It’s Tough Out There, Deloitte Report Says –

In a market that has become increasingly competitive and open to more rigorous financial disclosure scrutiny, the private equity fund services group of Deloitte & Touche recently released a report that examines the 10 most critical challenges facing private equity firms today.

Due to a boom in the number of private equity firms over the past five years, GPs are finding that they must both create a niche and develop a brand name for themselves, said Alan Alpert, managing partner of global transaction services at Deloitte & Touche. And as there’s a limited number of companies up for sale, today’s tight market just makes the competition more fierce.

Even when the recession subsides and the intensity of competition lessens as more deal flow develops, “I don’t think we’re ever going to get back to the M&A environment that existed three years ago,” said Alpert.

Whereas in the past many firms relied on networks of their senior management to raise new money, a trend has developed toward focusing on marketing and investor relations. Firms are also asking themselves whether they will have the institutional strength to survive a leadership succession when their founders retire, according to the report.

“The question is, can a private equity fund survive the retirement of its founding partners?” said Ed Daley, partner at Deloitte & Touche. “Can it become an institution without one or two particular personalities?”

Daley said most of the larger firms are going to have to face that issue sometime over the next five years, and he underlines the need for marketing and even diversification.

“The Blackstone Group is probably a good example [of what private equity firms need to do],” he said. “It was once just a buyout firm, and now they do a lot of things, [such as] hedge funds and real estate.”

Another sea change for buyout firms has come in the form of operational structure. Remember the 1980s when LBO firms thought of hands-on management as simply aggressively cutting costs? In the coming year, management know-how will be a critical differentiator of success for private equity firms, according to the report. The enhanced returns from increased leverage that were common in the 1980s are now less common: managers of leveraged buyout funds reported last year that while 41% of the returns from acquisitions came from financial leverage put out from 1986 to 1990, this figure had dropped to 24% in the last decade. Meanwhile, the portion of returns generated by operating improvements increased from 34% to 43% over the same period.

The punch line is that private equity firms are finding that it takes more skill than before to generate value by improving operations and that firms need fewer financial engineers and more executives with hands-on operating experience.

“The tremendous opportunities to invest in a company and to do some financial engineering and then flip it for four or 10 times the money, I think those opportunities are few and far between,” said Alpert.

Similarly, he said, when firms invest in a business today, they’re going to have to invest more than financial engineering and capital.

“I think you’re going to have to bring something else of value, which is sometimes operating experience, to help improve the business and help to grow it quicker than it would have grown without you,” he said.

The issue of how and when to capitalize on technology investments also looms. Private equity firms face difficult trade-offs when considering technology investments in their portfolio companies, because these companies need to maintain cash flow, while still investing for the future. Deloitte & Touche believes not investing adequately in technology would clearly be penny wise and pound foolish’. On the other hand, firms have learned from painful experience that the size of a technology investment has little relationship to its effectiveness.

Daley said it’s a question of how much of a short-term investment private equity firms want to make to get how much of a long-term payoff.

“And it’s questionable as to if the long-term payoff is really what you expect it to be,” he said. As a result, potential buyers have to spend more time in the due diligence phase to determine when and what the payoff is going to be and how much value will come with an exit, he added.

Exit strategies are another critical challenge facing private equity firms today.

Although the biggest impact is on venture capital firms, where taking portfolio companies public is essential to generating competitive returns, the decline of the IPO market has raised serious challenges for the exit strategies of all private equity firms, according to the report. Buyout firms use IPOs to exit roughly one-third of their portfolio companies.

Other trend areas in the report include the lack of an objective standard for the valuation of a portfolio company, which appears to have generated widespread skepticism among investors about the accuracy and consistency of reported values. In the end, Deloitte & Touche advises private equity firms to re-examine their business continuity plans for both their own operations and their portfolio companies to prepare for a range of – often unexpected – scenarios.

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