What lies ahead?
1. Feel the fear and do it anyway?
Uncertainty reigns supreme. No economist can say with absolute confidence whether the year ahead holds a full blown global recession or a minor correction. But the fear is there. The knife is falling and catching it safely is the trick behind good investing in an environment like this. But there are pockets of resistance. The mid-market and emerging markets are proving resilient sources of deals and exits. But the risk of contagion is ever present. Confidence among bankers is keeping the tills open for deals up to €1.5 billion ($2.2 billion). But it is not hard to imagine a scenario where sentiment turns overnight with more revelations from the subprime meltdown, causing vendors and bankers to freeze and blowing the tumbleweed across the M&A landscape. Step forward the brave contrarian.
2. In pursuit of value
There have always been value investors, of course. But finding it in today’s economic slow down is critical, with vendors’ mindsets still set to the buyout boom of the first half of 2007 when multiples were rocketing. In early 2008 the danger is that any deal palatable to a seller is one with yesterday’s pricing, which will make multiple arbitrage a tough play. The truth is 2008 will be the year that shows investors who the real value creators are, now that the crutch of cheap money has gone. For private equity funds, it is time to roll up the sleeves and get busy. Chances are there is already something in the portfolio that is proving a little challenging. It’s a great opportunity to blood the in-house turnaround team.
3. Bad time to sell?
Anecdotal evidence is starting to show: finally the trade buyer is prevailing after years of private equity dominance. That Apax Partners emerged victorious this week from the auction for UK media group Emap deal, where other pure-play private equity consortia fell away, is surely thanks to having trade buyer the Guardian Media Group on its team. According to market source, for the first time in years trade buyers feel they are on a level playing field with private equity. This is obviously a mixed blessing. Increased competition from cash-rich trade buyers will make it harder to do deals. But as refinancings remain tricky to execute and secondary buyouts diminish, at least one exit route, a sale to a strategic buyer, remains viable.
4. Lots of money, but LPs will be picky
Few fundraising specialists will tell you they’re dreading their next marketing campaign. And why should they? Several credible surveys of investor appetite for the asset class have been published since the credit crunch began, and all of them predict that institutional allocations will continue to rise. Underpinning these bullish forecasts is the notion that limited partners are now smarter than they used to be, determined to invest right through the cycle to take advantage of downmarket buying opportunities. Crucially, though, not all GPs will benefit. As the flight to (perceived) quality and scale continues, the brand-name mega firms will dominate more and more. Well-differentiated mid-market groups and best-in-class venture houses will also do well. Mid-tier me-too funds on the other hand will struggle.
5. Bad politics
Don’t think for a minute private equity can afford to relax its stance in the ongoing battle for a better public image. The industry’s foes may currently be distracted by the market turmoil, but many politicians, journalists, trade unions and bureaucrats remain united in their opposition to buyout funds in particular. The debate on tax continues in many countries, and the moment a high-profile portfolio company gets into trouble, private equity will be back in the headlines for all the wrong reasons. In addition, economic nationalism and protectionist thinking are in the ascendancy, which should be a major worry for those private equity practitioners hoping to invest capital outside their home markets.
6. Safety-first investing
Back to that word “fear” again. No-one knows precisely what the implications of a US recession will be on a global scale. For example, some economists predict that Asia will be more sheltered from the fallout this time than it has been in the past, while others dismiss this as wishful thinking. One thing’s for sure, however: the thoughts of many private equity professionals are turning to those sectors that offer maximum protection from the economic down-draft. Think predictable growth, steady cash flows, government contracts and consumer staples…and expect a big year for infrastructure, healthcare and discount retail among others.
7. Better times for some
While the crowd watches from the shore with a feeling of trepidation, certain investors will plunge into the choppy waters with relish in 2008. Most obviously, perhaps, turnaround and distressed specialists will take much encouragement from an environment that suddenly looks less than benign. For mezzanine groups left on the sidelines of a market fuelled by cheap and easy debt, there is much to like about the prospect of more sober financing structures. Buyers of secondary positions, meanwhile, are seeing a pleasing transition from premium to discounted valuations. For those who love swimming against the tide, the cry will resound: “Come on in, the water’s lovely!”
8. Political risk has been downgraded
Following a series of emerging market meltdowns that began in 1997, scores of private equity firms got mauled across Asia and Latin America. It is unclear, however, how much of the damage was due strictly to macroeconomic and geopolitical forces, and how much was due to GPs investing in bad companies run by bad managers who couldn’t get tough when the tough got going. The firms that stayed put through the “contagion” are now thriving and sought after by LPs. As more and more Western GPs flee the high prices of developed markets for places like Colombia and Uganda (the site of Blackstone’s latest deal), it is clear that they have a different take on risk in these markets, which is, as Actis’ Paul Fletcher likes to argue, that you’re more likely to lose your shirt due to regular old manager underperformance than to economic collapse or Hugo Chavez-style asset seizure. The question is not, could Chavez happen in Uganda, but rather could Refco happen in Uganda? The latter is more likely than the former, and in any case is something that GPs can actually work to avoid.
9. Sovereign funds can change their minds
The private equity market is right to view with awe the rise of sovereign wealth funds as major forces in global private equity. These enormous and growing pools of capital will be partners, backers and competitors of traditional private equity GPs. And they have demonstrated a keen interest in being industry insiders, as witnessed by their several purchases of stakes in Carlyle, Blackstone, et al. There has been talk of a “sovereign wealth premium” for certain assets, indicative of the low-cost-of-capital appetite these funds have to put their capital to work in long-term, private investments. But many of these groups, like the China Investment Corp, are new to the game and, just as internal politics have led them in the direction of Western alternative assets, internal politics can pull them back. CIC itself has indicated that it’s not sure to what extent it will continue its current spree of direct investment. There is no doubt that sovereign wealth funds will be important to the future of private equity and all other asset classes, but it is unlikely that their ramp-up in private equity will resemble a straight line.
10. Private equity and public markets go together like rama lama lama, ke ding a de dinga a dong
The private limited partnership, a species most frequently seen in Delaware and England, has thrived within the private equity ecosystem, but it by no means will be king of the jungle forever. As fund formation lawyers know, the LPA is the solution to a problem, and as private equity faces shifting problems, the solutions will multiply. The public markets present tremendous opportunities for capital formation aimed at private equity, and this market will continue to see innovations in this regard that will fundamentally change the way investors interact with GPs and the underlying assets managed by the GPs. Greece-based Marfin Investment Group raising a €5 billion vehicle on the public markets for private equity investment is a phenomenon to get used to. Every large firm, and many of the smaller ones, will tap the public capital markets in the near future. And no one need fear this trend. When a McDonald’s opens up across the street from a Burger King, business at both increases. As public vehicle capital increases, so too will limited partnership capital.