ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OCTOBER 2010 OF CHICAGO NUMBER 279a Chicag­o­Fed­Letter Understanding the new world order of private equity 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 tenth annual conference, The New World Order of Private Equity, held on July 21–22, 2010. To­kick­off­the­conference,1­Carl­ loss­of­competitiveness­over­the­long­ Tannenbaum,­Federal­Reserve­Bank­­ term­for­the­U.S.­and­other­developed­ of­Chicago,­reflected­briefly­on­the­­ economies­relative­to­China­and­other­ decade­since­the­passage­of­the­Gramm– emerging­countries.­Hutchins­cited­a­ Leach–Bliley­Act.­These­years­saw­exten- number­of­negative­indicators­in­the­U.S.,­ sive­financial­innovation,­along­with­the­ such­as­rising­health­care­and­energy­ removal­of­regulatory­barriers­that­­ costs,­the­trade­deficit,­governmental­ traditionally­separated­the­activities­­ budget­deficits,­loss­of­leadership­in­tech- of­commercial­and­investment­banks.­ nological­innovation,­lagging­educational­ The­financial­crisis­prompted­a­reeval- systems,­and­political­polarization.­ By a number of measures, uation­of­many­views­that­had­been­ the state of private equity widely­held,­culminating­in­President­ State of the industry has improved since the worst Obama­signing­the­Dodd–Frank­Wall­ A­panel­led­by­Mark­O’Hare,­Preqin­ of the financial crisis, but Street­Reform­and­Consumer­Protection­ Ltd.,­explored­the­evolving­role­of­pri- Act­on­July­21,­2010­(by­coincidence,­ vate­equity­(PE)­in­the­economy­and­ many features of the asset the­first­day­of­the­conference).­ in­investor­portfolios.­It­featured­Paul­ class have been altered. Carbone,­Baird­Private­Equity;­John­ In­another­wide-ranging­presentation,­ Crocker,­Atlantic-Pacific­Capital;­William­ Glenn­Hutchins,­Silver­Lake,­offered­a­ Franklin,­Conversus­Asset­Management;­ sobering­assessment­of­the­long-term­ Greg­Uebele,­The­Boeing­Company;­ challenges­facing­the­U.S.­economy.­He­ and­Wilson­Warren,­Lexington­Partners.­ emphasized­how­massive­deleveraging­ Based­on­extensive­data­presented­by­ by­financial­institutions,­businesses,­and­ O’Hare,­PE­has­clearly­improved­since­ consumers­could­severely­reduce­fu- the­severe­downturn­it­experienced­in­ ture­economic­growth.­He­also­warned­ late­2008­and­early­2009.­Net­cash­flows­ that­recent­fiscal­and­monetary­stimu- to­limited­partner­(LP)­investors­(see­ lus­programs­could­lead­to­future­ note­1)­fell­sharply­during­that­time­ problems,­such­as­unsupportable­levels­ period.­Valuations­have­recently­recov- of­public­debt­or­high­inflation.­U.S.­ ered­after­large­declines.­The­impact­ consumers,­who­represent­approxi- was­most­severe­in­the­largest­(“mega”)­ mately­17.5%­of­global­gross­domestic­ leveraged­buyout­(LBO)­funds,2­but­ product­(GDP),­may­no­longer­be­re- these­have­also­rebounded­substantially.­ lied­upon­to­drive­economic­growth.­ Surprisingly,­even­the­worst­vintage­of­ Hutchins­also­stressed­the­potential­ LBO­funds—2006—has­largely­recovered­ its­value,­reflecting­favorably­on­the­PE­ mergers­and­acquisitions­volume,­deal­ better­terms­in­the­current­environment.­ business­model.­ flow,­fundraising,­and­other­factors­ Investment­opportunities­over­the­next­ that­reinforced­the­conclusions­of­ 18­months­that­the­LPs­were­most­inter- Fundraising­is­still­very­challenging,­but­ O’Hare’s­panel.­ ested­in­included­mezzanine7­and­other­ LPs,­by­a­large­margin,­still­plan­to­main- fixed-income­securities,­“rescue­financ- tain­or­increase­their­allocation­to­PE,­ Meredith­Coffey,­LSTA,­surveyed­recent­ ing”­for­deleveraging­companies,­and­ especially­in­smaller­funds­and­specialty­ developments­and­future­prospects­in­ “dislocated­and­distressed­seller”­trans- areas.­Deal­flow­has­clearly­recovered,­ the­leveraged­loan­market.5­In­the­12­ actions—all­relatively­nontraditional­ particularly­in­North­America­and­Asia,­ months­prior­to­the­conference,­there­ targets­for­PE­by­historical­standards.­ covering­a­wide­range­of­industries.­In­ was­a­considerable­recovery­in­this­mar- 3 the­secondary­market, ­strong­motiva- ket,­followed­by­a­small­retrenchment­ Investing in the financial sector tion­to­sell­on­the­part­of­LPs­needing­ due­to­European­sovereign­debt­prob- Mark­Gormley,­Lee­Equity­Partners,­­ liquidity­has­been­offset­by­the­large­ lems.­A­large­volume­of­leveraged­loans,­ assessed­the­opportunities­and­risks­of­ price­discounts­sellers­have­recently­ which­Coffey­referred­to­as­the­“refinanc- investing­in­the­financial­sector.­Histor- faced.­Finally,­O’Hare­cited­a­number­ ing­cliff,”­is­due­to­mature­over­the­next­ ically,­a­significant­amount­of­private­ capital­has­been­invested­in­financial­ institutions­in­difficult­times,­such­as­ The new financial reform legislation will significantly affect when­banking­problems­arose­in­the­ banks’ involvement in private equity; however, many of the late­1980s­and­early­1990s­and­during­ specifics remain unclear. the­most­recent­banking­crisis.­Gormley­ judged­that,­from­a­policy­perspective,­ the­regulatory­response­to­the­most­re- of­studies­indicating­the­favorable­effects­ few­years.­Strong­issuance­of­high-yield­ cent­crisis­has­seemed­to­be­appropri- of­PE­on­the­broader­economy.­These­ bonds­during­2009­and­the­first­four­ ate—regulators­have­proactively­and­­ include­creating­jobs,­improving­the­per- months­of­2010­has­supported­the­­ effectively­managed­the­impact­of­bank­ formance­of­portfolio­companies,­pro- refinancing­process,­but­high-yield­­ failures.­However,­he­also­said­that­in­ viding­superior­returns­to­pension­funds­ issuance­dropped­sharply­in­May­and­ some­cases­regulators­may­have­been­too­ and­not-for-profits,­spurring­innovation,­ June.­Purchases­of­leveraged­loans­by­ patient­with­distressed­banks,­allowing­ and­seeding­economic­recoveries. issuers­of­collateralized­loan­obligations­ them­to­persist­with­minimal­or­negative­ (CLOs)6­will­need­to­play­an­important­ equity.­Letting­banks­remain­impaired­ The­panelists,­representing­both­gen- role­in­reducing­the­size­of­the­refinanc- reduces­new­loan­origination;­this­in­ eral­partner­(GP)­and­LP­perspectives­ ing­cliff.­However,­Coffey­indicated­ turn­lowers­new­job­creation­and­slows­ (see­note­1),­provided­additional­con- that­recent­legislation,­specifically­the­ the­pace­of­economic­recovery.­Gormley­ text­for­these­industry­data.­They­noted­ Dodd–Frank­Act’s­risk­retention­require- said­that,­with­fund­managers­having­ how­the­quality­of­valuations­has­im- ments­for­certain­securitizations­and­ allocated­more­than­$20­billion­of­funds­ proved­in­recent­quarters,­coinciding­ the­Foreign­Account­Tax­Compliance­ to­recapitalize­banks,­private­capital­can­ with­the­application­of­fair­value­account- Act,­threatens­the­revival­of­the­CLO­ be­an­important­part­of­the­solution.­ ing­rules.4­In­addition,­new­legal­and­ market­(and­thus­the­future­liquidity­ Private­capital­investors­assist­firms­by­ regulatory­developments­(discussed­in­ of­the­leveraged­loan­market).­­ 1)­working­with­seasoned­management­ detail­later)­may­significantly­increase­ teams,­acting­where­strategic,­more­short- secondary­market­sales,­since­banks­will­ LP perspectives term-oriented­investors­often­cannot,­and­ be­required­to­divest­some­of­their­PE­ John­Kim,­Court­Square­Capital­Partners,­ 2)­focusing­on­long-term­value­creation.­ investments.­At­the­same­time,­banks­ led­a­panel­of­LP­investors,­made­up­­ Therefore,­private­capital­offers­a­needed,­ are­increasingly­being­targeted­for­invest- of­Stephen­Can,­Credit­Suisse;­David­ willing,­and­valuable­resource­in­the­­ ment­because­of­the­current­challenged­ Fann,­PCG­Asset­Management;­John­ recovery­of­the­banking­sector. state­of­the­banking­industry­and­its­need­ Rompon,­McNally­Capital;­and­Greg­ for­new­capital. Turk,­Teachers’­Retirement­System­of­ The global venture capital model Steven­Pinsky,­Sutton­Advisory­Group,­ the­State­of­Illinois.­The­panel­was­­ Randy­Mitchell,­U.S.­Department­of­ led­a­panel­of­investment­professionals­ subtitled­“passive­no­more,”­implying­ Commerce,­moderated­a­discussion­on­ that­discussed­PE­trends­in­the­recent­ increased­assertiveness­on­the­part­of­ global­venture­capital­(VC),­with­panel- economic­cycle.­The­panel­comprised­ LPs.­However,­panelists­indicated­that­ ists­Robert­Ackerman,­Allegis­Capital;­ Warren­Feder,­Carl­Marks­Capital­­ most­LPs­have­had­limited­success­in­ Susan­Boedy,­Knightsbridge­Advisers;­ Advisory­Group;­Thomas­Janes,­Kerry­ “shifting­the­paradigm”­of­GP/LP­rela- Victor­Hwang,­T2­Venture­Capital;­­ Capital­Advisors;­Joseph­Linnen,­The­ tions—the­top­GP­firms­are­still­able­to­ Matthew­McCall,­New­World­Ventures;­ Jordan­Company;­and­James­Marra,­Blue­ raise­money­on­their­own­terms.­Never- and­John­Taylor,­National­Venture­­ Point­Capital­Partners.­The­panelists­ theless,­LPs­with­larger­amounts­of­capi- Capital­Association.­While­VC­funds­rep- identified­recent­trends­in­PE­activity,­ tal­to­offer­are­able­to­obtain­marginally­ resent­only­0.2%­of­U.S.­GDP,­revenues­ from­former­VC-backed­firms­correspond­ Mathonet,­European­Investment­Fund.­ prohibit­them.­The­Volcker­rule­will­­ to­22%­of­GDP.­U.S.­VC­assets­under­