The end of private equity?
Robin Buchanan, President of London Business School, discusses the shape of private equity when it emerges from the current crisis
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The early years of this decade were a boom time for private equity. Buy businesses at low multiples just after the bursting of the dotcom bubble, add bucket-loads of debt that was served up by the banks in vast quantities (and increasingly ‘covenant lite'), and then sell at the high multiples available as the economy went into overdrive three or four years later. Fantastic! For a while at least. But the feast attracted new players and even more equity and debt into the industry. This excess supply of capital forced up purchase multiples leaving private equity firms dependent on their ability to sell these businesses subsequently at even more stratospheric prices. Whatever they believed in 2005 and 2006 doesn't stack up with the grim reality of 2009. Indeed, the private equity industry is now reeling from the global credit crisis. Fund executives are overwhelmingly distracted by incipient and actual disasters in their portfolio. Problems caused by overpaying for businesses between 2005 and 2007 are being made worse by the current economic crisis. Some investments have been wiped out. Others are absorbing enormous amounts of time and additional resources as financial, managerial, and operational restructuring is put into place. Opportunities for exits at decent prices have been vastly reduced. Returns to limited partners and success fees, ‘the carry', for general partners will be, at best, very low for the majority of recent vintages. Many investors are sitting on losses of 50% or more.
Not surprisingly, raising new funds is a battle. Most private equity firms are not even trying. Worse, some investors are attempting to get their uncalled commitments rescinded. Those firms who have not yet spent the money they raised in the last couple of years are better off than their spendthrift competitors. However, they too have a problem. There is not yet much available to buy. In fear that the damage to their balance sheets would be too great, quoted companies are not selling businesses to private equity firms unless they have no option. Furthermore, there is a lack of debt to finance whatever new deals there are. Many private equity houses are convinced that asset prices have further to fall, so are not buying anything anyway. As a result, buyout activity has slowed almost to a halt. On top of everything else, the threat of increased regulation and growing public scrutiny looms large. All this bad news comes as a rude shock after a golden period of low inflation and nominal interest rates, a surplus of liquidity, and rising asset prices.
Indeed, the dream has turned into a nightmare as a wave of redundancies sweeps through the industry, including at leading players 3i, American Capital, Candover and Carlisle Group. So is this the end of private equity as predicted by some? Or just the usual boom-bust cycle in action? If this is only cyclical the answer is clear - buy in 2010 when prices will probably still be low or even lower, add debt as and when it becomes available, and sell again the next time the economy overheats. After that take four years off, then come back and do it all over again. Attractive as this strategy of riding the economic cycle might sound, it is unfortunately probably another dream. The industry has grown phenomenally over the last ten years and is now maturing. There are many more players, investors, and bankers than there were a decade ago. There is more than a whiff of over-capacity. Competition for funds and deals is going to be much tougher. Overcapacity in cyclical industries becomes very destructive of profitability. The opportunity for private equity to ride the economic cycle may have passed.
My involvement in private equity began in 1982. I was hired in the USA by Bain & Company, the leading consulting firm, which wanted to get into the LBO business. The mantra in the LBO industry at the time was buy-low, sell-high, add lots of debt. That created a problem for us. Back in the early eighties we didn't know how to buy low or sell high or anything about debt. So we used what we did know. We knew about markets, customers, products, competition and costs: we knew how to add value in between the buying low and the selling high. As a result, in September 1984 we set up our first fund in the gigantic sum of $37 million! Bain Capital separated from Bain & Company in 1987, and since then has become one of the top performing private equity firms of all time.
Having helped set up Bain Capital I returned to the UK in 1985. Not long thereafter, my Bain & Company colleagues and I started building a consulting practice focussed on private equity in London. It is now the largest private equity consulting practice in the UK, Europe and indeed the world.
Over the last 27 years, I have been told countless times that private equity is a fad. That it will go away. It hasn't. It won't. Adaptable private equity firms will surmount the current challenges, huge as they are. There are two main reasons why.
The first reason is that this new environment presents enormous opportunities for those private equity houses with the capital and skill. Richard Lambert, Director General of the Confederation of British Industry, referred to some of these in his recent speech to the British Private Equity and Venture Capital Association. For example, some private equity firms are sitting on large amounts of cash and callable commitments. Companies in choppy waters want more equity on their balance sheets; the need for private equity capital is greater than ever. Reduced prices for equity will lead to strong returns. We may be about to have one of the best fund vintages we have ever had.
The second reason is that private equity principles work - not just in private equity but in all companies1 . The most important job of any chief executive, any management team, any board is to make the business more valuable. The best private equity investors are focused on exactly that. One should not underplay the importance of buying low, selling high, and adding the right amount of leverage. That still can create massive amounts of value for investors - especially at the beginning of economic boom times. But great private equity investors and the management teams that run the successful portfolio companies do something more. They work out the four or five things that will make the investment successful. Then they put a plan in place to achieve that success. They put in excellent people to make the plan and the success happen. They make the leadership and much of the team feel like owners. They strip out all the unnecessary assets. They also put in enough debt not just to provide gearing but also to concentrate the mind. These disciplines supported by the leadership and energy of private equity professionals are more valuable now than ever. In fact, as London Business School Professor Viral Acharya has demonstrated, private equity backed companies outperform their quoted company peers during economic and sectoral downturns 2 . Furthermore, as demonstrated in research covering a 22 year period, companies backed by private equity that subsequently go public, so-called Reverse Leveraged Buyouts, also outperform their listed company peers. This is particularly true when the companies have been in private equity hands for a while 3 . These two authoritative pieces of research demonstrate the positive transformation of the management mindset caused by private equity ownership. The benefits to the overall economy as well as to private equity investors are enormous.
So what should private equity funds do going forwards? To begin with, they should review their business model to see if they need to be quite so debt reliant. Lack of debt finance, together with a belief that prices are still too high, is probably the main reason that private equity firms are sitting on their hands right now and not doing deals. They have got so used to high leverage that they are petrified that without enormous amounts of debt finance, they will not be able to get the returns. However, debt is not the only lever available to private equity players. If you are a private equity fund wanting to outperform there are four levers you can pull. One, the price you pay for the investment. Two, how much leverage you add to that investment. Three, how much value you add to that investment under your ownership. And four, how much you sell for. Let's review each lever in turn. Right now purchase prices are falling. They are probably going to continue to fall, so that is good news for private equity. The only difficulty is deciding when the market has bottomed. Secondly, there is very little debt out there right now and that is bad news. But ask yourself, are banks going to give up lending forever? Can we expect to have no debt availability over the next five years? Will sellers refuse to provide finance? I do not think so. Debt will come back, admittedly probably less of it, and with tighter covenants. Thirdly, private equity should build the capability, if they don't already have it, to add real value to the enterprises in which they invest. This emphasis on increasing strategic and operational effectiveness will be essential. Private equity firms who got by in recent years just by adding debt were riding a phenomenal wave. In this harsher time they will simply not cut it. Many are already losing their shirts. Indeed, Limited Partners in "transaction focussed" funds have historically lost out badly in downturns. The combination of inadequate evaluation of risk premiums and excess credit in the boom years led to high acquisition multiples which were never recouped. Those private equity houses that were in the business of buying low, adding debt, and selling high are yesterday's news. Frankly, they are going to struggle to find available debt anyway. It is the ones who actually create enormous amounts of value in between buying and selling who are going to thrive. Fourthly, as for selling high, none of us can predict the future. Given current low purchase prices, most people in the industry believe that sales multiples three or four years from now have a very good chance of being higher than they are today.
There is another critical requirement for future success beyond addressing the four levers. It is time to recognise that the industry has grown up and needs to behave accordingly. Private equity firms need to earn and maintain the support of society, a "license to operate". If you are selling newspapers on the street corner, your "license to operate" does not cost very much. Usually a smile at the passing policeman will do the trick. If you have an enormous nuclear power station within 100 miles of your capital city, then governments, regulators, planners, NGOs, local communities, and trades unions will be swarming all over you to find out what you are up to. The private equity industry has grown from being a couple of street corner news vendors to become a regiment of nuclear power stations. It needs the public on board.
These two necessary adaptations - building real capabilities to add value and acquiring a ‘licence to operate' - are nothing, however, compared to the extraordinary development and resulting success of the industry over the last 25 years. Do not mistake recent setbacks for the end of private equity. The industry is smart enough to evolve. It now has a superb opportunity to prove its mettle.
Robin Buchanan is President of London Business School, the home of the Coller Institute of Private Equity. He was the Managing Partner and then the Senior Partner of Bain & Company in the UK from 1990 to 2007. He was one of the team of six who helped set up Bain Capital in the 1980's. He has consulted to many private equity firms and their portfolio companies. He is also an investor in private equity funds.
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1 Orit Gadiesh and Hugh MacArthur, Lessons from Private Equity Any Company Can Use, Harvard Business Press 2008
2 Viral V. Acharya, Moritz Hahn and Conor Kehoe, Corporate Governance and Value Creation: Evidence from Private Equity, Working Paper, Coller Institute of Private Equity, London Business School, 2008
3 Jerry X. Cao and Josh Lerner, The Performance of Reverse Leveraged Buyouts, NBER working paper, October 2006