By most indications, 2011 should be a very good year for private equity. Deal flow is increasing, leverage is returning at a faster pace than many expected, and exit opportunities are increasingly available–through IPO, strategic sales and secondary transactions.
But a variety of challenges lie ahead including a volatile global market, challenging fund-raising conditions, continued desire by investors for more transparency and the institution of new regulation passed in 2010 in both the United States and Europe. Firms will need to proactively address and manage these challenges as they develop their for 2011 and beyond.
Deal flow significantly increased in 2010 and this trend looks to continue. In 2010, private equity firms closed nearly 2,000 deals worldwide, for a total value of more than $233 billion—an increase of 24 percent in volume and more than 125 percent in value, according to Dealogic. Activity was particularly brisk in the emerging markets as overseas funds expanded their footprint to participate in the growth of developing markets. IPOs also served as better exit vehicles than they had in years, with 155 private equity-backed companies raising $35 billion, more than twice the amount raised in 2009, and three times the amount raised in 2008. Secondary deal volume also improved—accounting globally for 30 percent of private equity exits—and should continue this upward trend back to normal levels seen in 2004 to 2005.
The number of creditor exits was lower compared with numbers in past downturns and liquidations were relatively scarce. Exits to creditors over the last two years were far lower than media reports expected. In fact, a study conducted by the Private Equity and Growth Capital Council found that private equity-backed companies defaulted at less than half the rate of comparable companies.
Private equity firms still have significant capital to invest. Though fundraising remains challenging, private equity firms have a global war chest now estimated at $444 billion, according to Prequin data; however, commitment periods are expiring soon. Financing is also more readily available. Lenders are less wary than they were a year ago and the amount of equity required for a deal is trending lower, from between 45 percent and 50 percent at the peak of the recession, to approximately 40 percent—and sometimes lower—in the current market. Banks are more interested in working with private equity firms now, and high-yield debt issuance reached a record high in 2010, with more than $400 billion in new bonds sold to investors eager for yield. While LBO lending may never return to heights seen during 2006 to 2007, debt levels have bounced back to historic norms. Private equity firms should be in full acquisition mode this year.
Market psychology is important for a vibrant transaction environment and the outlook of investors remains fragile. Deal volumes may be up in private equity and M&A transactions generally, but many corporates retain a wait-and-see attitude. One recent Ernst & Young survey, the “Capital Confidence Barometer,” found that 75 percent of companies say they plan to focus on organic growth in the coming year, potentially directing some of the $1.9 trillion cash on hand, according to Capital IQ data, to internal investments rather than external acquisitions. This would limit a key exit route for private equity.
2) Squeezed returns. As noted by Pitchbook in its Annual Private Equity Breakdown 2011, American private equity portfolios have reached an all-time high of approximately 6,000 companies at the end of 2010. Over the last five years, the number of private equity-backed portfolio companies grew by approximately 19 percent annually. Expected returns will struggle to achieve the 30 percent range seen at the height of the market, pulled down in part by the longer-than-anticipated holding periods of the current crop of portfolio companies. Any hesitance in the transaction market could squeeze returns further. Private equity funds must continue their focus on operational improvements to allow them to react quickly to exit opportunities.
3) The tax collector cometh. Strapped for cash, many governments are looking hard for revenue and becoming increasingly aggressive in their handling of large transactions. Predictably enough, some are being particularly tough with non-resident entities that pose little domestic political risk.
4) LP transparency. Beginning in 2008, limited partners have stepped up demands for increased transparency from the private equity industry. To this end, the Institutional Limited Partners Association issued its first set of Private Equity Principles in September 2009. Recently released and updated Private Equity Principles, coupled with the introduction of templates to help ease adoption of the guidelines, provide opportunities for standardization. Continued attention will be needed by private equity, especially as LPs increase their level of scrutiny as fund-raising heats up in 2011 and 2012.
5) Growing regulatory requirements. Regulators are now demanding much more transparency from private equity firms. This year, regulations and reporting requirements will grow substantially in both the United States and Europe. It’s a short-term response to the crisis, but clearly an issue that will occupy private equity and that ultimately will have long-term implications for the industry.
Indeed, the Dodd-Frank Act has established a variety of new reporting requirements that will create much more paperwork for private equity managers. Most funds with more than $100 million in assets under management will need to appoint a chief compliance officer. They will also be required to register with the Securities and Exchange Commission and be subject to SEC regulatory oversight unless they qualify for an exemption because they are a family office or a venture capital firm. However, even smaller firms will be required to do some reporting. Not only will it mean more documentation, it also signals a desire by the government to perform more regular inspections and reviews of investment management offices.
In Europe, passage of the long-debated Alternative Investment Fund Managers Directive by the European Parliament is likely to create more work, too. Although the Directive harmonizes rules for fund managers by enabling one European approval to act as a passport for all markets, the new rules actually raise the regulatory bar in a variety of ways. Among other things, the rules require more organizational structure, monitoring, third-party oversight, and enhanced reporting and disclosure requirements.
Much of the challenge will now shift to understanding and responding to future guidance, rules and requirements that result from these new regulations. The devil will be in the details, and implementation of the regulations could take one or two years, if not longer.
The “back-office” now moves center-stage. Solid internal control and reporting systems are no longer optional. Private equity firms will need to find ways to proactively manage both increased regulation as well as the need for increased transparency with LPs. For all but the biggest firms, this is likely to be a significant and complex investment.
All in all, this heightened regulatory and LP scrutiny will mean more effort for private equity firms. Handling it well may even become a source of competitive advantage— determining the winners and losers in the industry.
How To Win
The most serious risk, of course, though not the most probable, is another macro-shock. Sovereign financial risks seem likely to remain high, particularly in Europe, and currency volatility or trade wars could damage the prospects of many companies that rely on export sales or on access to imported commodities.
Our upcoming report, the 2011 Global Private Equity Watch, notes that many new funds are pursuing specialized geographic and industry niches. While likely to appeal to an LP community seeking more diverse investment opportunities, it is a strategic choice that could leave many private equity players especially vulnerable to trade wars and market volatility. Public and more balanced firms may be better positioned to weather another shock.
In the end, even as fund managers position themselves for a more prosperous decade, the most important question they may want to ask is: How well is our portfolio prepared for another major political or macroeconomic event?
It’s a question well worth asking, and not just because of the recent crisis. In a world that has seen at least four major market crashes in the last 30 years, the collapse of one major military superpower, the rise of four new economic powers, and a revolution in information technology, the chances of a disruptive event starts to seem almost more likely than not.
Predicting what that shock might be is a risky game, but one thing is certain: Regardless of what 2011 has in store, the private equity firms that will come out on top will be those that have continued to diversify in the wake of a changing economic environment, that maintain clear focus on enhancing value in their portfolio companies, that proactively work with their LPs and increasingly, those who invest in their back offices.
Jeffrey Bunder is a partner in Ernst & Young LLP’s Transaction Advisory Service practice and the Global and Americas Private Equity Leader. Mr. Bunder has more than 22 years of industry experience, advising both private equity and corporate clients on various transactions such as mergers, acquisitions, buyouts, spinoffs, initial public offerings, carve-outs and debt offerings.