It's capitalism's darkest hour for nearly a century, and it isn't over yet. In early October, the world held its breath as governments scrambled to rescue the banking system. Ostensibly, the scramble worked. At the time of this edition of PEI going to press, the $2.5 trillion bail-out has appeared to have the desired effect of beginning to restore confidence in the viability of financial institutions. But no one is suggesting that this historic crisis has run its course. With the real economy now bracing for a marked downturn, more pain is a certainty, and darkness will remain over many markets. How long it will take for light to return is impossible to predict. “Long”is an answer that most commentators are willing to make do with.
Specifically in the context of private equity, however, we at PEI would answer the question more positively: “Perhaps not as long as you might think.”We believe this is right because we are witnessing private equity living through the crisis in its own way. So far its experience of the turmoil has been quite different: whilst other pillars of the world's financial edifice have crumbled, private equity has been watching from the sidelines in relative comfort. No private equity firms have gone the way of the investment banks. Unlike hedge funds, they haven't watched their investors take flight in a panic. And the flow of bad news coming out of their investment portfolios has, thus far, been limited.
FULL IMPACT YET TO COME
In other words, the action in this spectacle up to now has been comparatively easy on private equity. But the industry is not isolated from the crisis, and most practitioners are resigned to the fact that the full impact of the private equity-specific problems resulting from it is yet to materialise. Before considering any reasons for optimism, these problems must be clearly understood.
In contemplating the challenges to come, the obvious point to start is the deleveraging of the global economy. The era of cheap credit is over, and for the private equity approach to financing and refinancing businesses, this constitutes a massive change. As a result of the crunch, leveraged buyout deal flow has slowed to a trickle already. And with the banks on their knees, leveraged lending won't pick up for a while. Don't expect the trickle to swell any time soon.
The deteriorating trading outlook for portfolio companies in the coming recession is another concern. As earnings weaken, the number of private equity-sponsored firms struggling and even failing will increase. The announcement of KKR's landmark purchase of RJR Nabisco almost exactly 20 years ago, which we commemorate in this issue in a special feature starting on p. 59, is testament to what can happen when the LBO cycle turns and deals fail to perform. RJR helped give the whole of private equity an unwarranted reputation for excess, and it didn't make any money for limited partners. It also ushered in a slump for private equity investment activity from which the industry took years to recover.
Developments in the LP universe are now also at the forefront of practitioners' minds. As the crisis has progressed, it has become apparent to participating institutions that the cash demands of their recent private equity allocations may be far greater than originally anticipated. Not only are some LPs worried that shrinking equity markets will leave them over-allocated to their favourite asset class, they also fear that the huge commitments made during 2006 and 2007 have put them on the hook for a long succession of capital calls that they can't service. Part of this anxiety is a fear of missing out on the attractive buying opportunities that post-crisis markets are certain to deliver. On p. 28, we discuss this issue in detail.
We believe the private equity success story is set to continue; today's crisis, deadly serious though it is, is not the end.
And then there's the threat of regulators going nuclear on the financial services sector. For private equity, this could be the gravest threat of all. For many months, private equity practitioners in Washington, Brussels, London, Paris, Berlin and elsewhere have been trying hard to persuade lawmakers of the macroeconomic benefits of their industry. The crisis has made this task much, much harder. In responding to taxpayers' furious demands that capitalism be reined in, politicians and legislators are bound to act in haste, and to use blunt instruments to boot. So even if private equity is spared a catalogue of measures aimed expressly at it, it could still get swept up in the great tidal wave of anti-market regulation that many observers now consider inevitable. Worst case scenario, according to a senior GP we spoke to recently, would be the death of the private equity business model as we know it. For more on this chilling prospect, see p. 14.
Like other crises before it, this one will pass, too. That is the moment for private equity to work towards, and this work may well start sooner rather than later. However alarming the worries listed here may seem, there are also good reasons for the industry to continue to look to a prosperous future, even in the relatively near term.
For a start, private equity is one of the few areas of finance that have remained open for business despite it all. Funds still have money to invest and are moving away from leveraged purchases to concentrate on growth equity and turnarounds instead. When the collapse of Iceland destroyed the country's retail group Baugur, private equity groups featured prominently on the list of parties interested in buying Baugur's assets – a reminder of the industry's knack for spotting opportunity in adversity. Students of the industry's history also know that private equity funds invested in downturns produce superior results. By that rationale, given the scale of today's correction, funds invested in the next 24 months are odds on to outperform massively. Already GPs are working on their game plans for the future. Matt Levin's roundtable interview of a group of US-based financial services specialists is evidence of this. His report on what proved a fascinating discussion starts on p. 72.
More reassuring still is the fact that not all LPs are bearish right now. To the contrary. Consider this excerpt from this month's this excerpt from this month's Privately Speaking (p. 52), a wide-ranging conversation with Roberto Paganoni and Ivan Vercoutere from LGT Capital Partners in Switzerland: “Private equity will come out of this strongly. Public equities are back where they were ten years ago. By contrast, people have done well out of private equity. This crisis will show that the asset class can resist a significant market dislocation and still produce attractive returns over the long term.”
FLEETNESS OF FOOT
And it is also worth bearing in mind the industry's creativity and fleetness of foot. It is possible that lawmakers aiming to regulate the industry to pieces will succeed. But is it likely? We think not. Private equity will continue to evolve and use structural innovation to move forward. What's more, in light of the calamity produced by the banks, its risk management and corporate governance techniques look convincing. Both will continue to stand it in good stead.
If all this is correct and private equity manages to use its inherent strengths to deliver results, investors around the world – including those currently fretting about the next round of capital calls – will continue their march into the asset class. The RJR Nabisco buyout may have produced little more than a great book and a mediocre movie. But a myriad of other private equity investments have made investors so much money that the industry has become one of the biggest growth stories in recent financial history. We believe this is a story set to continue; today's crisis, deadly serious though it is, is not the end. When the darkness recedes to reveal a new financial order, the private equity industry, in its many shapes and forms, will be widely visible – and thriving.