ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OCTOBER 2009 OF NUMBER 267b

Chicag o Fed Letter

When Worlds Collide: The Altered State of — A conference summary by William Mark, lead examiner, Supervision and Regulation, and head, Private Equity Merchant Banking Knowledge Center, and Steven VanBever, lead supervision analyst, Supervision and Regulation

The Federal Reserve System’s Private Equity Merchant Banking Knowledge Center, formed at the Chicago Fed in 2000 after the passage of the Gramm–Leach–Bliley Act, sponsors an annual conference on new industry developments. This article summarizes the ninth annual conference, held on June 25–26, 2009.

In his introduction, Carl Tannenbaum, and credit standards for these loans re- Federal Reserve Bank of Chicago, noted main tight. Evans said, overall, economic what a difference a year had made. Speak- activity is expected to bottom out and ers at last year’s conference had noted then turn positive later in 2009 or early the beginnings of fi nancial dislocation in 2010. and a rapid increase in risk aversion. However, no one could have foreseen State of the industry the subsequent near collapse of the fi - Sanjeev Mehra, Group, nancial system, the breathless succession surveyed the current state of the private of dramatic market events, government equity industry. During the fi ve-year pe- interventions on behalf of so many large riod leading up to mid-2007, leveraged At last year’s conference, institutions, and the wide range of special buyout (LBO)2 activity increased, driven no one could have foreseen government programs. Despite these by access to plentiful and low-cost credit. 1 3 the dramatic changes ahead events, private equity funds are still robust Leverage ratios also increased, new lev- and are playing a new role as part of the eraged loan4 issuance soared, and credit for the fi nancial system. recapitalization of the banking industry. quality declined. The availability of low- cost fi nancing came to an abrupt end in Charles Evans, Federal Reserve Bank of mid-2007, and buyout activity declined Chicago, shared his thoughts as the bank’s signifi cantly. The industry today faces a president and CEO on the macroeco- wall of refi nancing, and debt pricing has nomic environment and broader fi nan- not fully recovered. The recession has cial market developments, framing the caused default rates to increase, with fur- landscape facing the private equity in- ther increases expected. Private equity dustry. By most indications, the current fi rms are responding to these changes by recession will match or exceed the down- focusing on managing existing portfolios, turns of the mid-1970s and early 1980s in refi nancing and extending debt matur- depth and duration. According to Evans, ities, injecting new equity into target fi nancial markets, including the short- fi rms, investing in new ways (e.g., dis- term funding markets and longer-term tressed debt5), and waiting for the initial bond issuance, have improved since ear- public offering market to provide oppor- lier this year. However, the volume of tunities to exit and reduce leverage. commercial lending (a major source of funding for private equity) has fallen off Despite the numerous challenges facing sharply since the 2007 business cycle peak, the industry, Mehra argued that “reports of the death of private equity are pre- private equity professionals. Providing challenge is particularly acute in the mature,” citing continued fundraising assistance in this exercise were Thomas current stormy economic environment. and a signifi cant “overhang” of money Janes, Lincolnshire Management; Martin Kathleen Graham, HQ Search Inc., from 2007 funds still available to invest. Magida, of Carter Morse and Mathias; and spoke on staffi ng issues facing the private Top LBO fi rms have consistently out- James Marra, Blue Point Capital Partners. equity industry, from both the GP and performed the public market by pro- Topics addressed included trends in merg- LP perspectives. The presentation, using viding capital and high-quality resources ers and acquisitions (M&A), banking as a nautical theme, centered on the mantra to target businesses, focusing on value a target industry, private equity industry of “Can Do”: Communicate clearly and creation, aligning management and metrics, and compensation. The most completely, Align sails (interests and investor incentives, and closely moni- telling trends about the current state compensation), Navigate via better toring performance. of private equity were the drastic decline decision-making, Do due diligence, in M&A activity and sluggish fundraising and Operate effi ciently. A panel led by Mark O’Hare, Prequin and deal fl ow. Ltd., explored private equity valuations. John Kim, Court Square Capital Partners, It featured William Franklin, Conversus The secondary market7 was analyzed led a panel of LP investors, made up Asset Management; Thomas Goldstein, by a panel moderated by Stephen Can, of Greg Davis, State of Indiana Public formerly of Madison Dearborn Partners; Strategic Partners; it fea- Employees’ Retirement Fund; David and Erin Hill, One Equity Partners. After tured Ethan Falkove, of Neuberger Fann, PCG Asset Management; and John Morris, HarbourVest Partners. Panelists indicated that current market conditions have increased the infl uence that LPs Presenters agreed that reports of the death of private equity have in setting terms and conditions, are premature. including the key area of fees paid to GPs. In addition, long-term shifts in the types of benefi t plans administered by pension years of highly superior performance, Berman; Mark O’Hare; Carlo Pirzio- plans and the trend of private equity private equity saw write-downs averaging Biroli, Group; and Philip funds going public have altered the fund- 17% as of year-end 2008. Although signif- Tsai, UBS Investment Bank. The global ing available to GPs. LPs are currently icant, these write-downs were still much secondary market grew rapidly from 2006 interested in the secondary market, se- lower than those in other asset classes, through 2008. Transaction fl ow slowed nior bank loans, distressed debt, mez- most notably public equities. down in the fi rst half of 2009. Although zanine funds,9 energy, clean technology, both supply and demand are strong, bid Panelists concentrated on the impact of and emerging markets. Finally, although and ask prices are far apart. On the seller recently introduced fair value accounting (lagging) write-downs in private equity side, many LPs are facing a severe liquid- rules.6 From a general partner (GP) per- valuations have helped some LPs stay ity crunch, as their net cash fl ows (dis- spective (see note 1), these rules have within investment policy limits, future tributions less new capital calls) have created a need for a much broader ap- capital calls could once again challenge fallen signifi cantly. Furthermore, for proach to valuations, using a wide variety their ability to adhere to these limits. many LPs, declines in the value of other of data points. Independent valuation invested assets (such as public equities) Leveraged loan market committees and outside auditors are have caused the percentage of the over- also becoming more actively involved. Meredith Coffey, LSTA, surveyed short-, all investment portfolio allocated to pri- Some GPs have questioned whether fair medium-, and long-term trends in the vate equity to exceed policy thresholds, value is appropriate for private equity leveraged fi nance market. In the short triggering mandated adjustments.8 On assets, with their long maturities. Limited term, technical factors (increasing de- the buyer side, the secondary market partners, or LPs (see note 1), note that mand relative to supply) and fundamental prices buyers are willing to pay have de- valuations of the same asset can vary wide- factors (soaring defaults and rating down- clined sharply. Wary of “catching a falling ly across different funds. Valuations can grades) are moving in opposite directions. knife,” buyers are weighing the impact be useful to LPs in assessing the track In the medium term, the massive amount of the fair value accounting rules and the record of different GPs and in determin- of leveraged loans issued during 2005–07 recession on portfolio company perfor- ing asset allocations. The panel conclud- will need to be refi nanced over the next mance and GP valuations. In addition, ed that, while valuations are by necessity few years. Collateralized loan obligations providers of leverage to secondary market 10 subjective, the most recent efforts to de- (CLOs) had played a key role in fi nanc- buyers have essentially closed for business, termine valuations do represent diligent ing growth in leveraged lending during further reducing investing activity. and honest attempts to arrive at fair value. the boom, but CLO issuance has essen- tially ceased. Loan modifi cations (“amend GPs and LPs Steven Pinsky, of J. H. Cohn, moderat- and extends”) may lengthen maturities ed a panel examining current industry GPs face the daunting task of determin- for stronger companies and provide some trends, as well as perceptions, miscon- ing optimal staffi ng to accommodate relief. In addition, some of this bank debt ceptions, and predictions espoused by the multiple demands they face. This may be refi nanced in the high-yield bond argued that the most important ingredient proposals to increase the taxation of market, provided this market remains for success is picking the right manage- could adversely affect open and relatively healthy. In the long ment team—one that has the experience innovation and risk capital and, thus, the term, Coffey said, the leveraged loan mar- and fortitude it takes to successfully broader economy. Among the sectors ket is expected to be less levered11 and run a bank in today’s environment. projected to be the most active targets more expensive, but also more stable. of venture investing in the next three to More regulation on the horizon? fi ve years were clean technology, infra- Distressed assets and the banking The prospects for private equity regula- structure, and biotechnology. The emerg- sector tion were discussed by Michael Tokarz, ing markets of Brazil, China, India, and A panel on distressed asset investing MVC Capital, as interviewed by Edward Africa were mentioned as highly attractive was moderated by Kenneth Yager, of Hortick, VCFA Group. Tokarz provided regions for investment. MorrisAnderson. Panelists were Clifford a long-term perspective on this issue. Brokaw, Corsair Capital Partners; Navin Previously, as a member of Kohlberg, A long-term, global view Nagrani, Hilco Real Estate; David Onion, Kravis, Roberts, and Co., he was involved Adnan Hassan, Mecasa Advisors, provid- Chicago Capital Holdings; and David in the buyout wave of the 1980s and the ed a wide-angle perspective on confer- Wirt, of Locke Lord Bissell & Liddell. fi rst attempts at regulating private equity, ence issues. He indicated that sovereign While depressed asset valuations provide which involved proposed tax changes wealth funds13 serve their sponsoring an incentive to invest, available capital and the reporting of “highly leveraged governments by reducing volatility in has declined, and investors will likely re- transactions.” Regarding the current revenues, building up savings, supporting main out of the market through the end proposal to require registration of certain strategic planning, and diversifying earn- of 2009. In the fi nancial sector, recently hedge funds12 and private equity funds, ings streams. While these funds benefi t concluded stress tests at the largest banks Tokarz stated that private equity gener- markets through quick decision-making, were considered helpful in reducing ally does not pose systemic risk because, ample liquidity provision, and protection the uncertainty about capital needs. in his opinion, systemic risk is largely of the privacy of investees, they have Panelists judged that there was enough driven by liquidity issues, and private eq- raised concerns because of a lack of private capital available to recapitalize uity, on account of the long-term nature transparency, possible political agendas, the entire U.S. banking industry, but that of its assets and liabilities, does not pose and placement of assets into foreign mid-tier banks were the riskiest segment such issues. That said, he indicated that hands. Hassan pointed out that “Islamic” in the long term and that rescues for certain hedge funds and other very large fi nance is a small but rapidly growing small-tier banks from private sources fi nancial institutions may warrant regis- market niche that is essentially a form of would be extremely limited. tration due to potential liquidity risks. socially responsible or “ethical” fi nance, based on risk sharing and personal ties Richard Decker outlined how his fi rm, The venture capital model Belvedere Capital Partners, which spe- between partners in a transaction. cializes in acquiring fi nancial services Susan Boedy, Thunderbird Global Private companies, views current opportunities Equity Center, moderated a discussion on global venture capital, with panelists in the banking sector. Although the Charles L. Evans, President; Daniel G. Sullivan, Senior fi nancial services sector offers unprec- Jack Biddle, of Biddle Novak Venture Vice President and Director of Research; Douglas D. Evanoff, Partners; John Dominguez, SVB Capital; Vice President, fi nancial studies; Jonas D. M. Fisher, edented opportunities for investors, until Vice President, macroeconomic policy research; Daniel recently, very little private equity money Clare Fairfi eld, Venture Capital Institute; Aaronson, Vice President, microeconomic policy research; William A. Testa, Vice President, regional programs, has fl owed into it. Private equity fi rms and Randy Mitchell, U.S. Department of Commerce. Based on the number of and Economics Editor; Helen O’D. Koshy and face a dilemma of whether or not to be- Han Y. Choi, Editors; Rita Molloy and Julia Baker, funds, venture capital is the largest sector Production Editors. come bank holding companies (BHCs). BHCs face much greater regulatory scru- of the private equity industry, with 31% Chicago Fed Letter is published by the Economic of the funds raised to date globally in Research Department of the Federal Reserve Bank tiny and generally may not own control- of Chicago. The views expressed are the authors’ ling interests in nonfi nancial companies. 2009. However, it represented only 9% and do not necessarily refl ect the views of the of aggregate capital raised, compared Federal Reserve Bank of Chicago or the Federal However, avoidance of BHC status would Reserve System. require limitation of fi rms’ investment with 44% for buyout funds. Despite the fi nancial crisis and an extremely subdued © 2009 Federal Reserve Bank of Chicago in banks to relatively passive, noncon- Chicago Fed Letter articles may be reproduced in trolling stakes, with fewer of the control exit market, the amount of investment whole or in part, provided the articles are not in venture capital held up relatively reproduced or distributed for commercial gain features (such as board seats) investors and provided the source is appropriately credited. would normally require. In addition, the well in 2008 and so far in 2009. Prior written permission must be obtained for any other reproduction, distribution, republica- banking industry faces major challenges Panelists stressed the need for a broader tion, or creation of derivative works of Chicago Fed at present, including restoring sound “ecosystem” to support entrepreneur- Letter articles. To request permission, please contact credit fundamentals, improving capital Helen Koshy, senior editor, at 312-322-5830 or ship, beyond the existence of funding email [email protected]. Chicago Fed and liquidity management, and build- markets. The U.S. still leads the world Letter and other Bank publications are available at www.chicagofed.org. ing a “fortress balance sheet.” Decker in this regard. They also cautioned that ISSN 0895-0164 Policymakers, confronted with traumatic “Traditional” fi nancial values and conser- Conclusion events such as the collapse of the hous- vative banking are also returning, benefi t- Presenters at the conference were in gen- ing giants Fannie Mae and Freddie Mac, ing advocates of “Islamic” fi nance. Given eral agreement that, despite a dramati- are trying to prevent a global depression all of these factors, Hassan argued that cally altered fi nancial landscape, private while facing fi nancial risks of uncertain private equity, based more on long-term equity’s long-term and well-documented magnitude. In addition, state capitalism relationships than on pure fi nancial en- cyclical nature drives favorable expec- (whether in Washington, Beijing, or gineering, would remain an attractive tations of survival and prosperity after Abu Dhabi) is trumping freewheeling investment model. “worlds collide.” markets —at least for now.

1 Private equity funds are pools of capital 4 A leveraged loan is a bank loan that is 8 This phenomenon is known as the “de- invested by a private equity partnership, rated below investment grade (BB+ and nominator effect.” typically involving the purchase of major- lower by S&P or Fitch, and Baa1 and 9 Mezzanine funds target debt instruments ity stakes in companies (not listed on a lower by Moody’s) to fi rms with a sizable that provide the layer of fi nancing that has public stock exchange) and/or entire debt-to-EBITDA (earnings before interest, intermediate priority (seniority) in the business units to restructure their capital, taxes, depreciation, and amortization) capital structure of a company, demonstrat- management, and organization. The ratio, or it is one that trades at wide spreads ing both debt and equity characteristics. standard vehicle for investment in private over Libor, or London interbank offered 10 equity funds is the limited partnership. rate (e.g., more than 150 basis points). CLOs are structured credit securities The manager of the fund, the partner- 5 backed by whole commercial loans, These are loans of companies under- revolving credit facilities, or letters of ship’s general partner, makes, monitors, going (or expected to undergo) bank- and ultimately monetizes investments credit, where interests in the security are ruptcy or restructuring in an effort to divided into tranches with differing re- for a return on behalf of the investors avoid insolvency. (the limited partners). Limited partners payment and interest earning streams. 6 include pension funds, com- U.S. accounting rules that expand and 11 That is, less leverage in borrowers’ capi- panies, asset management fi rms, and clarify the use of fair value (or “mark- tal structures will be allowed than in the fund-of-fund investors. to-market”) accounting went into effect recent past. at year-end 2008 for most fi rms. Imple- 2 Leveraged buyouts involve the acquisition mentation of these rules has been con- 12 Hedge funds are investment pools that of a company using a signifi cant level of troversial in the current environment, face few restrictions on their portfolios borrowing (through bonds or loans) to where some market values are severely and transactions. Consequently, they are meet the cost of acquisition. Usually, the depressed and may not represent true free to use a variety of investment tech- assets of the company being acquired economic values. niques to raise returns and risk. are used as collateral for the loans. 7 A secondary market is a market where 13 Sovereign wealth funds are pools of funds 3 Commonly measured as the proportion an investor purchases an asset from an- set up by sovereign governments to manage of debt to equity (also assets to equity and other investor rather than from the funds not needed for short-term purposes. assets to capital), leverage can be built up original issuer. by borrowing (on-balance-sheet leverage) or by using off-balance-sheet transactions.