The view from Zurich

In our editorial accompanying the October 2008 issue of PEI, we referred to “the seismic significance of starred financial institutions toppling like a pack of cards” and to the “sad cardboard box-clutching figures heading through the exit doors of now-bankrupt banks”. Back then, even though it was clear that the good times would not return again for quite some time, it was very hard to predict what precisely would come next. In the private equity market, the lack of clarity was unsettling. There was queasiness at the thought that there might be some kind of negative payback for the boom years, but no obvious guidance as to how this might manifest itself.

One year on, with the picture having become a little clearer, PEI approached some of the leading alternative asset managers and advisers in and around the leading financial centres of Zurich and Zug in Switzerland to canvass their respected views on the present condition of private equity and what lies in store for the asset class over the coming years. The views expressed are characterised by caution and pragmatism – but also a sense that, in the long run, private equity is more than capable of justifying its place in investment portfolios.

In the short term, however, pain is beginning to be felt – and there may be a lot more to come. In the initial aftermath of the financial crisis, studies predicting mass casualties among the ranks of private equity fund managers seemed a little hysterical. However, there is now a lot more credence being given to the idea that a sizeable proportion of GPs will end up struggling for survival.

Alfred Gantner, co-founder and executive chairman of alternative assets manager and adviser Partners Group, predicts that as much as 20 to 40 percent of all private equity players might ultimately be culled. “Investors will likely concentrate on the big, established names and a number of smaller players could potentially experience difficulties in their fundraising. In an industry where investors sign long-term contracts, stability and independence of a firm will be major deciding factors. A number of companies will simply no longer be able to raise capital and thus will silently disappear.”

Rainer Ender, a managing director at funds of funds manager Adveq, agrees there will be a “shake-out” but thinks it will be a positive development: “People will once again prioritise private equity's most important ingredients: alignment and genuine specialists doing investments where they have an angle.”

There are number of reasons why the future of funds might be threatened. Some captive teams have seen funding lines cut off by the demise of their sponsors; GPs heavily reliant on listed affiliates have suffered from the latter's liquidity issues; while many first-time funds invested capital rapidly through a period when company valuations peaked – and are likely to face challenges raising subsequent funds as a result. Those forced to delay fundraising due to investor apathy may be faced with the prospect of team defections and find it hard to function properly. For all this, there is the important consideration that the typical 10 to 12 year lifespan of a private equity fund, coupled with annual management fees and other revenue streams, ensures that death does not normally come quickly. Because funds might linger for years before lifelines are finally cut, the industry is unlikely to see a sudden wave of failed GPs breathing their last in unison.

Aside from the speculation about the number of GPs that might disappear, another alarming topic for discussion in the wake of the crisis was whether the private equity model was dead. Katharina Lichtner, managing director and head of research at private equity manager and adviser Capital Dynamics, firmly rejects the idea. She points out that leverage is a useful but not vital part of the private equity toolkit when it comes to value creation. “Can a buyout fund operate successfully without any leverage at all? No. But are huge amounts of leverage necessary? No. More important than leverage is having a disciplined investment approach and the ability to generate profits through operational improvements.”

MAGIC INGREDIENT
Operational strength is the magic ingredient which GPs everywhere like to claim as part of their recipe for success. It is, to be frank, something of a cliché these days. But there has arguably never been a more opportune time to demonstrate that it really is part of the private equity armoury. Says Gantner: “We expect this crisis to separate the wheat from the chaff, with the coming quarters providing a magnifying glass which will aid in determining which GPs have the operational capabilities to ensure their portfolio companies make it through the cycle.”

This battle against prevailing economic headwinds is fully expected to leave casualties in its wake. “Full write-downs will be significantly higher than the loss rates during previous crises,” says Stefan Hepp, chief executive of SCM Strategic Capital Management, a provider of management and consulting services for alternative investments. “If you have deteriorating revenues and you need to refinance your debt in a choosy market environment, you won't cut it. Many of those portfolio companies that do make it through will deliver returns somewhat lower than their investors would originally have hoped for.”

From the LP perspective, seeing how GPs respond to the challenge of piloting portfolio companies through the maelstrom will be highly informative. A willingness to roll up sleeves and fight to return investor capital will earn respect and gratitude. “We expect GPs to fight for their portfolios line by line, company by company to return investors' capital and the best will end up delivering positive returns,” says Gantner. Interestingly, with respect to large deals done at the height of the boom, there is a view that simply returning capital would be a good outcome – any kind of positive return would represent out-performance.

While investors are anxious about recent fund vintages, the counter-balance is that recessionary periods in the past have seen private equity prosper (see chart p. 50). “We judge this to be one of the most attractive environments we have seen in over a decade of investing,” says Gantner. He adds that Partners Group currently has over CHF7 billion (€4.6 billion; $6.5 billion) in un-invested capital “to provide long-term financing to an economy facing a huge deleveraging process”.

One truism of private equity investing is that it's a long-term game that will – or at least, should – involve exposure to both up and down cycles. It's a truism that some may have lost sight of. Says Lichtner: “Those limited partners that have seen several cycles and have the experience are quite bullish about private equity right now, but some of the less experienced investors have got scared. They ploughed in at the peak and now they're pulling back, in some cases freezing their allocations. That's a pity because you won't have a balance of vintage years. You won't benefit from the current environment that many believe will be a very good vintage year and that could buffer the more problematic vintage years.”

Adds Ender: “The investors that will be disappointed are those that acted in a pro-cyclical way and in line with industry and market euphoria. The disciplined investors will not experience the same frustration.”

We expect GPs to fight for their portfolios line by line, company by company to return investors' capital and the best will end up delivering positive returns

One point that may have been overlooked in the face of declining absolute returns is the importance of benchmarking. For private equity, this has traditionally meant comparisons with the public markets. “The stock market has made no money over the last ten years, whereas private equity has made money,” says Hepp. “And that's because private equity firms are incentivised to sell. Traditional asset managers don't do that, they are always fully invested and past gains are thus fully exposed to a downward swing of the valuation cycle.” He adds: “Private equity has to out-perform the stock market and I'm confident it will do so. There again, a big recovery on stock markets would help private equity in some ways – so the fortunes of the two are linked.”

Hepp also points out that many LPs have initiated “a reassessment of alternative assets in general and how to go forward with the real estate, hedge fund and private equity mix”. He believes that, compared with the hedge fund industry, LPs are tending to view private equity as relatively untainted by recent developments. “In some cases, LPs are saying they were misled by hedge funds because the product was wrongly labelled as offering low volatility, stable returns, a disconnect from the broader market and liquidity. This turned out to be untrue. At least they knew that private equity was long term, illiquid and could be volatile. Private equity put its dangers on the wrapper, hedge funds didn't. As a result, I sense something of a shift from hedge funds to private equity.”

With predictions of a bright outlook for investments made in the coming period, a crucial question is when will new deal activity awake from its current slumber? Lichtner is optimistic: “Sellers have not quite adjusted their price expectations sufficiently yet, but continue to adjust. Once sellers' price expectations are more in line with those of the buyers we believe the pick-up will be quite fast because a lot of due diligence has already been done on potential deals.” She also believes that, while there is little debt available at present, the re-financing market will recover during the holding period of companies acquired today. “The re-financings are unlikely to be at the levels of 2005-06 but will provide interesting possibilities. This means that GPs can ratchet up the debt in companies as they go along, which will positively contribute to value creation once companies' cash flows pick up.”

NO GOLD RUSH
Rainer Ender agrees that new deal activity will increase, but does not believe this will happen quickly. “There will not be a gold rush for transactions,” he says. “Funds have to consider when they will be able to come back to market for fresh capital – they will need to show progress with investments before they can do that.”

As well as new deal activity, the fundraising market is also expected to show signs of improvement – although only for selected funds. Says Gantner: “I expect fundraising for the majority of large buyout players to remain on subdued levels for at least a few more quarters. However, the leading private equity players across all financing stages have continuously been able to raise funds and are already seeing substantial investor appetite for private market investments again.”

You need to really dig deep into the portfolio to understand where the troubled companies are

In terms of the GP/LP relationship, conversations with Swiss professionals do not leave you with the impression that material changes in fund terms and conditions are likely in many cases. Pressure on GPs is instead directed more towards the quality of information provision. Lichtner believes GPs must go the extra mile to maintain healthy relationships with investors. “We expect senior investment managers to get involved [in the discussions],” she says. “Just having an IR person on the phone is just not good enough. You need to really dig deep into the portfolio to understand where the troubled companies are, and managers that have been less approachable on the partner side need to open up.”

At the same time, another message that comes through loud and clear is that LPs are not keen to rock the boat with the best GPs, with whom they may have built relationships over a very long period. And why would they? Tycho Sneyers, partner at Swiss funds of funds manager LGT Capital Partners says: “Private equity is making a very strong case even with everything that has happened. A portfolio of high quality PE managers has significantly outperformed public market indices over the last 10 years. The long-term future of the asset class is very good as the crisis will result in a healthy clean-up of the system and a higher quality of participants.”