Why didn’t you invest?

Around two years ago, the financial world was in turmoil. Equity markets were close to their lowest point, investor and consumer confidence was rapidly eroding. Banks were certainly not lending for buyouts.

And, of course, deals were not happening. In the UK, for example, the first quarter of 2009 saw a 73 percent drop in deal volume compared to the same period in the previous year: just £2 billion (€2.13 billion; $2.89 billion) in private equity transactions completed, according to the Centre for Management Buyout Research, compared to £7.5 billion in Q1 2008.

To some people this was a failure on the part of the buyout firms. For example, the subject of our Privately Speaking this month, Edmund Truell, has not been backward about coming forward with his view of the “pathetic” failure of most private equity firms to capitalise on what was the most spectacular financial crash in a lifetime.

Private equity firms can give several valid reasons why deal activity stalled so completely. One has been referenced already: the total freeze in bank lending. This is irrefutable, but a cynic would ask whether leverage should be considered a necessity for private equity firms to generate returns.

A cynic would ask whether leverage should be considered a necessity for private equity firms to generate returns

Another – also irrefutable – reason was the uncertainty over trading conditions at the time. Arriving at a valuation in these conditions was certainly not easy; agreeing on a valuation with vendors, presumably, near impossible. This overlaps with another popular refrain of the time: vendors had – quite rightly in retrospect – not adjusted their price expectations downwards. With banks reluctant to take write-offs on their loans, forced sales were not happening; vendors could sit tight.

However, critics of the industry – typically those who do not operate within the structure of traditional 10-year closed-end private equity funds – point to other, less flattering, factors. Starting with:

Fear and inexperience. Some GPs had not lived through a crisis of anywhere near this magnitude before and as such behaved like the proverbial “rabbits in the headlights”. In some cases that lack of experience led to an …

Inability to source deals. Desk-bound deal-makers who had got too used to waiting to be contacted by a big four accounting firm or a bank with a deal suddenly found the supply dried up. Deals were, in fact, likely to be low down on the priority list as there was significant work to do in…

Tending to the existing portfolio. Most firms had a task on their hands in keeping their equity stakes in prior investments alive. Capital structures needed to be adjusted and a firm hand was needed on the operational tiller.  Problem portfolios were not, however, confined to general partners. Some of the freeze was down to …

Pressure from LPs. Some limited partners were struggling with over-allocations to private equity, while others were experiencing very real liquidity issues. While the LP is in no legal position to veto a deal, a GP would be unwise to press ahead with a capital call when investors are suffering.

Some of these deal-blockers can clearly be seen as failures. A lack of experience and an inability to source deals are shortcomings that will be probed by limited partners when these firms inevitably return to investors to raise a new fund. These are examples of areas in which good managers – those who deserve repeat LP commitments – distinguish themselves from the sub-par ones.

The final verdict on whether private equity firms missed out on a massive opportunity during the crisis will be delivered by the institutional investors whom they rely on for capital

Can it be seen as a failure to sacrifice new investment activity to focus on keeping the existing portfolio alive? It’s a grey area. Ideally the portfolio company should have the management team in place to pull the business through dark economic times. Nevertheless, it is hard to imagine LPs taking too dark a view if these troubled investments end up ultimately returning them capital.

 The last of these concerns – that LPs had a hand in the stalling deal activity – is not so much a failing of general partners themselves but of the private equity limited partnership fund model. Perhaps some innovation in this department will change things.

In our interview, Mr Truell refers to the banks. When the banks needed recapitalising, why was it left to sovereign wealth funds – as the Qatar Investment Authority successfully did with Barclays – to step in? It is worth remembering, however, that for every Barclays there is a Washington Mutual.

The final verdict on whether private equity firms missed out on a massive opportunity during the crisis will be delivered by the institutional investors whom they rely on for capital.

 

 Those GPs planning preparing to pass the hat around for a new fund this year may well want to prepare a watertight answer to this question: When that markets were gripped by fear and loathing, why didn’t you invest?