Reflecting on the way in which the dotcom bust destroyed the aspirations of many a venture GP, observers of the private equity market today – and especially the segment of the market reserved for the largest funds – might conclude that a similar fate awaits those now confronting the double whammy of liquidity crisis and economic downturn.
It's easy to think that the peak of the market has passed, that the interminable descent towards a market trough is the unfortunate fate that awaits the asset class – or at least a significant part of it.
But is such doom and gloom appropriate? PEI recently visited some of the leading advisory and funds of funds groups in and around Zurich in a quest for illumination.
Given their huge sums under management, impressive client bases, experience of industry cycles and global reach, this part of the world is not a destination you head to solely for aesthetic reasons (though the panorama is never less than stunning). It is also as good a place as any in which to seek considered, balanced views of the outlook for private equity.
And the message conveyed was largely reassuring for those worried about the industry's future – despite what they may have read in sections of the press. Stefan Hepp, chief executive and founder of Zurich-based alternative asset management and consulting firm SCM: “Public image and media coverage has turned much more negative. People are once again asking whether private equity is anything more than just leveraging companies up and then selling them. But then people are always sceptical in down markets – it's a cyclical phenomenon.”
Such scepticism will likely be fuelled by headlines such as those relating to ailing US department s tor e chain Me rvyn's . On 4 September, the Wall Street Journal reported that the company had i s sued former pr ivate equi ty owners Cerber us Capital Management and Sun Capital Partners with a lawsuit alleging they had stripped the firm of valuable real estate, nearly doubled its rent and then pushed it into bankruptcy.
Whatever the merits or otherwise of the argument, it's hardly the kind of publicity that will assist the industry in its efforts to focus attention on its value creation credentials.
NO LOSS OF APPETITE
Nonetheless, among Swiss professionals there is little sense that capital inflows into private equity are likely to suffer. katharina Lichtner, managing director at Zugbased private equity asset manager Capital Dynamics, says fundraising has “experienced a slight reduction from a very high level” [a claim supported by, for example, media reports that US buyout firm Madison Dearborn Partners has lowered the target for its latest fund from $10 billion to $7.5 billion]. But she notes that until now there has been no substantial loss of investor appetite resulting from the credit crunch.
Hepp adds that allocations to private equity are driven by a fundamental premise that hasn't changed: “Demand for private equity and other alternatives are driven by the conclusion that you can't fulfil your investment objectives through bonds and public equities alone. The current environment confirms that.
If you want to diversify, you need a handful of options and private equity is one of them.”
Jochen Weirich is a partner and co-head of the limited partner team in the investment solutions department of Zug-headquartered alternative asset manager Partners Group.
He claims to have witnessed increasing demand for access to private equity from clients in Germany and Switzerland. “It used to be mainly insurance companies in Germany, but now it's corporate and public pensions as well.”
Although some financial institutions are selling down private equity exposures in order to help nurse credit crunch-battered balance sheets back to health, the general view is that investors are keen to maintain or increase allocations to private equity. Ironically, the biggest difficulty faced by mature investors trying to boost their allocation further is an obstacle created by private equity's success – specifically, the so-called “denominator effect”, through which private equity's outperformance within investment portfolios has resulted in over-exposure.
Peter Laib, managing director at Zur ich-based funds of funds manager Adveq, says that even if the appetite of traditional investors in private equity were to decline, sovereign wealth funds are waiting in the wings with their vast reserves of capital. Pointing to their total assets under management of almost $4 trillion and a six-week period at the end of last year in which they invested around $45 billion into financial institutions, Laib says: “A share of their cash will be set aside for private investment, and they could easily compensate for any drop-off from traditional LPs in the medium term.” (See figure 1, p. 76).
BAD TIME TO LEAVE
In any case, the common view seems to be that now is a rash time to contemplate reducing or scrapping private equity allocations if you have a choice. For one thing, the substantial premia offered by the secondaries market a year or so ago are much rarer today if not completely non-existent. Secondly, Swiss professionals point out that great vintage years often accompany economic downturns. Based on this kind of analysis, the clever money might gravitate towards the asset class in an environment like today's rather than away from it.
At the moment there are some declines in value due to mark-to-market, but these are moderate. The real test comes when the debt matures and has to be renegotiated, which in many cases will be around 2010/11
In an upbeat assessment, Lichtner summarises current market conditions as follows: “On the equity side prices of companies are starting to fall, especially in the small- and mid-size market which offers good investment opportunities.
On the other hand debt levels went down by a third and debt financing is more difficult to get because banks continue to be under pressure. Though debt availability is low, good deals are still being financed. With respect to existing investments we believe cash flows will be sufficient in most cases to service debt payments.”
Even at the larger end of the buyout market, where concern is frequently expressed over the prospects of 2006 to 2007 deals characterised by lofty debt multiples, there is an argument that conjuring doomsday scenarios may be misguided. Peter Laib points to the covenant-lite element of many debt packages, meaning that lenders have less power to intervene when a company experiences difficulties. And, when problems do arise, the larger funds have plenty of additional equity available to limit any damage.
Furthermore, he points out that while struggling portfolio companies may be value-destructive for their current owners, they will also present opportunities for savvy buyers. Says Laib: “At the moment there are some declines in value due to mark-to-market, but these are moderate. The real test comes when the debt matures and has to be renegotiated, which in many cases will be around 2010/11. Some companies may get picked up at very low valuations.”
Laib continues: “There will be some equity wiped out and deals cut with mainstream distressed specialists as well as traditional buyout houses which have been deepening their distressed resource. If I was one of these funds I would want to have money available to invest it around 2010 to 2011. Up until then, there will be some innovative and smaller deals, but LPs would be foolish to push GPs to put their money to work. They can see a big opportunity ahead.” (See figure 2, p. 78).
There is also a big opportunity to erode the J-curve effect when constructing a new private equity programme, says Weirich. “The current environment is a great opportunity to start building or increasing allocations through secondaries [thanks to attractive discounts on high quality assets] and mezzanine, which offers a running yield. Not all investors commit for the purposes of asset allocation, some invest opportunistically – and it's much easier to persuade them to take a positive first step into the asset class right now.”
Of course, to pretend that all is rosy in the private equity garden would be misleading. Not least, investors suspect that a degree of future financial pain is currently hidden within portfolios. Says Maximilian Brönner, a partner at alternative asset manager LGT Capital Partners in Pfaeffikon: “We've not seen a softening of earnings yet but we would expect to see the consequences of recession and the impact of high oil and energy prices on portfolio companies in the next few quarters.”
Nonetheless, there is little hint from those best able to gauge investor sentiment that negative reappraisals of private equity's role in investment portfolios are being widely undertaken. Some pain is being anticipated – so too is more gain.