Correction offers rich opportunities

Talented private equity investors will reap the rewards of strategic plays in the long term despite the contraction of the buyers’ market – and the outlook for 2008 remains optimistic.

Before last summer’s debt market upheaval, buyout funds took advantage of the lending environment to return cash early via leveraged recapitalisations. Post credit crunch, and although predictions differ as to the severity and duration of the debt market contraction, that route to liquidity is closed.

A return to longer, more typical holding periods for buyouts can be expected. This will be reflected in a dip in short-term performance numbers, and in turn will give rise to some apocalyptic headlines. But short-term returns should be irrelevant to the strategic investor in private equity, where fund lives may extend well beyond 10 years.

The credit crunch will make itself most immediately felt for mega-buyouts. We can expect the late 2007 slowdown in the pace of transaction activity to be maintained during the first half of 2008 at least, as the credit overhang washes through the system.

A divergence in pricing expectations will also retard the pace of deals. Private equity bidders will be quick to adjust their structures and return expectations. But to reflect higher borrowing costs and a more conservative lending environment, it may take vendors longer to adjust to these new realities.

But, what the industry may lose on the investment swings, it may recoup on the exit roundabouts. Corporate buyers will return to a playing field that looks more level in terms of cost and availability of capital. The benefits of the anticipated increase in corporate acquisition activity will be most immediately reaped by mid-market and venture funds.

Successful exits from more mature investments within these market segments will underline the validity of the classic private equity model. They should also mitigate the effect of longer holding periods for more recent large buyout investments on overall portfolio internal rates of return.

A widespread relaxation of credit discipline presented a honey-pot of temptation to undisciplined investors. Disciplined investors took advantage of these conditions, so as not to compromise their reputations. The classic private equity model is not predicated on cheap money.

Leverage is a means of enhancing returns. But for a private equity manager it is a weak crutch on which to support an investment case, in the absence of creative and coherent development strategies. Performance dispersion, typically wide in private equity, (see first chart) will broaden further, as those managers that add value get a chance to shine. This differentiation will be reflected in increased dispersion of private equity investment performance for coming vintages.

But any dramatic fall-back in investor demand for private equity is unlikely. According to the 2007-08 Russell Investments Survey of Alternative Investing, institutions generally forecast that their strategic allocations to private equity will continue to increase through 2009 (see second chart). While institutions may plan to increase their strategic exposure in percentage terms, a protracted weakening of public markets and consequent shrinkage of asset bases would cause some to trim their portfolios in absolute terms.

Quoted private equity should be a long-term hold, but it can be a useful tool for adjusting private equity allocations in times of flux. The other major tool for portfolio adjustment, in a largely illiquid asset class, is the secondary private equity market. Secondaries will move to the fore once again during this year and beyond. The return of the financial seller is anticipated through regulatory and balance sheet pressures. Strategic sellers are also expected to continue to increase their secondary selling activity.

Competition, from specialist secondary funds and from opportunistic financial acquirers, has increased. Therefore, while we expect to see the return of discounts on some secondary assets, major pricing declines are unlikely to be universal. Successful investors in this phase of the market – as, we believe, in any other – will be those who focus on the quality of secondary assets.

Recent benign conditions may have given inexperienced investors unrealistic expectations both of private equity’s characteristic cash flow dynamics and its typical returns. But the outlook for 2008 continues to give grounds for cautious optimism for long-term performance on the part of the selective investor.

However, if institutions have not already flown to quality they might have missed their chance. Access to top-tier funds remains the key challenge for investors. Managers with proven abilities to outperform across market cycles are justifiably oversubscribed: there will be no return to a buyers’ market any time soon.

Every so often the market is subject to a correction, which prompts a re-evaluation of core principles and values. Such periods offer rich opportunities for private equity, which as an agent of change, is well positioned to thrive.