This article has been written as a part of a research project undertaken for ZENeSYS. All information and content has been derived from secondary research and insights gained from recent projects at ZENeSYS for the PE industry. Credits have been provided in the references for text and data. ZENeSYS provides Market Research and Market Intelligence services to PE Industry on a regular basis. It was originally featured at http://zenesysconsulting.wordpress.com/2011/07/31/the-great-liquidity-crunch-private-equity-firms-re-invent-themselves/
Abstract: The liquidity crunch, tighter regulations and more control demanded by general partners is forcing the PE industry to re-invent itself.
The three key areas of transformation are:
- More secondary deals – establishing the best valuations and finding the right buyers
- Restructuring deals – creative ways of re-negotiating (past) unrealistic deals
- Employing turnaround specialists – creating consultancy like capability for operational improvements
Over the last decade, uncharacteristic of what one might think, the private equity industry has gone through an economic cycle just like the stock market does – up and down. The up phase of the PE market started around 2003 and it continued to boom till 2007-2008 or just when the financial crisis kicked in.
During the up phase, which started after the telecom burst in 2002, the PE industry saw the largest leveraged buyout (LBOs) taking place in history. In the year 2006, PE firms had bought more than 650 US companies for a figure of $375 Million, which was around 18 times the transactions, closed in 2003 [ref 1] alone.
The LBO movement was fueled by decreasing interest rates, low lending standards and tight regulatory framework of owning a public enterprise (Sarbanes Oxley Act) [ref 2]. Consequently, it is one of the reasons why venture capitalists started relying on sales to strategic buyers for an exit.
The arrival of financial crisis in 2008 and the liquidity crunch brought about a quick halt to the LBO frenzy. The leveraged finance market almost stood still during and after the financial crisis. Not only that but as a result of this crisis, many deals were withdrawn or had to be re-negotiated [ref 3].
PE industry is measured with help of two metrics – fund raising and investment activities. The fund raising refers to the money, investors have committed to PE funds in a year. That fund raising activity had fallen to $150 Billion globally in 2009 from $450 Billion in 2008. Coincidentally, the 2009 figure is the lowest since 2004. The lack of debt in the following year of 2010 meant no hope of any speedy recovery.
The other metric, investment activity, which represents the financing of businesses, had fallen from $181 Billion globally in 2008 to just over $90 Billion in 2009. It 2010, it picked up to $110 Billion [ref 5]. This minor jump could possibly be attributed to increased investments in Small & Medium Enterprises and emerging markets such as Brazil, China and India.
Since PE funds acquire firms so that they could be sold at a profit later, life becomes difficult for them during an economic slowdown. Especially more so, where there is a liquidity crunch factor in addition. This was apparent from the total value of PE exit transactions. They fell from $151 Billion in 2008 to $81 Billion in 2009.
From here on to the next five years till 2016, over $800 Billion in loans extended on committed deals would become due or will have to be refinanced [ref 6]. This $800B is distributed almost equally between bank loans and high-yield bonds. To add further complication in hiving off these assets the US government has passed a bill that would require any PE firm which has more $150 Million in assets under management to register with SEC.
The implications are public disclosure of risks, business activities names of the personnel involved, assets owned, amount owed to each creditor, performance metrics, debt and defaults [ref 7].
According to estimates [ref 9], there is one trillion dollars worth of dry powder in PE funds globally. However, LPs are now demanding more control and requesting more information about their investments. The LPs want to keep track of the draw-down capital so that GPs don’t overdraw their limits [ref 8]. This in effect has created a liquidity crunch of sorts, within the PE community itself.
This puts PE funds in a tight spot. How should they service their existing debts and acquire new assets? The solution for servicing debts is to look for different options such as secondary markets, restructuring the deal or employ turn-around specialists to improve valuations. For acquiring new assets, they must look harder in the marketplace or find greener pastures in emerging markets.
Hence, turn-around specialists are in demand nowadays. PE firms are turning away from traditional leveraged deals and looking into investing in distressed companies. They feel it is better to restructure deals based on a change in strategy rather than to take money out and pursue matter in courts.
Turn-around is becoming more and more important as top lines (revenues) are shrinking. Even vendors have stopped extending favorable credit terms. Hence the success of any PE acquisition is down to operational excellence. This means improved management, optimizing expenditures, and rooting out inefficiencies such as overcapacity created in high growth years.
Interestingly, PE firms have identified a new gap in the market – companies, which do not have the means to hire expensive management consultants, are now finding this as a welcome opportunity to bring aboard high quality leadership.
Emerging markets such as Brazil, China and India are still attractive and PE firms need to find ways of entering them. China and India are the two fastest growing economies even during the recession and they need to develop infrastructure to support the high growth. Brazil is set to hold 2014 World Cup and 2016 Olympics.
With increasing pressure from the regulators, lack of liquidity, and tighter control demanded by general partners, future PE deals would need to be financed and executed with better insights and strategic planning. This means deeper research before deals are struck, awareness of best practices in target markets for operational excellence and market intelligence for finding the right buyers quickly and at the best price.
By Vaibhav Gupta – Brand Ambassador from IIM Indore (2010-12 Batch), ZENeSYS Consultant.
Vaibhav completed his B.Tech. in Mechanical Engineering from Delhi College of Engineering. Before his MBA, Vaibhav worked in Project Management for 4 years with Siemens Energy. Vaibhav intends to join the Management Consulting industry after his MBA.
- Wharton PE Report 2010
- A Closer look at “Dodd-Frank Wall Street Reform and Consumer Protection act – Impact on Advisers to PE Funds” – a report by PwC May 2011