ParisTech Review

The current global financial crisis, triggered by meltdowns in the housing mortgage and credit markets, has placed tremendous pressures across the industry, and private equity firms did not escape unscathed. Indeed, the media, regulators, and clients have been highly critical of private equity, especially with respect to the debt levels used in portfolio companies but also in regards to the stringent restructuring plans and exploitation of certain tax advantages. The situation has been exacerbated by confusion between private equity and the speculative and high-risk hedge fund industry. As a result, the private equity landscape has been dramatically altered over the past 18 months. Bank debt to finance investments has all but evaporated and new regulation is coming into force. The bottom line is that the value of new global private equity investments and of fundraising has plunged such that the level last year was about equivalent to that of 2002.

Given this hostile environment, what’s the future of private equity? Specifically, when the global economy recovers, will private equity also return to its normal business level? And what do firms have to do to ride out the current storm? Can they continue operating as they’ve always done or must they instead make sweeping changes to the ways in which they operate? Such questions require a thoughtful, deep analysis of various issues, but before we delve into them we first need to take a look at how we arrived at the current situation in the first place.

The Coming Shakeout

Without a doubt, the current credit crunch has drastically altered the private equity landscape. Following two years of increasingly favorable lending conditions, leverage is no longer readily available and the era of “mega-buyouts” has come to an end. According to research by Dealogic, the annual debt issuance for leveraged buyouts (LBOs) rocketed from $71 billion to $669 billion from 2003 through 2007. Since then, the world’s debt markets have virtually ground to a halt: only $6 billion was raised in LBO transactions in the United States and Europe in October and November 2008.

As bank debt has become limited (and thus more expensive), deals have become scarcer. In June 2007, buyouts worth over $120 billion were announced, whereas in June 2009 the figure was only $9 billion, according to Deutsche Bank Research. However despite the collapse in deal flow, small and mid-sized buyouts are still taking place. While debt has certainly become more expensive and increasingly difficult to obtain, it does still exist, and the rise in prices has only brought them in level with historical averages. According to research by the Boston Consulting Group (BCG) and the Instituto de Estudios Superiores de la Empresa (IESE), credit spread levels have merely returned to levels reached in 2005 when private equity was already booming and are nowhere near their historical highs.

The combination of a weakening economy and heavy debt loads has been devastating for many companies that went private in leveraged buyouts since the start of 2006. According to a study by the BCG and the IESE, almost half of those businesses are expected to default within the next three years — a potential book loss of $300 billion. It is important to note that, until the third quarter of 2007, most industries enjoyed strong earnings growth and many business plans for the next five years were built on expectations of further earnings growth. Today, however, most companies have negative earnings before interest, taxes, depreciation, and amortization (EBITDA) growth, and this situation is likely to worsen, bringing with it the potential of negative earnings for many companies if sales volumes continue to drop and drastic measures are not taken. Furthermore, from 2003 through 2007, EBITDA multiples (enterprise value divided by EBITDA) grew by 41% in the United States and 43% in Europe, but in 2008 the dramatic 45% drop in stock prices pushed multiples down, resulting in a risk of mass defaulting. A rash of defaulting will, in turn, lead to a major shakeout in private equity. The more diversified firms will tend to survive but a significant number – anywhere from 20% to 40%, according to research by the BCG and the IESE — will disappear altogether.

In the past, institutional investors were attracted to private equity primarily by its lack of correlation with other asset classes (hence its diversification from those investments) and secondly by its potential for high risk-adjusted returns. But as many other assets like bonds, equities, and real estate have rapidly depreciated, many of those investors now have a relatively higher exposure to private equity than they would like. In addition, they have also become increasingly worried about the economic and regulatory future of private equity and, as a result, some are now trying to back out of their commitments either by requesting heavy discounts or by threatening defaults. Take, for example, the California Public Employees’ Retirement System (CalPERS), the largest pension fund in the United States. CalPERS has reportedly asked private equity firms to reduce their requests for additional capital that it had committed to previously.

An Image Problem

The financial sector has become the lightning rod of criticism for the global crisis that has devastated so many businesses and individuals. Much of that is certainly understandable given, for example, the toxic role played by financial instruments like synthetic collateralized debt obligations (CDOs). But much of the blame has also been grossly exaggerated or misplaced. Consider, for instance, how harshly the press and politicians have criticized and accused private equity of having been too greedy and profit-focused — despite the lack of evidence to prove that private equity had much of anything to do with the crisis.

Part of the problem is the considerable confusion that exists between private equity and hedge funds. The two have often been viewed as synonymous when, in fact, they are quite different in fundamental ways. Typically, private equity is a long-term investment (four to five years) that promotes partnerships between the private equity managers and company executives in order to create value in the portfolio companies. Hedge funds, on the other hand, tend to be much shorter-term investments (six to 18 months) that are more highly leveraged (that is, more speculative) with generally little knowledge of the target company and its management. A telling statistic of the difference between the two types of investments is that, according to research by Prequin, private equity firms lost about 20% of their clients’ money in 2008 while hedge funds lost around 47%.

In spite of those basic differences, private equity and hedge funds are often lumped together, sometimes even by those who are knowledgeable about the financial industry. Consider the recent draft proposal of the European Union Directive for Alternative Investment Fund Managers (AIFM). The initial document attempted an “all encompassing” approach to regulating the diverse AIFM industry, which in the EU includes both private equity and hedge funds. Even after the directive’s threshold was raised to €500 million of assets under management for those fund managers who are free of debt and with a minimum investment period of five years, that figure was still only half the amount that the private equity industry was wishing for.

In short, private equity has a pervasive image problem. A portion of that is understandable because some firms have become increasingly oriented toward the short term, and they’ve relied more on leverage to finance their investments. In other words, they have become more speculative, like hedge funds. Instead, the private equity industry needs to avoid such practices and return to the basics. It needs to refocus on the characteristics that, under many conditions, make it a superior form of financing that has a number of advantages.

The Advantages of Private Equity

A company can finance itself through bank debt, market capitalization, or private equity. In general, private equity, which consists of investing equity primarily in non-listed companies, has outperformed the market and other asset classes. Consider, for example, the following table, which compares private equity returns with the market over different time periods:

Source: Cambridge Associates LLC data provided at no charge, Bloomberg, Lehman Brothers, Morgan Stanley Capital 6, International Standard & Poor’s, Franck Russell Company, Thomson Datastream, The Wall Street Journal, and Wilshire.

One of the reasons for that difference is that private equity firms typically partner with and support their portfolio companies throughout the duration of their relationship. They can, for example, provide expertise with respect to strategy development, acquisition opportunities, risk analysis, and various managerial best practices, including employee incentives and numerous modern processes at the operational level. Moreover, they can also offer valuable access to their networks of industry experts and key stakeholders.

In contrast, banks can serve both the short- and long-term financial needs of a company but they tend to be concerned more about limiting their risks than about the future growth of a business. Thus they might be reluctant to provide capital to small private companies run by entrepreneurs. Equity financing, however, does not involve the loaning of capital but rather the buying of a stake in a company such that future gains depend on the growth of that business. In other words, equity shareholders are far more intertwined with the fates of their portfolio companies, which is why they typically provide not just capital but management advice and a long-term vision. Moreover, companies that have a high debt-to-equity ratio will often have great difficulty obtaining additional bank debt without first acquiring more equity financing to support the added debt and reassure the creditor. Bank debt can also be difficult to obtain when the projects to be financed are not tangible assets such as property, equipment, vehicles, and so. The bank financing of a new advertising campaign or opening of foreign subsidiaries, for example, can often be problematic. In such circumstances, equity financing can provide an advantage because of its greater focus on potential growth and long-term vision.

With respect to market capitalization, equity financing also has advantages. First, complying with market obligations incur costs that can be significant for small- and medium-sized companies. Second, publicly listed companies must comply with an increasingly heavy level of disclosure, governance, and regulation, which typically tempts executives to adopt shorter-term strategies due to the obligatory reporting. Such regular disclosure also leads to market valuations that often do not reflect the full potential of a company, especially in certain financial environments (such as the current economic downturn). But that’s not to say that governance is necessarily bad, and indeed private equity firms are also regulated. The point, though, is that private equity generally takes a longer-term view whereas market capitalization exposes a company to shorter-term pressures dictated by the daily evolution of the market. Furthermore, equity financing can be made discreetly or with much public fanfare, depending on the wishes of the company in question, whereas market capitalizations always generate publicity whether or not it is desired.

A Return to Basics

Given the inherent advantages of private equity, why is the industry currently facing a major shakeout? A part of the problem has been that private equity firms have not always fully capitalized on their key strength – the long-term holding of companies. That’s certainly regrettable because investors have generally been amenable to that kind of approach. Infrastructure funds, for example, last for an average of 20 years, and capital raised through institutional investors is typically available for periods exceeding 10 years. But to take advantage of such patient investing, private equity firms first need to return to the fundamentals with respect to the following key areas.

Partnership with managers: Private equity must concentrate even more deeply on partnerships with their portfolio companies. In times such as these, they must establish strong collaborations in order to move on from the crisis and determine common strategies and goals. This involves fund managers preparing their portfolio companies for a long and deep recession by focusing on operational improvements because that will be the most critical differentiator in today’s recession.

Operational excellence: According to a London School of Economics study, companies owned by private equity are better managed than those owned by governments, families, founders, and other private individuals. They also have almost no tail of badly managed firms, and they are particularly strong on operations management. Private equity must retain that strength. Indeed, that should be a principal objective. During a crisis, uncertainty about the future can be destabilizing for companies and their employees; good management is essential in restoring confidence in order to move forward.

Transparency and reporting: Countries have different regulatory standards for private equity. For instance, all private equity firms are regulated by AMF in France and by SAS 70 Type II if they are listed in the United States. Some private equity firms have also decided to go above and beyond such compulsory regulations by, for example, conforming to the Global Investment Performance Standard (GIPS). In the future, regulatory requirements are likely to increase as politicians have seized on the opportunity provided by the financial crisis to propose new rules for the industry. In addition, more than half of investors in different regions of the world believe that improvements are needed in the transparency and risk management of most fund managers. Specifically, dissatisfaction with the current level of transparency was expressed by approximately half of North American limited partnerships (LPs), two thirds of European LPs and three quarters of Asia Pacific LPs, according to a report by Coller Capital. Especially given the recent bad press and confusion with hedge funds, it behoves private equity firms to work even harder to improve their reporting and disclosure procedures.

Responding to Criticisms

In addition to returning to their fundamental strengths, private equity firms must also respond to various criticisms. For example, private equity is often blamed for using too much bank debt and for leading companies further into debt than they can manage in the course of LBO deals. But fund managers are generally very careful to select a level of debt compatible with the growth of a company. After all, it’s not in their best interest to drown a company in debt especially because they themselves must carry the burden of that debt as major shareholders. Indeed, those who were tempted by an excess of debt are now paying the price for that error in judgment. And LBO companies are not the only users of debt. According to a study by Ricol, Lasteyrie & Associés, many of the Cotation Assistee en Continu (CAC) 40 companies are at least as indebted (if not more so) than the portfolio companies of private equity firms, as shown in the following table:

Source: Ricol, Lasteyrie & Associés, « Profil Financier du CAC 40 2008 », as of 31 December 2007

Another criticism is that private equity unfairly exploits tax advantages. The argument here is based on the fact that interest payments on debt is a tax deductible expense, so when a company is highly leveraged (from 80% to 90%) it will pay very little tax, as almost all its profits will go towards the debt interest. The criticism is that there is no real value creation that takes place but rather a “transfer” of tax obligations between different groups of tax payers, resulting in a substantial loss for the government, which is deemed unfair and immoral. But LBO funds are not the only users of this tax lever; listed companies also do so in their acquisitions. Besides, private equity firms do create true value by helping to transform portfolio companies over the long term into more effective and efficient businesses — a fact that has been supported by a recent study by the BCG and IESE.

Such successful transformations of companies are the source of another criticism, namely that private equity overly deploys cost-cutting measures and job destruction as a means to improve the productivity and efficacy of companies under LBOs. But members of the European association of private equity firms (EVCA) and national associations have stated otherwise. According to them, companies backed by private equity stimulate the economy because they grow faster than other businesses; they invest heavily in R&D; and they grow internationally. Moreover, they are actually better job generators than listed companies. The following graph, for example, compares the average annual employment growth in private equity firms versus traditional companies in Europe and the United States:

Source: AT Kearney, “Creating New jobs and Value with Private Equity” (2007)

Toward a Stronger Industry

Such criticisms notwithstanding, private equity has the added challenge of becoming a more responsible long-term player with respect to various environmental, social, and governance (ESG) issues. Indeed, the essential function of private equity is to create value and build partnerships with companies over the long term – governance is thus at the very center of the private equity approach. Thus private equity managers need to have a greater degree of involvement in their portfolio companies and play a larger role in influencing the corporate governance practices of those firms, as compared to other investment professionals, such as mutual- or hedge-fund managers. Moreover, the recent series of scandals in the U.S. corporate and financial world have resulted in a public outcry and backlash that has included large institutional investors such as CalPERS, which have become increasingly vocal in their demands for better governance.

Of course, satisfying the demands of public opinion, institutional investors, and regulatory requirements should bear their fair weight, but the primary goal of every private equity investment is a profitable exit, and there is no absolute guarantee that well-governed companies will produce smooth exits and high returns. Various studies have shown, however, a positive correlation between governance and stock performance. Research conducted by Georgia State University of more than 5,000 U.S. public companies, for example, found that businesses with superior governance practices tended to have better stock price performance, as well as higher profitability, larger dividend payouts, and lower risk levels than their industry peers. Similarly, a study by Credit Lyonnais Securities Asia and the Asian Corporate Governance Association uncovered a strong correlation between the quality of corporate governance and stock performance over a period of five years for 380 public companies in ten different Asian markets.

Although good governance cannot alone produce a successful business, it clearly helps to drive company performance. Greater transparency, for instance, enables the early detection of problems so that management can more quickly address them. On the other hand, deficiencies in governance as well as potential exposure to environmental and social issues can certainly have a substantial negative impact on future performance As such, several private equity firms, including AXA Private Equity, KKR, Deutsche Asset Management, LGT Capital Partners and OFI Private Equity, have signed the United Nations Principles for Responsible Investment (UN PRI). In doing so, they have committed to integrating ESG into their daily operations, investment decisions, and practices as shareholders. The intent is also to ensure that their portfolio companies will likewise take those ESG factors into account in running their businesses.

Another important topic that needs to be addressed in the coming years is profit sharing. Specifically, the private equity industry must put in place clear rules for sharing the value created with a company’s management and employees. As stated by the charter of the Association Francaise des Investisseurs en Capital (AFIC), the success of an investment partnership requires both the alignment of interests of the parties involved as well as the sharing of the value created, taking into account the risks taken and the contributions made by each party. Hence many private equity firms have in fact put into practice various policies to accomplish that. Indeed, according to a recent report by Gestion Finance, 20% of companies under LBO have already begun to share profits with employees, with certain exits leading to the distribution of bonuses.

The Future of Private Equity

Despite the worsening credit climate, the private equity industry still has ample funds for investment. Indeed, Prequin estimated that “dry powder” to be approximately $820 billion in 2009. Moreover, institutional allocations to private equity are expected to rise. Sovereign wealth funds, for example, have been aggressive in their appetite for private equity and are expected to control up to $5 trillion in capital over the next five years, according to Prequin. In addition, private equity stills remains an emerging asset class and, even after passing the $2 trillion benchmark, it accounts for only 3% of the market capitalization value for both global equities and bonds, as stated in a report by RREEF Research of Deutsche Bank. As of December 2008 the Private Equity Intelligence Report was predicting that private equity’s assets under management (AUM) would grow to nearly $5 trillion within the next five to seven years. Therefore, certain risks to the industry are most likely just short term. For example, although leverage has become less available, the levels and prices have not actually dropped below those of 2005, when the industry was booming. Investors might be cautious but they have also been optimistic, taking a more active role in choosing a diverse set of fund managers that can consistently deliver solid results by returning to the fundamentals discussed earlier.

That said, the industry can’t continue with business as usual. The global financial crisis has already had — and will continue to have — an intense impact on private equity. For one thing, increased regulations will force certain changes because leverage will no longer be as effective a tool to improve investment performance and because a much higher level of transparency will be required. Moreover, the industry’s image has suffered a serious blow and must promptly take the necessary corrective actions, for example, by increasing its transparency through information openly provided not just to clients but also to the public, the financial community, and regulators. In doing so, private equity will move out of the shadows to regain the trust of others and repair its image as a responsible and important source of financial capital. None of that will be easy, but a return to the fundamentals is absolutely necessary. Otherwise, the current global financial crisis might prove even worse for private equity than it already has.

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