Over the next 12 to 24 months, the private equity buyout business will face the deepest losses it has seen in many years.
Unfortunately, the depth of the challenge may get worse before it gets better. The fallout will accelerate a difficult transformation that has already begun, as the traditional way that buyout firms create and capture value through investment selection, negotiation, and financial structuring has become insufficient. Firms must provide significantly deeper strategic insights regarding new investments and stronger capabilities to add value post-acquisition. Questions such as ‘Where will value be created in this industry?’ and ‘How can we help this company?’ will become much more important than in the past.
What is propelling this structural shift? As the set of companies with financial engineering skills and capital has expanded over the past decade, private equity firms have encountered greater competition for attractive deals. Moreover, the companies in their portfolios now compete in more dynamic markets with greater strategic risk. Given this new environment, the winners will be those private equity firms that identify and build superior business designs and spur portfolio companies to create value and manage their own strategic risk.
Trouble in the Portfolio
While the crisis in venture capital portfolios has been well documented, problems in buyout portfolios are just now surfacing. The economic downturn, which earlier undermined investments in telecommunications services, business-to-consumer, business-to-business, and infrastructure, has extended to ventures in outsourcing, business services, basic manufacturing and retailing. As a result, private equity funds have encountered reduced valuation multiples and Ebitda growth, fewer exit opportunities, and a decline in debt market support.
To gauge the extent of the problem, Mercer Management Consulting recently analyzed a subset of buyout portfolios. We used the performance of publicly traded peer company multiples to estimate portfolio valuations, adding individual company results where possible. The results indicate that up to 50% of funds that invested heavily between 1998 and the year 2000 would show a loss if they were currently liquidated today, and many more would achieve only single-digit returns. A number of funds are down 20% to 30% from invested levels.
Many investments, of course, are in companies whose gains have not yet been recognized and have performed better than our analysis indicates. On the conservative side, our analysis made no adjustment for the impact of recapitalizations not yet announced, but widely recognized, which will result in equity values close to zero.
This analysis is consistent with recently released CalPERS data from year-end 2000 that documents the performance of its own private equity investments by vintage year. Over 55% of the funds CalPERS invested in from 1998 to 2000 have posted negative returns so far, compared to only 16% of the funds that CalPERS invested in between 1990 and 1997. While private equity fund performance generally improves over time, our comparables-based analysis suggests that the vintage years of 1998 to 2000 are likely to show further deterioration in the short to medium term.
Based on our analysis, therefore, the $143 billion invested in buyouts between 1998 and the year 2000 may harbor losses, recognized or unrecognized, of between $10 billion and $20 billion. Losses in debt facilities that supported many of these acquisitions will increase this figure. Although the business press reports investments that have been written off almost every day, accounting conventions effectively allow funds to delay recognition of problems in their portfolios until a “material event” or a refinancing occurs. Some industry executives believe that when the full accounting is made, the results could be even worse than our analysis suggests. As one managing director tells us, “We’ve only begun to witness the issues in the industry’s portfolio. We estimate that up to 70% of funds will not return 100 cents on the dollar.” Losses of this magnitude will dampen future new investments and fund raising.
Private equity firms will need to invest significantly more time in post-acquisition efforts to revitalize existing investments. At one extreme, many companies with severe near-term liquidity or business problems need to aggressively manage their costs and cash flow and, often, change their product line and target customer. Other firms will benefit more from optimizing the company’s business design by taking new sales and marketing approaches, redesigning logistics capabilities, or making other operational improvements.
Finally, select opportunities exist to redesign companies in order to make them attractive to specific strategic buyers. For example, a technology distributor was losing $1 million per month and faced a core market that was shrinking at 30% annually. We helped the firm shift its focus to a higher-value product category and follow-on services, as well as develop the operational and sales plans needed to make the transition. The firm broke even within three months and was successfully sold to a value-added reseller.
The Future is For Activists
Even if the current losses are managed, private equity funds must contend with a tougher competitive environment. The high returns that the industry has enjoyed over the past decade stemmed from rapidly expanding multiples and a set of capabilities that include unique financial engineering skills (especially the ability to structure leverage), privileged access to capital, proprietary deal flow and specialized industry knowledge. But as the industry matured, traditional advantages have waned. Over the past decade:
– The financial engineering skills needed to execute huge and complex deals have spread to hundreds of firms and thousands of individuals.
– Large fund size and capital access are no longer unique. While the mega-funds Thomas H. Lee Co., J.P. Morgan Chase, KKR, and others have attracted attention, there are now more than 50 private equity funds that each have more than $1 billion to invest.
– Proprietary deal flow has diminished in importance, as the majority of transactions are now auctions or involve numerous strategic and financial investors.
– Many North American industries have matured, reducing the pool of easy consolidation or rationalization opportunities.
These trends will continue. While deal activity has quieted, an overhang of capital across the private equity industry will maintain pressure on fund managers. Attracted to the returns posted by buyout funds in recent years, the amount of capital raised in the year 2000 was almost double the annual average of the previous six years. Despite the emerging pain and distraction of losses within current portfolios, this multi-billion dollar overhang of uninvested capital will fuel competition for high quality deals over the coming years.
Even more challenging than the heightened competition for deals is the increased strategic risk that fund managers face when putting that capital to work. Markets have become more dynamic and the lifecycle of any given business design has become shorter and shorter. If a portfolio company misses a critical turn in the market or lags in updating its business design, the penalty is often severe. Many industries are now characterized by a polarization of value creation, with the lion’s share of value flowing to the winner and even second- and third-place finishers generating little or no shareholder returns.
Until recently, few buyout fund managers paid much attention to strategic risk. Many implicitly assumed that market trends and business models would remain largely unchanged over the estimated three- to five-year investment and relied on linear or market-share estimations of financials. Going forward, most portfolio companies will likely need to adjust or reinvent their business design several times within the three- to five-year investment window. So a hands-off policy toward managing portfolio companies “I bet on the jockey (management) and not just the horse (company)” will increasingly fall short. Even excellent operational management teams might not have the ability to anticipate and respond to shifts in where profits and value lie.
Innovative Enough to Respond?
Our interviews with private equity senior executives indicate that most recognize the need for more specialized knowledge of business strategy and management. They acknowledge the importance of identifying business design advantages and weaknesses early on, conducting more robust analysis in the due diligence phase and working more aggressively with portfolio companies after the acquisition.
Unfortunately, the business designs and partner skill sets at the majority of funds remain more financial and transactional in nature. That limits the management time and resources available to work in a hands-on manner with portfolio companies. The tasks of evaluating business strategies, overseeing turnarounds, and contributing to innovative repositionings represent a significant expansion in the current business design and require building new internal capabilities, or directly or indirectly aligning with external partners such as strategy consulting firms and other specialists.
In the short term, firms with expanded capabilities will be able to help their current portfolio companies in several ways: improving marketing or operational performance, recasting product development and branding strategies, or repositioning the companies for an exit. Further ahead, these firms will find strategic capabilities increasingly valuable in evaluating new deals, actively identifying attractive sectors and sub-sectors, and managing post-acquisition value.
Despite the economic slowdown, opportunities still abound in private equity. Multiples on new investments have become more reasonable and credit liquidity will return, creating a new set of attractive investments. But firms first must work through the pain of a major investment cycle downturn and negotiate a difficult business design transition. Those that respond quickly and develop superior business designs will emerge from the next turn of the cycle in a better position to renew their growth.
Neal Pomroy is a vice president and leads Mercer Management Consulting’s private equity business in North America. Antonis Polemitis is a senior associate. They are based in New York.