On the Mend

This treacherous environment was far different from the prosperous days of 2003–2007, when private equity helped to bolster returns from traditional portfolio holdings by 4% to 9% per year. Just as private equity debt magnified returns when markets were rising, it magnified losses as markets declined. According to the State Street Private Equity Index (including data from more than 1,600 private equity partnerships), investors saw returns retreat by 25.8% in 2008.

Recessionary pressures, restricted credit lines and liquidity evaporation permanently altered the private equity industry last year. But today’s improved environment, with higher cash flow volumes for both deal closings and client distributions, is operating on a whole new playing field.

Quick Shift
Once a fairly simple machine fuelled by robust economic growth, inexpensive debt and lively risk, the private equity industry became complex almost overnight.

Valuation was hit first. Generally, private equity firms (also known as general partners) operate on a buy-and-improve strategy, eliciting investments from limited partners and creating a fund to acquire a portfolio of assets destined to be held over time. Termed “patient capital” because its investors are committed to longer-term ownership, private equity investments are generally held for years as their underlying assets mature. Investments are assigned no value until they are sold on the open market.

With the economy’s collapse and the stock market’s precipitous fall in 2008, private equity firms found themselves unable to quantify potential losses. And without knowing their losses, limited partners discovered that the private equity component of their portfolios distorted their portfolio allocation strategy.

Today, limited partners remain rightfully concerned about the value of their investment portfolios, and some are struggling to comply with unfunded commitments. Those who locked into decade-long private equity positions when credit was easy and valuations were high now face a difficult rebuilding period, as the value of their investments is significantly reduced.

Quelling investor angst also became a major focus for private equity firms over the past year. With liquidity and deal-making all but halted, enhanced client services became even more important. Staying in close contact with limited partners, holding more meetings and reacquainting themselves with aspects of their long-term partnerships have become new requirements for private equity firms. Going forward, successful general partners will devote more time to offering transparency, streamlined administration and technology systems that will give limited partners the information they demand.

New Models
Even if the 20% gains in the global stock market during the second quarter can reignite deal interest and generate more IPOs—a traditional exit strategy for private equity funds—many groups have already shifted their business models.

Some are diversifying away from debt-based deals, moving toward distressed debt, minority stakes and non-bank financial bailouts, and accepting seller financing for their acquisition targets. Smaller, more targeted deals are taking hold. There have even been instances of de-leveraging, in which funds apply unused cash to buy up the debt of their own portfolio companies.

While these changes were occurring, other factors came together last year to prime the private equity industry for today’s new growth. First, inactivity in leveraged buyout deals left large amounts of uninvested capital lying idle, as evidenced by all-time highs in assets under management. In 2008, private equity assets under management soared 15% to US$2.5 trillion.

Next, savvy investors with significant capital have begun picking up stakes in solid companies at a reduced price. They are also purchasing other funds’ distressed private equity portfolios on secondary markets. With more deals on the horizon, private equity fundraising appears to be on the increase—a trend that is expected to continue through the balance of 2009. Investor appetite is beginning to return, although it may be some time until the industry returns to the levels of previous years.

Data from the State Street Private Equity Index provide further proof of this shift. After hitting a 10-year low in March 2009, capital drawdowns relative to capital committed have begun to pick up. Drawdowns mean the cash is now being put to use, another indication that the days of private equity sitting on the sidelines may be over.

State Street data show that private equity losses are also beginning to narrow. For the three months ending in March, quarter-to-quarter internal rates of return of participating funds rose to -6.46% from -16.32% in December 2008, ending four consecutive quarters of declines. However, investor patience will still be key, as the index shows return rates remaining negative for a three-year horizon and turning positive over the five- and 10-year horizons.

Encouraging new buying opportunities—along with the potential reappearance of long-term positive returns—could bring about much-awaited growth in the private equity arena. Given the new landscape, growth will be peppered by new types of complex investment deals that require both the hyper focus of general partners and new administrative tools to keep accurate information flowing.

Regulatory Reform
Around the world, some of the most dramatic alternatives to the private equity industry landscape are still being constructed. Government regulation, aimed at eradicating systemic risks that could once again threaten the global economy, is slowly finding its way to fruition.

Proposals to require private equity firms to register as investment advisors are already taking hold in the U.S., as are guidelines on private equity firms investing in failed financial institutions. In Europe, the European Commission has proposed a Directive on Alternative Investment Fund Managers, which is being argued as inequitable to the private equity industry. So far, Canada has managed to skirt the issue of widespread registration of private equity firms; however, momentum for similar regulations could re-emerge at any time.

While it’s an honourable intention to try to avoid a repeat of last year’s near-collapse of the financial system, policy-makers should aim for a balance between defending markets from systemic risk and impeding the ability of private equity investments to fund new ideas, restructure companies and drive corporate productivity. Given the heightened focus on regulation, private equity firms must step up to ensure that new regulatory regimes improve markets and do not inhibit the freedom and productivity of general and limited partners.

Navigating Change
As the private equity industry embraces new tactics for partner co-operation, regulatory adherence and promising investment trends, leading firms will turn to third-party
administrators (TPAs) for help.

Offering assistance with reporting and compliance, control procedures and custody, and lending services, TPAs can be invaluable in providing a clear view of portfolio structures, partnership agreements, risk concentration and regulatory requirements. TPAs can help sustain the infrastructure needed for today’s complicated private equity deals while allowing general partners to concentrate on raising capital and finding the best investments. They can also facilitate the efficient transfer of information to investors, even as the private equity industry restructures itself. And they can assure governments that operational excellence is in place to maintain sustainable, transparent business practices.

The private equity industry is regaining the position it needs to move forward in the years ahead. Doing so with the assistance of global administrators will not only help to rebuild the industry, but will also position it to contribute to—and profit from—renewed investment growth and economic recovery.

Jack Klinck is executive vice-president and global head of Alternative Investment Solutions, State Street Corporation.

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the Fall 2009 edition of INNOVATE magazine.