options have to be examined – including looking at overseas stock markets.” Regulatory requirements stemming from Sarbanes-Oxley make too many demands on small companies, says Hepp. “You now have the reverse situation of everyone going to Nasdaq. You don't go there unless you have at least $200 million per year in revenues.”

But while European venture exits show an upturn (albeit stimulated by overseas companies), the value of European buyout exits is in danger of heading down as the cost of debt begins to climb. “If you have a business that you want to re-cap but haven't yet done so, you'd better hurry up,” urges Hepp. “The current year will see a significant decline, and trade sales must become more prominent to make up the difference.”

The SCM survey was based on data provided by 41 private equity firms representing 171 partnerships. The partnerships were spread fairly evenly across the vintage years 1990 to 2005. Of these partnerships: 51 percent invested globally; 31 percent focused on Europe; 13 percent focused on the US; and 5 percent on the rest of the world including Asia. With regard to stage: 42 percent were balanced funds (e.g. buyouts and venture/growth); 33 percent buyout funds; 23 percent venture capital/growth funds; and two percent mezzanine/other funds.