To employ a phrase much beloved of sports coaches, the private equity exit market in 2007 has been a game of two halves. In short, a strong first half showing became a less than impressive display in the second period.
Preliminary data for the 2007 Annual Exit Analysis, the fourth yearly study of global private equity exits compiled by Swiss alternative asset adviser SCM Strategic Capital Management, shows a 35 percent climb in the value of exits in the first six months of 2007 compared with the equivalent period last year. This represents an impressive increase given that exits in 2006 were already at a high level – up 31 percent by value (and 27 percent by number) compared with the previous year.
However, as the credit squeeze continues to bite, it is clear that the second half of 2007 has seen a reversal in fortunes. Although figures for the second half are not yet officially available, the survey's authors observe that “the trend towards rising interest rates and widening credit spreads did…have a severely negative impact on realisations since mid-2007”. Overall, SCM expects exit volume in 2007 to be within a range of plus or minus 10 percent compared with 2006.
SCM chief executive Stefan Hepp offers the opinion that European private equity funds are more exposed to the liquidity crisis than those in the US for reasons that can be deduced from the now-finalised 2006 figures. They show that, in the US, recaps and secondary buyouts accounted for just 30 percent of total exit value during the year (up from 21 percent in 2005). In Europe, meanwhile, the share delivered by such deals was 61 percent (up from 48 percent).
Comments Hepp: “I can't explain why this predominance of secondary deals and recaps has persisted in Europe, but the common theme of both is that they are contingent on credit availability. In our view that's an unhealthy situation and it means that European funds will suffer more from current market conditions than their counterparts in the US.”
MALAISE IN THE MIDDLE
Further to this, Hepp does not believe that exit difficulties will be confined to the larger buyout market. He says that, for the first time on record, Europe's mid-market funds distributed more cash back to their investors than the region's larger funds in 2006. But, given that the large funds have been significant buyers of mid-market portfolio companies, Hepp predicts a “ripple effect” that will deliver more widespread damage to European distributions than some commentators have been predicting.
Because of this, he does not feel it would be appropriate for investors in private equity to change their weightings from large buyouts to mid-market buyouts based on the credit crunch alone. He says: “If you're shifting your allocation because you feel that the mid-market will be less affected by the credit crunch, that's not a good reason in our view. It's misguided because the effects will be across the board.”
While over-enthusiasm with respect to mid-market prospects is cautioned against, there are also words of warning for those taking encouragement from what appears to be a venture capital recovery. The survey shows that, in 2006, venture funds were able to take advantage of bullish stock markets – in particular by disposing of shares in companies that had an IPO in prior years. This drove the volume of global venture capital exits up 110 percent by value and 23 percent by number. It is also worth noting that the one-year IRR delivered by venture was only four percent lower than that posted by buyouts (17 percent versus 21 percent).
However, while venture funds' strong reliance on the stock market is beneficial when sentiment is positive, it is also an Achilles heel when the climate changes. The report's authors note: “As stock markets have increasingly been dependent on a continuation of the M&A boom, it is very likely that a tightening debt market might just cause the type of nervousness that closes the IPO window.”
This may be a cause for concern for investors with a strong exposure to Asian growth and venture funds, which Hepp believes are “over-funded”. He says that, in 2006, seven times more money was raised for such funds than was invested. However, a notable aspect of the survey is the increasing contribution made by buyout funds to Asian distributions. In 2005, buyout exits accounted for 25 percent of the total value of exits in Asia – by the following year, this figure had risen to 47 percent. Hepp believes the figures hint at the developing maturity of the Asian private equity market as buyout strategies in the region begin to demonstrate their viability
After several years of almost unalloyed good news, this year's survey is a mixed bag. On the one hand, 2007 will go down as another very strong year for distributions despite the slowdown since the summer. But the major concern is how long liquidity issues will linger and also whether the current difficulties may worsen in the event of a slowdown in the global economy. Next year's survey may find it hard to adopt a cheerful tone.
The SCM study was based on data provided by 50 private equity firms representing 172 partnerships. The partnerships were “fairly evenly spread” across the vintage years 1991 to 2006. 51 percent of the partnerships were focused on Europe, 41 percent on the US and 8 percent on Asia and the rest of the world. 42 percent were buyout funds, 29 percent balanced funds (buyouts/growth/venture), 26 percent growth/venture, and 3 percent mezzanine and others.