Is the party over for private equity managers?
Through the latter part of 2006 and the beginning of 2007, the UK press was full of reports about the good returns enjoyed by what were termed ‘the barbarians at the gate’ – private equity managers. By taking advantage of freely available and modestly priced lending over the past few years, deals became increasingly leveraged and the market witnessed a wealth of large public-to-private transactions.
Unsurprisingly, the levels of return which were generated were very attractive to institutional investors and many sought to increase allocations to this asset class. As a result, concerns were voiced that there was too much money chasing too few deals – a situation termed ‘overhang’ in the industry. A year on, however, in an environment following the credit crunch, the landscape appears to have changed considerably. Indeed, investors may now be concerned that they are exposed to deals which may sour. Lack of credit One of the first effects of market turmoil is a dislocation between buyers’ and sellers’ expectations of what a company is worth. Coupled with the unfavourable credit environment, in the short term, the number of buy-out deals has dropped considerably– and this could persist through 2008. This type of situation is, however, often followed by a time when purchase prices and purchase price multiples fall and the equity contribution required to complete deals increases. A drop in the purchase price is generally a good thing for returns as investors pay a lower price for opportunities into which they are buying. Implications In our view, one of the challenging aspects of the credit crunch is the difficulty investors may have exiting their commitments in the current environment – companies simply may not fetch the prices they previously expected. In the short term, this may mean that holding periods are extended in the expectation of more favourable market conditions. This is not ideal for those seeking liquidity and have money locked up in private equity deals – they may have to exit at a much cheaper price than they wanted just to get their money out. The silver lining is that this may turn out to be a good opportunity for investors to enter what is termed the ‘secondaries market’ – buying into existing deals to relieve over- committed investors. One can thus gain exposure to deals which are relatively near completion – and have a good idea of the finished product– thus picking up a lower risk investment at a favourable price. A buying opportunity? Ultimately, our view is that now may potentially be as good a time as any to increase allocations to private equity. For example, a declining housing market and the follow-on effect on consumption, higher energy prices and a lack of market liquidity may see default rates rise which will yield opportunities in the distressed market (buying companies who may be about to go under but have valuable assets). As described above, mainstream markets have also cooled and, as with many other asset classes, we are witnessing a flight to quality – which means prices and leverage will fall to more sustainable levels. For the long term investor who is less reliant on liquidity in the short term, private equity deals may therefore be well worth careful consideration.
