The Private Equity (PE) industry experienced its worst year ever in 2008 with overall returns on investment down 27.6%. Although performance has picked up in H1 2009, the industry still faces a set of fundamental challenges ahead. There is recent evidence showing PE capital markets units sidestepping investment banks and providing bridge finance and underwriting services themselves.
According to FT, the private equity industry is sitting on over US$1 trillion in dry powder (i.e. committed but not yet collected equity capital by investors) but is facing a dearth of investment opportunities. Banks’ continued woes are the main reason the cash remains uninvested. Although many bank shares have seen their share prices rocketing over the past few months, the reality is quite different, especially when it comes to "risk management". Banks are unwilling to provide loan financing for leveraged buyouts (LBOs) they cannot securitize and sell on to hedge funds and other CLO investors.
Moreover, as long as banks are not willing to write down their distressed assets, PE funds cannot buy them up cheaply, especially as LBO sponsors prefer to loosen covenants in order to keep companies alive. Meanwhile, the FDICs new rules make investment in destressed banks too onerous. This leaves the secondary funds market where PE firms sell their stakes to each other as an exit strategy.
PE owned companies need to refinance or repay US$400 billion of leveraged loans within the next five years (BIS estimates US$500bn in 2008-2010). On the other hand, the maturity structure of high yield bonds starts to kick in in 2014 as many high yield bonds were refinanced at record low interest rates shortly before the crisis hit. It remains to be seen whether PE partners agree to deploy funds to rescue zombie companies or whether they rather redeem their stake, even at a loss.
PE's core competences include management restructuring and improvement of operative efficiency. These are in high demand during a recession. Investments in U.S. and UK account for about 50% in buyout value. China and India account for only 4% of buyout value and 8% of the number of buyouts. Although many funds want to invest in emerging markets to take advantage of impressive growth rates, corporate challenges in emerging markets differ from those in industrial countries. It will be necessary to develop tailor made management solutions.
Earlier research predicted that 20-40% of the largest 100 LBO firms will go out of business in this cycle. For the remaining firms, limited partners have committed more 'dry powder' than ever before but there is a risk that some limited partners will not be able or willing to make good on their earlier commitment in the aftermath of the crisis. The future PE contribution of financial institutions, of family offices and foundations, and of endowments in particular is likely to shrink whereas pension funds, insurers and sovereign wealth funds/government agencies will grow in significance as limited partners.
p/s photos: Aum Patacharapa Chaichua
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