Mar 18th 2010 | From The Economist print edition
THE locusts went hungry in 2009. The private-equity industry, the bête noire of many a European politician, managed just $81 billion of buy-outs, compared with more than $500 billion in 2007. Indeed, almost anything that could go wrong for the industry last year did so, as a recent report from Bain, a consultancy, makes clear.
Private equity has prospered for most of the past 25 years thanks to a favourable combination of circumstances: easy access to cheap credit, rising asset prices, a relatively stable economy and a friendly regulatory environment. But credit was neither available nor cheap last year. The industry raised just $20 billion of new loans in 2009, perhaps because managers were unwilling to pay double the spread (or excess interest rate) they had paid in the middle of the decade.
Equity prices did rebound last year but that was a double-edged sword. The result was that even those private-equity firms with access to capital found that deals were not as cheap as they might have hoped. Nor were markets quite strong enough for managers to offload the companies they had acquired earlier in the decade. Private-equity firms realised only $68 billion last year, down from $324 billion in 2007.
The lack of “exits” from investments had a further knock-on effect. When private-equity managers sell companies in their portfolios, they distribute the proceeds to their clients, known as limited partners (LPs). These distributions allow the LPs to invest in new private-equity funds. In addition, many LPs are pension funds or endowments which have target allocations to private equity in their portfolios. Because the declared returns of private-equity managers outperformed public markets in the crisis (something that may have more to do with the way portfolios are valued rather than any inherent superiority), many LPs found their weighting to private equity reached its maximum allocation. With distributions also low, LPs were unable to sign up for new funds. The industry raised just $248 billion in 2009, down from more than $600 billion in each of 2007 and 2008.
The good news, as Bain points out, is that some managers still have plenty of “dry powder” left, having raised funds in the boom years. Around $1 trillion of uninvested capital could be put to work. The bad news, from the managers’ point of view, is that with debt harder to get hold of, more of this capital will have to be invested in the form of equity. That means gross returns will be lower than in the golden days of the industry when internal rates of return reached 30-50%.
Another big problem is the refinancing hump that faces the industry between 2012 and 2014, when Bain estimates that some $460 billion of loans will need to be rolled over. The investor base that originally bought this debt—the managers of collateralised-loan obligations (CLOs), specialist funds that purchased leveraged buy-out loans—will not be able to help, as the market for new CLOs has collapsed in the wake of the credit crunch.
Many of these loans relate to deals done in the boom conditions of 2005-07, when prices were high and companies ended up being financed by too much debt. There may still be bad news to come from those deals. Banks have been reluctant so far to force problems into the open by adhering to the strict terms of debt covenants—they have little desire to create more write-downs on their stretched balance-sheets.
The final factor to throw into the mix is the effect of tighter regulation. European politicians postponed debate on the Alternative Investment Fund Managers directive this week (see article) but the industry is still worried about the legislation that will finally emerge from the Brussels sausage machine.
To offset all this, the industry needs a charm offensive. It needs to show, both to investors and to politicians, that its returns are based on something more than exploiting cheap finance and the tax-deductibility of interest payments. And it needs to show that it can manage companies for growth, not just cost-cutting.
Of course, many private-equity fund managers would argue that academic studies already demonstrate they have such virtues. The difficulty, at least on the European side of the Atlantic, is that there are very few Googles—high-growth, well known businesses that can trace their initial success to private-equity or venture-capital backing. And in a slow-growth economic environment, it will be very difficult for the industry to start generating such examples in the next few years.