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The Golden Age of Private Equity?

Private equity firms, which hold $100 billion in uninvested funds, are coming into the improving economy with an appetite for large deals. In some cases, they are forging alliances to come up with enough equity to compete for promising opportunities, according to speakers on a Knowledge Wharton panel titled, Financial sponsors: Finding value in a competitive market.

Michael Movsovich, a partner in the law firm Kirkland & Ellis, suggests that the new attention to private equity has increased competition and speeded up deal making. "It used to be you had time to develop relationships. Now everything is an auction or a potential auction."

The burgeoning size of private equity deals is driving a trend toward large syndications, he said. "This is a sign of how mature the industry is and where it is going. What we have seen in these big deals is a need for capital and diversification for truly large deals." Deals today are so large they are beyond the equity capitalization that even a large, established private equity firm such as The Carlyle Group or KKR can muster.

To raise even more money, private equity firms have turned to pension funds and insurance companies, but to attract those investments, private equity funds have been forced to distinguish themselves with specialized expertise to draw investors trying to diversify their holdings into the best investments. "You have seen a stratification of the private-equity business in the last several years," said Movsovich. "In order to raise capital from pension funds and insurance funds, people have had, by necessity, to distinguish themselves and develop expertise."

When private equity firms team up, he added, many legal issues arise in structuring the arrangements. For example, firms need to consider whether it will be a 50-50 joint venture. How will the board be structured to respond to disagreements? What is the projected lifespan of the partnership?

"Some have said we are living in the Golden Age of private equity," said Daniel A. D'Aniello, founding partner and managing director of The Carlyle Group, the Washington, D.C.-based private equity firm with more than $18 billion in funds under management. Investor disenchantment with the technology crash, combined with cheap debt, gives private equity firms power to pursue deals on their own, or in partnership with other private equity firms, that previously would have been the province of large, public funds, he suggested. "I would argue the consolidation has already taken place."

Pension funds have tried to exploit economies of scale and drive down back-office expenses by concentrating investments with fewer and fewer asset managers, he added. The winners have been firms that have invested in infrastructure. That has allowed them to perform well under the new Sarbanes-Oxley regulations. "Fiduciary issues are now preeminent - as well as economies of scale."

D'Aniello predicted the industry will develop along two lines: One to two dozen firms with global resources on one hand, and small specialized boutiques on the other. "The middle market is pretty barren especially with respect to generalists," he said. "In the early days you could get away with being a generalist. Not anymore."

D'Aniello cautioned, however, that pension funds and insurers are not too supportive of the private equity partnerships because they like to spread their investments across firms to remain diversified. When private equity firms team up, institutional positions are consolidated. "Not only that, they are being consolidated at the highest price possible."

D'Aniello forecast that financial spreads will tighten. As a result, The Carlyle Group is building in-house expertise in the industries and companies that make up its portfolio. "Carlyle is focusing on operational people rather than financial engineering. In the future, money is going to be made on the factory floor, not in the investment banking or the commercial banking office."

A generational shift

According to John A. Katzenberg, managing director of Citigroup's financial entrepreneurs group, strategic buyers looking to make acquisitions that will complement their existing business have been losing ground to financial buyers in recent years. At the end of the 1990s, strategic buyers using their own stock price were able to trump financial buyers in making deals. The subsequent fall-off in stock prices has now put more power in the hands of financial investors, who are benefiting from cheap and available capital. "In many transactions where there would be a strategic buyer, they are being outbid by financial buyers." Katzenberg also said regulatory requirements on financial buyers have been reduced. "They are willing to pay more and get less return."

Despite a lot of attention in the press, Katzenberg noted, hedge funds do not represent a significant amount of activity in the private equity market. Hedge funds have mostly concentrated on buying debt securities of distressed companies. Hedge funds and private equity firms each have about $1 trillion under management, "so they have equal buying power but the skill set needed to buy and invest in private equity is different than the skill set of running a hedge fund. You need infrastructure. You need people who understand an industry, can do due diligence and have deep relationships with management and investment bankers."

Jorge Mora, executive director of UBS Investment's financial sponsors group, predicted that private equity investment in Europe will outpace that in the United States in the next few years. The private equity industry is maturing but may still face some volatility ahead. "Is it here to stay? Absolutely. Is it stable and predictable? I don't think so."

Mora pointed to a generational shift that will take place in the private equity business in the next decade as big name figures in the industry, such as Henry Kravis and Tommy Lee, retire. Younger partners in firms may decide to spin off their own funds. "I think the people that focus on the institution being a permanent institution are going to do a lot better."

Kathryn B. Swintek, managing director and head of the leveraged finance group at BNP Paribus, noted that a major company recently said a signature deal in the early 1990s required 15% equity and returned 40%. The same size deal a year ago would have required 35% equity and returned 15%. "That leads to even more pressure to come up with the proprietary idea where you can achieve decent returns - i.e. above 25% - which is tough in an auction environment," she said. Swintek predicted a stable market for the next 6 to 12 months, but said cyclical factors may eventually lead to a downturn.

Knowledge@Wharton is a bi-weekly online resource that offers the business insights, information and research from a variety of sources. These include analysis of current business trends, interviews with industry leaders and Wharton faculty, plus articles based on the most recent business research, book review and conference and seminar reports.