In Recent Years, Surplus Cash and Increased Liquidity Have Made It Increasingly Difficult for Private Equity Funds to Find Good Deals

10 MASTERING FINANCIAL MANAGEMENT / PRIVATE EQUITY PRIVATE EQUITY / MASTERING FINANCIAL MANAGEMENT 11 Private equity funds look for strength in numbers In recent years, surplus cash and increased liquidity have made it increasingly difficult for private equity funds to find good deals. The solution may include consortium investments and specialised portfolios hirty years ago, the private the ∑12bn leveraged buy-out of Wind, the Ital- With state-owned assets of approximately ■ Substantial capital flows to private equity equity industry was not really ian telecommunications company; the $11.4bn ∑700bn privatised in Europe over the last 30 can be self-defeating in the sense that too an industry at all – the practice buy-out of SunGard, the US financial services years, the key question is: how much is left? much money is chasing too few deals. This of buying shares in private com- and data recovery company; the $6.6bn acqui- According to the website Privatization problem was identified by Professors Paul A panies for investment purposes sition of Toys R Us, the USretailer; and theBarometer EU governments still hold direct Gompers and Josh Lerner of Harvard Busi- was confined mainly to wealthy ∑4.3bn buy-out of Amadeus, the Spanish and indirect stakes worth almost ∑300bn, ness School, who found that the greater the Tfamilies, and they generally wanted to invest provider of IT solutions to the travel industry. mostly in France, Germany and Italy. How- supply of private equity capital to a fund, the in small, fast-growing companies at an early Venture capital also had a strong year, with ever, the actual privatisation potential is higher the prices paid for the acquired com- stage of development. Today, private equity the recovery of capital flows into European substantially larger if one takes into account panies. Subsequent research has confirmed is mainstream, sophisticated and US early-stage funds wholly-owned state enterprises as well as that this effect does indeed lower the returns and huge. It accounted for gathering momentum. public infrastructure. to private equity investment, with asymmet- about $500bn worth of deals in By The knock-on effects in ric information between buyers and sellers 2005, and the vast majority of PETER CORNELIUS, other industries were pro- and herd behaviour amplifying fundraising that sum was spent on buy- OLIVER GOTTSCHALG found. For example, private and investment cycles. In other words, the outs of established companies. equity deals generated sub- With more and more amount of attractive investment opportuni- However, the miracle could and MAURIZIO ZOLLO stantial demand for services ties is finite and, at some point, capital will be about to lose its shine. So such as advice on mergers flow into less attractive investments. many investors have piled and acquisitions, initial pub- capital to manage, the The recent surge in entry prices has been into private equity in recent years that it has lic offerings and loans. Investment banks interpreted by some market participants as a become increasingly difficult for private benefited to the tune of about $10bn, or talents and resources of sign of this “money-chasing-deal” phenome- equity fund managers, also known as “gen- nearly 20 per cent of their total revenues. non. According to the LCD Loan Review, eral partners”, to outperform the public mar- In the medium to long term, the outlook general partners have been published by US rating agency Standard & kets. As more and more capital has flowed for private equity looks equally rosy thanks Poors, European buy-outs have become par- into private equity products, so the talents to various macroeconomic factors. For exam- ticularly expensive, with average multiples and resources of the general partners have ple, in Europe, where the entire investment stretched to breaking point reaching 8.3 times earnings before interest, been stretched to breaking point. Many funds portfolio “at cost”, a measure of capital tax, depreciation and amortisation in 2005, up have grown excessively from one generation invested in portfolio companies, was still As far as the buy-out market is concerned, from a multiple of 6.8 in 2003. However, profit to the next and, as the industry has become below ∑200bn at the end of last year, or less about 6,300 European and US companies growth and cash flows of underlying portfo- Nick Lowndes awash with liquidity, so it has become easier than 2 per cent of GDP. Even in the UK, have a value of more than $500m. Of these, lio companies have remained strong. And, for less able fund managers to survive. Con- Europe’s most attractive economy for pri- 3,600 are based in the US and 2,700 in Europe. encouragingly, average debt-to-equity ratios This effect may be compounded if less skilled But recent research by Prof Gottschalg returns through cost and revenue synergies sequently, the average returns on the asset vate equity, capital under management More than half appear to be unsuited to pri- have increased relatively moderately, despite fund managers help inflate acquisition mul- shows that managerial motivation can be has allowed them to outbid private equity class as a whole are under threat. stands at only about 3.5 per cent of GDP. To vate equity because their performance or highly liquid debt markets and historically tiples. As the variance of returns across indi- In the more mature private enhanced through non-financial mechanisms competitors in a number of recent deals. With too much money chasing too few reach the same degree of private equity activ- public ownership structure makes them dif- low interest rates. vidual investments and fund managers could after a buy-out and that this type of motiva- Some private equity investors have begun deals, the industry is putting itself through a ity as the UK, continental Europe would ficult to acquire. However, research by McK- increase further, the successful selection of tion is a particularly important determinant to recognise the potential opportunities radical restructure in the search for higher require net investment flows to increase by insey, the management consultancy, ■ Excessive growth in fund size from one the funds that perform in the highest quar- equity markets, funds are of buy-out success. One key driver of such a shift from a stand-alone approach towards returns. For example, private equity funds 10 per cent annually over the next ten years suggests that the remainder is still big fund generation to the next can have a sig- tile becomes even more vital. motivation stems from the fact that man- a more portfolio-oriented one may bring are beginning to club together in order to – not an unrealistic scenario given the poten- enough to provide the private equity industry nificant detrimental effect on subsequent The private equity community has begun pooling their resources to agers of acquired companies may not only about. A number of them have become construct huge deals, reach out globally and tial demand for private equity financing. with plenty of growth. performance. As investors have grown to to recognise these challenges. For example, take financial but also emotional ownership increasingly industry-focused, and there are penetrate new markets. They are beginning An important source of demand will be On the supply side, recent survey evi- appreciate how important it is for their gen- investors are increasingly searching world- make mega-investments of the companies they manage, which pushes several examples where companies bought to manage their investments more actively – family-controlled companies, which typically dence, such as the Alternative Investing Sur- eral partner’s performance to be in the “top wide for opportunities, as evidenced by the them to do everything they can to make by private equity houses have made subse- with new governance and incentive struc- account for two-thirds of all enterprises in vey published by Russell Research, indicates quartile” of the market, more and more sharp rise in cross-border investment flows. “their” buy-out a success. quent acquisitions. tures, and the direct involvement of general industrialised countries and about half of that European and especially Japanese pen- money has flowed to general partners with a Several US private equity houses have opened ous owners for less than they were worth, or The second mechanism comes from the Nevertheless, for the industry as a whole, partners in the operational and strategic deci- economic output. In Europe, more than 2,250 sion funds and insurance companies actu- superior track record. This has raised the offices in Europe and some of them have the tax shielding effect of the large amount of more direct involvement of the acquiring adopting a new model where value is created sions of portfolio companies. And they are companies of this type have been involved in ally plan to continue to play catch-up and question of whether a private equity group been involved in top European buy-outs, such debt that was used in the transaction. buy-out group in the transaction. A recent through portfolio synergies will require a beginning to specialise in particular indus- European private equity transactions since increase their exposure towards US levels able to invest a $250m fund successfully over as TDC and Legrand in the UK, and Eircom However, the increasingly competitive Insead study shows that an active involve- fundamental change in mindset. This is part tries or sectors, on the basis that they can the early 1990s. On average, they accounted over the coming years. US institutional the past few years will be able to invest a Fixed Line in Ireland. ` market for corporate control and changes in ment of buy-out fund managers in financial, of private equity’s biggest challenge: find- enhance returns through synergy and col- for one in every five deals and, in some years, investors currently allocate around 7.5 per $1.5bn fund with equal success, using essen- While the penetration of the US market by the institutional environment have lowered strategic and operational decisions of the ing new ways to enhance the fundamental lective experience.

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