By KELLY HOLMAN, Investment Dealers’ Digest
June 29, 2009
If private-equity executives were sailors, right about now they might be rounding Cape Horn, an area at South America’s tip where treacherous waters have sunk more than a few vessels.
A significant amount of leveraged buyout firms, or 23%, are expected to go out of business in coming years, according to the latest survey of 120 global institutional investors conducted by London and New York-based secondary private-equity firm Coller Capital. The poll confirms and bolsters past theories, following up on a study from Boston Consulting Group from this past December that predicted between 20% and 40% of the 100 largest PE firms could disappear in the coming years.
Coller’s survey found that 28% of the world’s venture capital firms and their leveraged buyout peers won’t be able to raise new funds over the next seven years. As a result, these groups will be forced to stop investing since there won’t be capital available to finance new deals.
Even private-equity veterans like Boston Ventures managing director Vikrant Raina, a former Goldman Sachs banker, thinks an industry shakeout is inevitable, but ultimately good for the buyout business. “The industry got too big and raised too much money, but it’s going to be smaller,” he says. “The shrinkage is going to be good for the overall financial markets.”
Buyout firms, though, aren’t likely to fail in droves over the next year or two. The reason is they are required to wind down, or realize liquidity on their portfolio of investments before going out of business, which can take several years.
If data from Coller’s survey offer any indication, fundraising isn’t likely to be easy. Buyout partnerships declined 22% on average last year compared with venture capital partnerships, which fell 11%.
“The funds that have generated strong realized returns have a better chance of getting re-upped than those with lower returns or unrealized returns,” says Brian Boyle, a senior managing director at McGladrey Capital Markets, a Costa Mesa, Calif., investment bank.
Institutional fund managers have reported declining fund returns. For example, Coller’s survey noted that 37% of respondents reported average private-equity returns of just 16%.
A substantial majority of institutional investors, 84%, declined to provide their existing fund managers with capital for new funds over the past year and 20% plan to reduce allocations to private equity in the next 12 months. North American-based investors comprised the highest percentage of refusals at 92%, while 82% of European institutions and 70% of Asia-Pacific investors made up the remainder.
The moves are an effort by limited partners, as investors in private-equity funds are also called, to rebalance their asset allocations.
Some have gone further. Harvard Management Co., for example, sold off some of its interests in funds to select buyers known as secondary market private-equity firms.
Large buyout funds, those with capital of $7 billion and larger, experienced a 35% decline in their valuations, while middle-market funds valued up to $500 million only declined by 8%.
Additionally, some investors are seeking to reduce their investments in private equity because of a lack of return on their investments. Some 74% of respondents are expecting distributions — capital culled mainly from initial public offerings of private-equity-owned companies or corporate sales — to deteriorate over the coming year. A mere 25% think conditions for exits via IPOs or M&A transactions will improve.
In the meantime, limited partners may also prevent their buyout fund partners from executing transactions. In North America, for instance, investors forecast an average 13% default rate on capital calls over the next two years. By comparison, only 8% of European investors are expected to default and Asia-Pacific limited partners are projected to have a 7% default rate.
Capital calls are the funding that private equity firms request from their investors to finance deals.
Raina says when it comes to raising capital the multinational private-equity firms like the Blackstone Group or the Carlyle Group are better positioned to secure new commitments given their capital base and breadth of operations.
The story, meanwhile, could well be different for the class of middle market firms that have reputations as generalist investors, or those that invest opportunistically across a broad range of industries.
“The industry-focused and style-focused funds have developed better-quality deal flow than their ‘generalist’ counterparts because there are so many of these types of funds out there,” says McGladrey’s Boyle. “I believe that limited partners will want more focus on the high-return sectors or different investment styles.”
Financial sponsors that are seeking to raise new funds have found a much different environment than the period from 2005 to 2007 when limited partners couldn’t seem to put enough capital into funds. Now, fundraising is a more arduous process and one that is only expected to get tougher, say veterans like Coller Capital partner Frank Morgan.
“My understanding is that there are a number of funds in the market now trying to raise new money, but it’s very slow going,” he says. “As one investor said to me, ‘I need another large buyout fund like a hole in the head.’”
Additionally, 52% of polled respondents think that a constraint in resources will limit their chances to monitor their private-equity investments over the next two years. However, 23% plan to increase their private-equity teams.
