Private equity markets turn on a dime

By March, the private equity markets were ice-bound.

Then, as stock markets rebounded, private equity managers moved fast to make exits from their portfolio companies. They floated initial public offerings. They sold to strategic buyers. And, with the credit taps turned on, they refinanced.

But Canadian private equity managers worry the door will close as quickly as it opened. That was the view yesterday of a Toronto panel of managers sponsored by CVCA, Canada’s Venture Capital and Private Equity Association.

While tight economic conditions have crimped private equity companies, they have also prompted reflection on the basics of buying up private companies. The Great Recession has shown “the premium on having superb decision-makers at the management level in companies is never higher than it is during a crisis,” says Steve Dent, a partner at Birch Hill Capital Partners.

And a crisis can strike suddenly. Michael Lay, managing partner at Toronto-based ONCAP, recalls a deal he made last year at this time that would have fallen through had it been undertaken four or five days later. “It’s just remarkable how quickly things change.”

One thing that seems to have changed is the motivation to make a deal. “You really have to ask yourselves why you want to buy this business,” Lay says. A year or two years ago, businesses were turned over in 18 to 24 months. “Those days are long gone. You actually have to do something with these companies if your going to add value.”

OMERS Private Equity has been less affected by the downturn, suggests senior managing director Don Morrison. It’s still building up its portfolio, which now stands at $9 billion, by another third. To reach that goal, OMERS is “disciplined and patient.” Still, opportunities are not dropping into OMERS’ lap.

Rapid changes in private equity markets may compel patient institutional investors to act, however. Since capital markets open and close in “quite irrational ways,” says Erol Uzumeri, senior vice-president at Teacher’s Private Capital, Teachers had to act quickly to sell in 2007 and 2008. “Had we held onto those businesses, we wouldn’t have generated the returns for shareholders. Timing is very important.”

Indeed, he finds that current takeover and IPO activity is a product of the fact that “people are very worried the markets are going to shut again.”

Although current markets are volatile, he thinks there are opportunities for long-term positions. In the private equity boom, many “great” companies took on too much debt. They are “a train wreck waiting to happen” in about two years time, as their debt comes due for refinancing. Teachers sees a pending opportunity for deep value or distressed investing.

Similar opportunities are there for smaller private equity companies such as ONCAP. Lay can see taking minority stakes in companies to allow them to make acquisitions or to fix their balance sheets. And, in his portfolio of five companies, they have made 14 acquisitions. The brake on activity, however, is that “we’re having a hard time understanding where the economy is going.”

That makes modelling a company’s prospects—and the return potential—challenging. Models that assume a normal economy are bound to disappoint. “It’s very difficult to run your revenue assumptions in an economy like this,” Dent says.

For private equity managers—the general partners who run the business—that means investing more money in existing businesses rather than taking on new commitments, with the potential for add-on acquisitions.

Which may be just as well. Potential investors—the limited partners—”are running away,” Dent says. “They expect it to get worse.”

But there is something else at work, Uzumeri points out. As private equity investors made new or follow-on investments, they were also receiving cash as previous investments were sold. “There doesn’t appear to be a wall of capital coming back to investors,” he notes. Since funding has dried up, “people panicked and stopped investing.”

That circumstance will challenge some of the large private equity partnerships with “social issues,” he says. They will lose talented employees. Indeed, many expect a much smaller industry in the future.

One sign is that the number of lenders for private equity deals is down by half, Lay notes. Those who remain are resetting the terms of their loans. They are no longer willing to lend for five years. Instead, it’s three years. And of course leverage has come down.

That doesn’t mean all the excesses have been drained, warns Uzumeri. He’s seen some high-yield refinancing deals recently “on really, really bad names.” Better, he suggests, to be involved with relationship bankers—essentially the Canadian model—because with refinancing in the U.S. there may be multiple lenders. “Know your lenders,” he emphasizes.

And with Teachers, some portfolio companies end up being financed by the pension fund itself. “When the market is going to offer relatively cheap subordinated debt, we’ll take that,” Uzumeri says. “When the markets are irrational, we’re not going to pay that out to the market. We’ll take that. We’ll hold that and our pensioners will benefit from that.”

At the same time, some private equity partnerships are shopping portfolio companies to large institutional investors. “They need some liquidity,” Morrison explains.

Despite current market distress, both Uzumeri and Morrison are optimistic on the longer-term return for institutional investors.

“It’s truly a long-term yield gain,” Uzumeri says. “We think the private equity class, done correctly, should return north of 20% every year consistently on a long-term basis.