But all is not negative in the world of private equity. It is estimated that GPs are sitting on “dry powder” of approximately $500 billion, assuming their LPs don’t default. Extended capital structures, marked-to-market valuations and the economic downturn have created both distressed sellers and investment opportunities. While not great for the original investors, those with money to spend are buying these assets at between 40 and 60 cents on the dollar.
In a rather negative article on private equity in the February 2009 issue of Vanity Fair, even they admit that there may be some fabulous opportunity for some…. “if the private equity business is, by all logic, looking at imminent catastrophe and ruination, it can also see the best possible environment in our time for investing—a world in which sound and necessary businesses have lost two thirds or more of their value, a world in which public companies can be bought up by private money for a pittance. This is heaven on earth for the brave and the greedy.”
As we saw in 2001/2002, recessionary periods can provide strong investment opportunities. Some of the best vintage years in the past decade were 2003, 2004 and 2005 when somewhat similar conditions prevailed. Managers with strong operational skills will distinguish themselves in this environment. Creative financing may be required to save portfolio companies given debt markets have yet to properly unfreeze themselves. This might be through greater usage of vendor financing and mezzanine debt.
Deals and exits will change as well. We will no doubt see smaller deals done with more equity, and deals done alongside other corporations, and/or sovereign wealth funds. PIPES (public investments in public entities) are returning to fashion. There is no doubt that exits will take longer to effect and likely will be in the form of trade sales. This is truly patient capital, although one could argue a value investor is not much different. We expect returns to be lower since refinancing is no longer a source of return. General partners with operational experience, who can buy and build companies will still provide strong returns above listed markets.
What remains true is that manager selection is the key to success. A brand name does not necessarily translate into a skilful group of people who are focused on creating value for their LPs. Rather those who stick to their knitting—raise sensible size funds in industries they understand, financed appropriately—are more likely to succeed. Investors have always known this. Apparently we need to be reminded, though, now and again.
Janet Rabovsky is the Practice Leader, Investment Consulting, Central Canada for Watson Wyatt Worldwide.
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