NO DECOUPLING FOR THE MID-MARKET

It's official: buyout activity in Britain, Europe's most active private equity market, has fallen off a cliff. And quite a high cliff it was, too: according to numbers published by the Centre for Management Buyout Research at the University of Nottingham in early January, UK deal-making dropped 80 percent in the final quarter of last year. £15.4 billion of transactions in Q3 was followed by just £2.9 billion of deals in Q4.

In the wake of the credit crunch, this black-and-white confirmation of a sharp downturn is hardly a surprise. But the magnitude may still have shocked some: given private equity's recent prominence in European M&A, an 80 percent decline is as close to a complete standstill as seems conceivable. According to CMBOR, Q4 was the dullest quarter for buyouts since 2003. If extrapolated to the full year, its £2.9 billion tally would blast the UK market back to levels last seen in 1998.

The main cause of the decline is the crunch-triggered disappearance of large buyouts. The £11.1 billion public-to-private for Alliance Boots, Britain's largest chemist and Europe's largest LBO to date, helped push 2007's third quarter to an all-time high. The absence of anything even remotely similar in the fourth quarter then produced the sobering numbers at year-end.

The mid-market has fared better. News flow relating to buyouts valued at up to £1 billion has held up reasonably well so far. This is partly because, as mid-market practitioners monitoring the availability of debt finance to fund deals often note, key mid-market lenders such as balance sheet-powered European commercial banks have remained open for business, whereas the distribution-focused international investment banks servicing the top end of the market have had to shut up shop.

Despite this, the numbers show that mid-market deal activity is not proving immune to the overall slowdown. CMBOR found that Q4 produced just £735 million worth of deals in the £100-500 million bracket, down from £1.8 billion in the same period of 2006. Looking ahead, many mid-market funds are predicting a quiet first half of 2008 in terms of new investments.

Tom Lamb, co-head of European mid-market specialist Barclays Private Equity and a sponsor of CMBOR, says the credit crisis has opened up a gap between price expectations of buyers and sellers, which will hamper the market for some time: “There is always a dislocation as buyers wait for prices to drop further and sellers for them to recover.”

dislocation as buyers wait for prices to drop further and sellers for them to recover.” If (or when as the bears would have it) the trouble in the debt markets helps trigger an economic recession, the dislocation is likely to get worse. Prospective buyers watching corporate earnings deteriorate won't bid aggressively for assets until they see the cycle turn. Otherwise, as Colin Taylor, managing director of London-based mid-market sponsor DLJ Merchant Banking Partners, noted at PEI's European Mid-Market Summit in Munich in December, they run the risk of “catching falling knives”. Avoiding this risk is not just a priority for mega-funds: falling knifes can cause heavy bleeding at funds of any size.

Neither is the lukewarm (though hopefully short-term) outlook for capital deployment the only area where big and small private equity funds are facing similar challenges. Another is political in nature. Even though liquidity crunch and tumbling stock markets have temporarily diverted media attention away from private equity, the industry's negative public image remains a problem that needs fixing if a populist backlash is to be avoided.

At first glance, this again may seem an issue primarily facing the mega-funds, which last year came under massive pressure to evidence a change of behaviour in order to appease their many critics. But don't kid yourself, as Rod Selkirk, head of Hermes Private Equity, warned PEI's audience in Munich: the moment a large private equity firm makes negative headlines with a failed portfolio company (probability: increasing), the fallout is bound to affect the entire industry. Therefore public relations management must be taken seriously by everyone in the business, not just the mega-funds that invest in large, high-profile companies.

Mid-market firms, in other words, shouldn't seek too much comfort from the idea that their being different from the large-cap end of the market in itself will be a big help in dealing with some of the tests that private equity is now facing. The way the financial world has changed in recent months has genuine implications for everyone involved in European buyouts, and it would be wrong to think of the mid-market as having decoupled from the large LBO segment altogether.