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PRINT THIS PAGE Market commentary28/05/2008. Source: Newgate CSP.
The start of 2008 has seen a steady flow of bad economic and financial news, with continuing uncertainty in credit markets and signs that there are increasing downside risks to the global economy. These trends are likely to increase pressure on private equity-backed businesses, writes Newgate CSP in this market commentary. In this environment, how should the experienced private equity investor respond? There are now tentative signs that the fall out in capital markets at the turn of the year may now have stabilised, and some commentators are starting to talk about the worst being over. However, the real risk now is the extent to which the ongoing shortage of credit feeds through to the real economy. Leveraged buyout debt continues to trade at a signifi cant discount to par, anticipating a substantial rise in default rates. If default rates do increase, this has significant implications for highly leveraged private equity backed companies and the funds which hold equity in them.
The key question for private equity managers and investors is: how bad will the fallout be? Will we see leveraged buyout funds suffering a similar fate to venture funds following the collapse of NASDAQ in 2001? The driver of losses on those investments was the collapse in enterprise values (remember the 90% club?). No one is now forecasting similar declines in company valuations. But, where businesses have been bought on historically high earnings multiples funded by record levels of debt, it only requires a relatively modest decline in enterprise values to have a substantial impact on the value of the equity.
The immediate threat to leveraged companies is a decline in operating profit sufficient to breach covenants, causing debt defaults. While in some more recent transactions the use of ‘covenant lite’ structures may defer the day of reckoning, it will not change the basic arithmetic. In such circumstances, the equity holders will be fighting a rearguard action to avoid write-offs. Private equity managers will have to commit substantial resources when attempting to recover value from such investments.
The challenging environment of the next few years has the potential to result in significant change amongst private equity managers. Some will be badly hit by their fund’s underperformance impacting their business model. Others might see substantial turnover in personnel driven by diminishing prospects of carry - experienced partners may retire and aspiring lower ranking executives seek better opportunities elsewhere. Some private equity mangers are likely to emerge from this with reputations enhanced; others will struggle to raise their next fund.
How should the long term investor in private equity respond to this changed environment? Distributions from existing funds are likely to fall substantially as exits dry up. Portfolio losses are likely to rise, eroding the excellent returns that have been achieved in the past few years. At the same time, new investments written in the current environment are likely to benefit from lower entry pricing driven by the reduced availability of leverage, lower profit expectations and lower vendor price expectations given falls in comparable quoted businesses. If history is repeated, 2008 vintage funds could deliver excellent returns.
Bolder private equity investors will see this as a time to take stock of their current fund positions, and look to rebalance their exposure. The development of the secondary market has enabled investors to sell a wide variety of portfolios of private equity investments at competitive prices (to an extent that was not available in the Tech downturn of 2001-2003). Indeed, the record amounts raised by secondary funds in 2007 means there is no shortage of buyers. An example of such an approach is the recent sale by CalPERS of a portfolio of over 50 legacy fund interests with a reported value of $3bn. Investors who take a particularly negative view of the immediate outlook could sell a portion of their existing portfolio in the secondary market to effectively hedge the returns of the last few years and provide additional investment capacity for current vintage funds.
The message to private equity investors is to recognise that the benign conditions that led to the exceptional returns enjoyed recently have changed. The new environment will present significant challenges for some business models, but create substantial opportunities for others. In such circumstances investors should hold their nerve, but be rigorous in their selection of managers to back. Those that are bold in their review of current relationships, and incisive in their selection of new relationships with the potential to outperform at this stage in the cycle, are likely to reap the greater rewards.
Newgate CSP is an integrated investment and advisory business focused exclusively on private equity. Newgate CSP provides a range of advisory services and offer investment opportunities to both current and potential participants in the private equity market. These range from long established major institutional investors and private equity fund managers through to smaller institutions and private individuals seeking access to the private equity asset class. For more information go to www.newgatecsp.com
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