Private equity training course question: recent issues affecting the industry

The question: what are some of the big issues facing the Private Equity industry?

Background

Private equity is a subset of the funds management industry. Private equity firms draw down funds from their investors and use those funds to buy portfolio companies. The private equity firms charge investors a small % of funds under management but hope to make most of their money when portfolio companies are sold, splitting gains on sale with their investors.

The big threat for the sector is consolidation amongst private equity firms who can’t sell portfolio companies at a profit and attract new investors (who pay fees) in.

The private equity industry: past trends

Past features of the private equity industry, which have attracted public comment include:

1. High pay for private equity executives. Controversy over high pay outs for private equity executives, leading to an increase in the UK capital gains tax rate to 18% across all businesses, impacting more private business owners than private equity firms.

Reference: “Fund success leads to bumper pay-outs at CVC”, by Ellen Kelleher, Financial Times. Published Oct 15, 2007.

Private Equity executives have made their money by capturing a share of the upside when they sell portfolio companies at a profit. Reference: “Private equity investors: The bosses, the takeovers and the dividends”, by Martin Arnold, Financial Times. Published October 31 2007.

2. Union pressure. Private Equity executives were under pressure from unions for the changes they make when they restructure portfolio companies. The heat has died down a bit for them since we have all had the credit crunch to worry about!

Reference: “The bashful buy-out king”, by Peter Smith, Financial Times. Published: Apr 24, 2007.

3. A lot of debt. Pre credit crunch, high levels of debt were being used to fund purchases of portfolio companies. Now private equity firms can’t purchase companies with as much debt as they could, and this has some severe implications (see points 6-8 below).

Reference: “Overheated private equity market suggests trouble ahead”, by Martin Arhold, Financial Times. Published: Oct 5, 2007.

The private equity industry: recent trends

More recent trends for the private equity industry include:

4. Debt write offs. Write downs in the valuations of loans, much originating from private equity buy outs, tempting distressed debt buyers into the market. They see an opportunity to make their investments at reduced values. One of the criticisms banks have faced is that they lent too much money to private equity portfolio companies.

Reference: “Banks tempt 'vulture funds' to shift $200bn LBO backlog”, by James Mackintosh, Financial Times. Published October 5 2007.

5. Stuck with high debts. Private equity portfolio companies, with high levels of debt and unable to sell themselves at a high value, are likely to face difficulties refinancing their existing debt.

The level of debt being supplied by banks is very low, despite the extent of government support they have received. Pre-credit crunch principals could raise anything up to 10x for the biggest buy outs, sometimes more. Now, for mid-market deals, it is down to around 3-5x EBITDA, less for smaller deals. Anything beyond that is a stretch for banks, so little debt is available to fund buy outs.

Reference: “Private equity faces refinancing headache after era of easy money”, by Henny Sender, Financial Times. Published: March 18 2009.

6. Stuck with portfolio companies. Private equity firms are having trouble selling their businesses at high values, partly because banks won’t lend the money to the purchasers.

Banks are dancing with fewer and fewer partners. Banks are, unofficially, limiting who they provide finance to. Banks are so short of finance that they’re choosing to work with people they have backed before, so as to preserve those relationships. Banks are not advertising this but, according to industry insiders, it does seem to be the case. This makes it very hard for someone who needs finance to get it, because the number of potential banks they can turn to is limited to those they have worked with before.

Pre credit crunch private equity firms used to drag a couple of banks into the room for meetings with potential vendors. One or none of those bankers would expect to get the deal but they would all play the game because they were so desperate for the business. Now the boot is firmly on the other foot. The challenge for private equity is just getting one banker committed when vendors are very wary of a potential buyer who can’t demonstrate that they can get bank finance in place.

So we’ve got banks supplying a reduced amount of available finance. At the same time valuations of portfolio companies are plummeting and private equity firms are having to book the losses.

Reference: “Private equity exits plummet”, by Martin Arnold, Financial Times. Published March 25 2009.

Reference: “European buy-out funds left bruised”, by Martin Arnold, Financial Times. Published April 15 2009.

7. Forecasts for a cull in private equity firms. If they can’t get exits and make profits, private equity firms can’t attract new investors in (who pay them management fees and bonuses) and they’re out of business.

Reference: “Buy-out bosses warn of private equity cull as 'tourists' quit”, by Martin Arnold, Financial Times. Published: March 16 2009.

Reference: “Candover assures it can meet debt covenants”, by Martin Arnold, Financial Times. Published: June 2 2009.

8. Investors taking flight. Private equity’s funds are at risk of evaporating, as investors put less money into private equity funds.

Reference: “Permira hopes fund move will appease investors”, by Martin Arnold and Henny Sender, Financial Times. Published: December 7 2008

Reference: “Investors steer clear of private equity funds”, by Martin Arnold, Financial Times. Published: April 2 2009.

9. Increased regulation. The private equity industry, post credit crunch, is seeing the threat of more regulation imposed on it from Europe. This seems a bit harsh if you take the view that the industry has been a victim, rather than a cause, of the credit crisis. Most commentators would have thought regulation might be targeted at banks before private equity firms.

As mentioned at the top of this article, the big threat for the sector is consolidation amongst private equity firms who can’t sell their portfolio companies at a profit and attract new fee-paying investors in.

The private equity industry: opportunities

Opportunities in the sector are there for:

- Private equity firms that do have cash to invest (now should be a good time to buy assets);

- Specialist private equity firms that invest in stressed businesses;

- Specialist investors in distressed debt. They have the opportunity to buy debt at a low face value and then sell on at a profit later;

- Specialist investors who purchase private equity companies’ portfolios wholesale;

- Advisors who can help private equity firms refinance debt as well as crunch their businesses or portfolios together to deliver savings.

In short, the industry is facing outrageously difficult times but there are always opportunities for someone!

About the author: training company FTA Ltd

This blog post was written by a course trainer in response to a question received on one of FTA Ltd's CPD courses.  FTA Ltd is a provider of finance-related CPD course training and financial modelling course training to accountancy, banking, law, and  financial services industry professionals.  Please see www.cpd-courses.org for more information regarding FTA Ltd.