Click here for printer friendly page

Stage set for star European performance

There's no shortage of bad news about Europe's stalling economies and exit routes drying up. But look a little further and you'll find that, in the medium term, the prospects for Europe's key private equity markets look bright.

The fall of high-tech investments has dominated the headlines for much of this year. US private equity firms have suffered badly, some unable to raise funds, others finding it impossible to exit investments. European funds are unlikely to escape entirely and some venture capitalists are already preparing investors for the worst by saying publicly that returns for this year will be well below those for last year. But in a long-term investment such as private equity, a year is a relatively short space of time. Despite current gloom in Europe, much has been happening behind the scenes to improve the medium-term prospects for private equity.

Something spectacular happened to the European private equity industry in the final few years of the twentieth century. Funds and investments grew at bionic rates and returns were often meteoric. The industry shrugged off its reputation for being a highly specialist niche practice operating in the shadowy corners of the capital markets. Governments began to view private equity as a way of boosting the European economy.

European governments have become increasingly excited at the prospect of invigorating the jobs-rich, growth-focused small business sector. For big businesses, private equity oils the process of restructuring and spinning off non-core assets. Investors no longer need to feel envious of the impressive returns being achieved on the other side of the Atlantic by venture capital and private equity funds. And, despite the recent downturn, the high-tech explosion helped to establish private equity as an important source of funding in Europe.

Healthy optimism
A recent research report produced by AltAssets, European private equity: the positive impact of legislation*, reports a healthy optimism among private equity participants across the continent. There is some caution about the industry's short-term prospects. Many are a little jittery about the effect of the internet boom and subsequent bust on this year's returns; others worry that the high returns of the previous couple of years will have skewed investors' expectations. ‘European institutions have taken to private equity quickly - too quickly maybe in the last few years,' says Ivan Vercoutère of LGT Management. ‘The adjustment is happening now. Investors are starting to realise that it is not easy and that they have to be cautious.' And yet the overriding feeling is that, in the medium term, Europe's private equity market will offer institutional investors a good home for their money because the right legislative framework has now been put in place.

The regulatory landscape has seen dramatic changes in recent years. Governments across Europe have done away with many of the restrictions on both the supply and demand side of the industry. One of the most significant pieces of legislation in Spain was the 1999 Ley Uno, for example. It meant that funds could for the first time be invested in unquoted equities. Meanwhile, the German government's massive tax reforms have cleared the way for a wave of corporate restructuring. Germany's new capital gains tax regime is likely to have a particularly profound effect on the private equity industry. ‘The change to CGT is one of the most important things concerning our industry,' says the chairman of the national VC association (BVK), Holger Frommann. ‘We expect that there will be a new boom because of this. There will be a lot of buy-outs of varying size.'

In the UK, the pressure has also been on to make legislative changes that will encourage the development of the private equity industry. Gartmore chairman, Paul Myners, recently outlined his own recommendations in the treasury-sponsored Myners review of institutional investment. A key proposal was for the abolition of the ‘minimum funding requirement' - a sort of solvency test for pension funds that has long been blamed for encouraging investors to overweight their exposure to gilts. Chancellor of the Exchequer Gordon Brown has accepted the recommendation and is expected to pass the legislation now that the general election has brought the Labour party back into power.

Wherever you look in the major European economies, governments are well down the road to completing phase one of the sort of reform that makes for a healthy private equity industry. And in some instances, as in the UK, the government has gone as far as to push the asset class up the agenda so that big funds are more or less obliged at least to think about it as an option. Wrinkles remain in the tax regimes, but these are mostly of secondary importance. The need for ongoing reform in these areas is now well accepted.

Once-in-a-lifetime opportunity
Many of these reforms have already started taking effect, particularly in deal flow. Talk to most venture capitalists and they'll tell you that Europe has, indeed, changed. Andrew Joy, director of buy-out house Cinven, talks about the new opportunities in Europe brought about by the ‘changing business culture'. ‘In the US, the large buy-out market is in stagnation,' he says. ‘In Europe, the market is growing. European companies are increasingly focusing on shareholder value and are disposing of their non-core assets. This happened in the US ten to 15 years ago, but it represents a fundamental change in Europe. It's a once-in-a-lifetime opportunity and it won't last for ever.'

Andrew Cowley, head of investment strategy at Dresdner Kleinwort Capital agrees. ‘The most interesting opportunities at the moment are in Europe,' he says. This is in part because of structural changes to the European economy - in Germany in particular. ‘In the German market there is a big opportunity in corporate orphans. There are around 6,000 subsidiaries of large companies that will spin off in MBOs and other take-private deals.'

There is still progress to be made. The industry itself will need to become ever more professional. And more will need to be done to encourage institutions across the continent to consider private equity - many are still wary about investing in the asset class. However, economic forces are likely to push this progress. The irresistible demographic pressure of ageing populations is forcing governments to rethink the extent to which the public sector can afford pension provision and private funding is set to explode. At the same time, the introduction of the single currency is accelerating this process of equitisation. It has already injected a concentrated dose of competition into the region's economy, introducing some more Anglo-Saxon economic principles into the boardroom, and helping to deepen Europe's capital markets dramatically. It may not arrive overnight, but Europe is on course for a much more dynamic, growth-oriented business culture.  And the implications of this change promise an enormous bounty for the private equity industry and the institutions that invest in it.

Key reforms in Europe that affect private equity investment