Private equity primed for comeback

Contrary to suggestions by naysayers, the global private equity industry weathered the great recession rather stoically, and is now poised to see a marked increase in activity going forward, says David M. Rubenstein, cofounder and managing director of The Carlyle Group, one of the world’s largest private equity firms.

As the keynote speaker at the recent Private Equity Symposium, Rubenstein said the worst was over for the industry and that the future lay in the emerging markets.

“Emerging markets will become much more significant part of private equity, partly because this is where great growth is occurring in the global economy and partly because there is less private equity penetration there already,” he said, pointing out that Asian markets seem to be able to yield much higher returns than people thought it could a few years ago.

“We are witnessing that more and more money is going into the emerging markets,” he said. “Compared to the past few years, a much higher percentage of money went into emerging markets last year. Not only in terms of money being raised there, but also money being invested there.”

He cited a recent growth forecast that predict “for the first time, in the year 2014, the GDP of the emerging markets will surpass the GDP of the developed markets.”

It is a historic development. “As a result you are going to see much more activity in the emerging markets. I think China, India, and Brazil are probably the three most attractive markets.”

The symposium provided a forum for leading industry experts to discuss critical economic issues, as well as the challenges and opportunities posed by the current environment.

Part of the keynote presentation took the delegates through the history of private equity, which started as a small industry. Known at the time as “bootstrap industry”, it later reinvented itself as the “leveraged buyout” industry, before evolving into the “management buyout” industry. Finally, its identity settled on the private equity industry.

The industry peaked in 2007, with about a trillion dollars in assets globally.

“The reason for this growth was the fact that, over time, it promised returns in the multiples of what the market index would offer,” said Rubenstein. “The Canadian numbers show that the industry was following the global trend and deal value, activity, and fundraising were growing dramatically, peaking in 2006.”

There were concerns, however. These numbers didn’t do much to allay fears about the size of deals and funds, about the leverage from the deals and the price being paid for the deals. There were questions about likely returns from these deals. Issues such as taxation levels and losses incurred in privately backed companies further fanned the flames and brought unfavourable attention to private equity.

Worst fears and forecasts Then came the great recession. “During the recession people tended to think the private equity industry was doing one of the worst things to the economy and to itself. Many people expected large employee lay-offs from portfolio companies and thought private equity firms would implode, says Rubenstein.

Experts at the time predicted the industry would shrink dramatically. The impact was expected to force large number of partners to abandon the asset class, and sell their fund commitments into the secondary market.

“There is no doubt private equity suffered during the recession. You can see the field activity went down, fundraising numbers went down quite dramatically — from the second quarter of 2007 to the fourth quarter of 2009, they declined by about 87%.” In the U.S., distributions plummeted to [between] $2 million and $3 billion each quarter, from a peak of $18 billion.”

Canada followed the same curve. “The amount of activity being done (in Canada) was incredibly lower than what was the case before. The same is true of fund raising,” he says.

What actually happened Private equity firms fought the downturn by intensifying their focus on portfolio companies to ensure their survival. They cut operational costs, focused on areas of distress, scaled back their own fundraising, and drastically modified their business models, says Rubenstein.

“Their gravest concerns actually did not materialize. Private equity escaped the worst outcomes of the great recession. No major private equity firm went out of business. There were very few secondary sales. People didn’t like the prices so they didn’t sell,” says Rubenstein.

The banks that finance so much of the private equity industry expected to be left holding massive loan losses, but were able to dispose of the loans, even if they were at a discount. This allowed them to free enough capital to meet their capital requirements.

Contrary to the popular sentiment at the time, there were very few private equity bankruptcies and governments, generally, did not move to constrain the industry. The experience was the same on both sides of the Canada-U.S. border.

He took a dig at cynics who blamed private equity for “everything from leprosy to climate change,” while conceding that “(private equity) was not actually blamed all that much for the downturn.”

He chalks it up to the visibility of the banks and attention attracted by their loans. But in Europe, the story is quite different, and there is growing anti-private equity sentiment.

“The EU is considering a directive that will dramatically change private equity growth. If it goes through, Canada and the U.S. would not be able to raise money from private equity investors in Europe,” Rubenstein said. “Governments in the EU are probably the greatest threat to private equity right now. The EU would be the centre of much intense lobbying and activities.”

Europe has dubbed private equity ‘Anglo-Saxon capital’ as many continental Europeans firmly believe the industry benefits only the U.S., Canada and the UK.

“And that is not a term of endearment,” says Rubenstein. “Improving the image is important. Trade associations and other organizations in the U.S. and Canada, and those around the world, could improve the image of the industry.”

Efforts are being made to increase social awareness of the industry and to develop guidelines for responsible investment, he says.

The private equity industry is on the upswing, says Rubenstein. “One survey shows over 51% of institutional investors say they would again begin commitment to private equity funds.”

That, he says, is a big change from last year. He draws attention to increasing portfolio valuations and to deals getting done with different leverage ratios and in lower multiples. “The average equity contribution has increased. In the mid-1970s average equity component was only 5%, but it went up to over 30% in 2007, and now it is at over 50%.”

Industry transformation The private equity industry tends to transform itself to protect against recession and other negative trends. It is doing so once again by reducing the size of its deals and its funds. “I don’t think you are going to see a lot of $10 billion and $20 billion dollar funds. You will see a lot more $3 billion to $5 billion funds,” Rubenstein predicted.

Co-investments and diversification of product offerings are other trends that are predicted to emerge.

Some of the other protective measures would include sparing use of leverage, higher equity contributions, and more expensive debt. “The investment base is going to change a bit. You will see shrinkage of high-net worth investors. There will be more institutional investors, who were not as heavily hit as public pension funds were.”

(03/26/10)