|IN A NUTSHELL: The financial crisis has had important implications for Private Equity sponsors, and the funds that will be successful in the future may need to adapt their strategies to earn consistent returns.
Disclaimer: I am an executive in a private equity sponsored company, we have a very supportive sponsor, and I truly believe in the potential of the private equity model to boost the economy, without tax-payer stimulus dollars.
People tend to be strongly polarized regarding the role of private equity and it’s potential for benefit or harm. Proponents cite the fact that the focus on EBITDA and free cash generation which PE groups drive is actually beneficial for many company management teams. It’s hard to argue with the fact that with some skin in the game, operating management teams typically have incentive structures which drive them to relentlessly focus on their companies’ performance. And there are many stories of firms where a strong and involved private equity backer helped a management team eliminate huge amounts of waste and unlock large amounts of shareholder value. But for every positive story, there are a number of negative value erosion exploits which can be told. Many deals were done as mere financial engineering demonstrations with little to no actual improvement in business fundamentals. The market’s addiction to leverage unfortunately frothed to a point where many respectable, longstanding franchises were driven into re-organization or receivership due to debt service loads which were incapable of being managed through even the slightest of downturns. At the deal market’s peak, a churn mentality was prevalent with hold times of less than 2 years, which clearly drove a short term focus on results and a lack of re- investment in the firms’ future capabilities.
As the global economy begins to think about trying to crawl out of the last 24 months’ meltdown, the Private Equity world reaches an interesting branch in the road. More than $500B of portfolio company debt will mature over the next 4- 5 years, and it is unclear whether there will be sufficient risk-tolerant liquidity to fund many of the recapitalizations. A number of newer or less prudent funds have tumors in their portfolios, some diagnosed, but many probably not as of yet. Experts have estimated that as many as 1 in 4 of current funds will fail or will need to be severely restructured. Although we frequently hear of the huge stashes of dry powder on the sidelines, without properly structured debt financing, this money is unlikely to get deployed any time soon. More than 20% of current vintage funds are more than three-fourths committed on their current capital raise, meaning that they will have to wait for institutional investors to regain their appetite for alternative investments before they can receive additional investment fuel.
So, will Private Equity go away? Unlikely. It has been an engine for recovery for the last several economic cycles, and it is unlikely that this one will be any different. What will be different, I believe, is the kind of Private Equity firms who will emerge as winners in the landscape of Private Equity 2.0. My fairly obvious predictions:
- There will be fewer deals and it will be quite some time before the deal market regains any level of irrational exuberance. Fewer deals means more time to do deals right. Firms will be more selective and firms that have very solid due diligence and value recognition processes will capture more of the upside than those which are impatient or inperceptive. Fewer deals also means more time to negotiate tough, and more firms will realize that money is made more from the buy and less from the sell.
- Deals will be less levered, so by definition, returns will be lower. It will not be uncommon to see deals with more equity than debt or even all equity deals. Firms will either need to raise larger funds to reduce fund concentration or will need to have the courage to make relatively large concentrated equity investments.
- Hold horizons will be longer. Deals that are held in a portfolio for 5 to 10 years will not be uncommon. Private equity groups will need to have the vision, patience and the constancy of leadership to fund and enact long term multi-year improvement strategies in their portfolio companies. Not all PE groups have this headset today. LP capital return expectations and timelines may need to be extended accordingly.
- The firms that will win will be the groups that can bring real value creation expertise to the table. The days of just betting on a solid management team, incentivizing them and amplifying their progress with a heavy dose of leverage and letting the portfolio company print equity returns on it’s own have probably passed. Although many PEG’s have solid operating partner teams today, the groups that will win will probably be the ones that develop full in house multi-functional consultancy capability (LEAN, six sigma, strategy, value selling, global expansion, change management) which can be deployed to address opportunities in the portfolio. Additionally, the tougher environment will probably drive a premium on developing true domain expertise via multiple sequential investments in a sector. This trend will allow savvy PE groups to identify value plays which may not be obvious and will also enable inter-portfolio synergies which will be accretive for both companies.
- As returns get squeezed, the often overlooked EBITDA drain of service providers on the portfolio companies may become a focal point and an opportunity for well capitalized private equity groups. We may see sponsor groups which totally centralize and/or insource service providers, including public accountants, retained executive search, legal firms, risk assessment firms, environmental management firms, IT and other back office tasks. While this would start to blur the line between financial sponsor and conglomerate, it probably could account for 2 – 3% of EBITDA margin lift across the portfolio.
- Finally, I think the firms which win will be the groups that invest most heavily in the talent management of their portfolio companies. Private equity groups will begin to have fully resourced human capital teams and will be heavily involved in recruiting into the portfolio company, and not just at the C-suite. New manager assimilations, 360 appraisals and detailed organizational leadership development plans will become the norm and will be driven by the equity sponsor if they are not already a part of the portfolio company’s DNA. Incentive structures for management will continue to be highly tied to company performance, but will probably take on a greater degree of long term value creation. Top-talent retention will become even more paramount than it is today. PE groups’ HR processes will begin to look much more like those of blue-chip Fortune 500 companies than they have historically.
Just like in nature, a changing environment requires adaptation for survival. It is difficult to predict exactly how the Private Equity industry will adapt as it comes out of this downturn, but I think it is safe to say that the industry will adapt in many ways. Only time will tell. What do you predict?