Between the years 2001 and 2003, when a vast number of private equity portfolios were underperforming due to the slow economy, the buyout market was ripe with speculation of when a shakeout would occur. But as fortune had it, the economy turned around, interest rates remained low, portfolios perked up, and the stage was set to host today’s record-breaking deal market. There has yet to be an industry-wide shakeout in the 40-year-old buyout market.
And though one could argue that the extent to which the market has evolved over the past 18 months could lead to a shakeout, buyout pros say the likelihood of that are next to nil.
There are well over 1,000 private equity firms looking for deals in the U.S. alone. Add to that the steady stream of new startups and spinouts, the mounting mass of starved strategic buyers on the prowl for fresh assets, a growing class of sophisticated sellers, scores of fast-paced investment bankers leading expensive auctions, a large capital overhang and an abundance of inexpensive debt that’s being used to leverage portfolio companies to levels not seen in years, and you have a snapshot of today’s private equity marketplace.
And yet, amid this crowded amalgamation of frothy chaos, buyout pros remain confident that the investment practices needed to compete in it-specifically the necessities to work fast and lever heavily-are not putting their portfolio companies in positions that could preclude strong return on equity.
“If you look at the amount of private equitycapital availablerelative to public-market equity value, thatpercentageremains very small and has beenlargely consistent over the years,” says Jonathan Lynch, a general partner at JPMorgan Partners. “So I don’t see increasing capital formationin the private equity space driving a shakeout in the industry.”
“I don’t think private equity firms are being reckless,” adds Jeff Rosenkranz, a managing director at Piper Jaffray. “Certainly they’ve been more aggressive, and I think part of it is just the general cycle in the market. They have to be more aggressive because the market is more aggressive.”
As such, any firm that hasn’t don so already, will have to shift from trying to buy low and sell high, to the scenario of paying a “fair price” for a business and finding a way to create value during the ownership period, Rosenkranz added.
But for every action there is an equal and opposite reaction, presumably. The hefty debt multiples that accompany today’s higher prices will likely have an impact on what some firms are able to do to prod out returns, especially in what has become the age of the dividend recap. “With regards to some of the bigger guys, they’ll be able to finance their deals; I just don’t think they’ll be able to recap them at the rate we’ve seen,” says Kevin Landry, CEO of TA Associates. “They’ll be able to recap an ’02 or ’03 deal, but I don’t think they’ll be able to recap the stuff they’re doing in ’05-unless they have spectacular performance…” But, he added, the extended 10- to 12-year life of a buyout fund should provide ample long-term returns to fill any void left by a retreat from the dividend recap.
And to the extent that there is any downsizing in today’s buyout market, deal pros say that it most certainly will not be of the wholesale sort that rocked the venture capital arena after the tech bubble burst. Instead, they say, the only shakeout we’ll see in the buyout market is the same naturally occurring one that has befallen underperforming funds since the asset class’ beginning-where even firms with sub-par returns tend not to flee the market or get squashed completely by LPs, “When you think of the term shakeout in an industry, you usually think about companies that go out of business,” said one private equity pro who spoke on condition of anonymity. “Here it’s not a function of these firms going out of business, it’s more a function of which firms are able to grow their capital base and become more impactful competitors in the marketplace, and which have taken a step back.”