The future of the private equity model for financing young, growing companies has come under fire as the UK and the world embarks on a fragile recovery. The lack of recent exits is putting continued pressure on private equity funds that, like many organisations, are having trouble finding cash. Does this spell the end of this method of financing?
At last week’s Criticaleye Private Equity CEO Breakfast, a group of experienced executives and non-executive directors from private equity backed organisations met to discuss the issues concerning PE, the future of the model was widely debated.
Private equity’s history of high returns may have led to its troubled present. “There is no doubt that many PE companies have generated spectacular returns for the investors and PE executives alike. There is some considerable debate as to how much of this was due to upside generated by the financial engineering possible with the high levels of leverage and how much was due to the value added to the business model by the PE investment. What we do know is that the level of leverage seen in 2007 and 2008 was also there in the late 80s during the last serious crash. What was different this time is the weight of debt was many times higher than last time,” explains Sam Ferguson, Chief Executive Officer, EDM Group.
Iestyn Roberts, Chief Executive Officer, Freeport Leisure, agrees and explains further. “My personal view is that we will see significant evolution in the PE model as we know it. There appears to be a general belief that the period 2000-2008 was ‘normal’ and this will eventually be restored. My view is the opposite, this was an aberration founded mostly on a tide of cheap money. Most of this work was financial engineering aided by a booming world economy. There will be a role for PE in the future and it will be much more about providing funding for emerging ventures or providing equity in situations where it is needed (eg, MBO). From the investor point of view, it will be part of their portfolio exposing them to higher risk/reward situations. Inevitably this is a smaller industry than before.”
The lack of successful exits in the past year is troubling the market, as it was questioned how long PE houses are willing to finance companies. By preventing organisations exiting, leaders feel that business is being constrained, turning well-run, positive cash–flow organisations into ‘zombies’.
“The paucity of exits with the resultant lack of liquidity has undoubtedly put pressure on the traditional LP/GP private equity model. This will inevitably lead to a shake-out in the medium-term. Leverage and exit multiple arbitrage cannot be relied upon to deliver returns, those private equity firms who work with their investee companies to add value are likely to emerge as leaders. At LDC our evergreen funding model and commitment to supporting initiatives to both grow the revenue and improve the operational efficiency of the companies that we invest in should ensure that we are well placed,” says Tim Farazmand, Managing Director, LDC.
According to experts, only 25 per cent of private equity funds are doing well, a figure that does not bode well for the future of the model. This low percentage of well performing firms may be due to the fact that models can vary significantly.
“I feel we have seen the end of highly leveraged buy-outs as a widely used structure. For some businesses, it may still be appropriate but for many it will not work in the future. Medium levels of gearing, sensible mix of financial tools – payment in kind (PIK) vs repayments, etc, can still enable businesses to expand and create significant returns. I’ve already seen the wiser PE firms restructuring their portfolio investments in this way to be sure they lead the way out of this recession,” explains David Tydeman, CEO, Oyster Marine.
There are still PE funds that are doing well, for example, funds that work off the balance sheet of banks or well-established financers have had strong showings.
“In this discussion it is important to distinguish between funds that still have money available to rescue ailing portfolio companies and snap up new deals at low valuations versus funds that no longer have access to money and are struggling to raise fresh capital from institutional investors,” says Peter Roosenboom, Professor of Entrepreneurial Finance and Private Equity, Rotterdam School of Management.
Although cash is important, the experience and knowledge of the partners is vital, especially in these tumultuous times. Peter continues: “Academic research shows that funds that are doing well, do so persistently over time. They employ the best general partners, recognise opportunities early on, before everybody joins in and valuations go up (money chasing deals) and most importantly they do not raise too much capital (ie, they only invest in a limited number of portfolio firms so as to not spread their general partners expertise too thinly). My educated guess is that the funds that are younger, with less able general partners and funds that got invested in the recent years (when high multiples were paid for deals and deals were more debt financed) are going to struggle. The others have better chances of survival.”
The importance of private equity in the pre-recession world is undisputed; however, the model is now in flux and evolving to meet post-recessionary circumstances. Rupert Cockcroft, Chief Executive Officer, CancerPartnersUK says, “The PE model is still important. However, the model seems to be changing from short-term, high multiple returns to longer-term investments that require a closer alignment with management teams.”
According to Sam, the change in private equity comes from the sheer volume of firms. “I think there are too many PE companies now compared to the days of super returns made in the late 90s to the period just before the ‘crash’. These companies are chasing too few good investment opportunities. This has meant that the longer established PEs have pushed up market to ever larger and larger deals. These larger deals bring with them the same risk profile that conglomerate plcs had in the 80s. The competitive market created by the number of PE funds and the larger deal syndrome mean that the equity deal shapes have to change and investment periods will be longer with less opportunity for spectacular returns; measuring these deals as a multiple of money invested. That is the way to deliver longer-term future for business rather than rely on the cyclicality of the debt and equity markets to generate the high returns,” he contends.
Although there are questions about the continued feasibility of the private equity model, many believe that the method of financing is essential for some growing businesses. “While the PE model is under great pressure it is still viable and represents an attractive route to growth and success for many portfolio companies,” says Murray Hennessy, Chief Executive Officer, Thetrainline.com.
The next Private Equity CEO and NED Breakfast will take place in May. If you would like further information on today’s subject please see the Insights page. In the Community Article Variant Viewpoints: Private Equity versus public management teams, Criticaleye speaks to Jacuzzi UK’s Mark Prince, and LDC’s Tim Farazmand about the challenges and benefits of working with/being part of a management team that is new to private equity.
Please get in touch if you have any comments about the issues in today’s update.
I hope to see you soon