Twenty percent – and maybe as high as 40 percent – of large buyout firms around the world could go out of the business in the next few years, resulting in losses of up to $1 trillion in the broader economy, according to a new study.
The study, authored by The Boston Consulting Group and Spain’s IESE Business School, said private equity firms that enjoyed years of “exponential growth” have been battered by the global financial crisis.
“Private equity firms have enjoyed extraordinary growth and returns over the last five years, but the collapse of the world’s debt markets and the deepening economic crisis have brought this boom to an abrupt end,” the study’s authors, Heino Meerkatt and Heinrich Liechtenstein, said in the study.
Meerkatt is a senior partner in Boston Consulting’s Munich office, and Liechtenstein is an assistant professor of financial management at the IESE Business School.
They said firms that don’t survive the downturn will have four things in common. First, managers that need to fundraise in the next two to three years may not be able to survive because of the lack of liquidity in the market.
Second, investors will only sign up with firms that have “top-quartile, long-term performance”. In the past few years, investors were willing to form relationships with lower-quartile players, but that will not be the case in the current financial environment, the study said.
Third, firms that made acquisitions just before the financial crisis broke last year, and paid high multiples on their purchases, will face losses even if their portfolio companies are performing well because multiples have collapsed.
“In 2008, the 45 percent drop in stock prices has changed this situation dramatically, pushing multiples below the level of the previous three to four years. Any potential sale of a portfolio company with reduced earnings expectations and lower multiples will lead to a loss,” the study said.
And finally, it said firms’ performance amid the downturn will be based on whether their portfolio companies are in “relatively recession proof industries” like the European utilities sector.
The study predicts that many buyouts firms’ portfolio companies will default, which could lead to a loss of up to $1 trillion in the broader economy.
“When we analyzed credit spreads of 328 private-equity portfolio companies in November 2008, we found that roughly 60 percent of their debt was trading at distressed levels,” the study said. “This suggests that almost 50 percent of these companies could default during the next three years.”
To protect themselves, private equity firms should prepare their portfolio companies for a “long and deep recession”, through the creation of “operational value”. Firms also should look to take stakes in the troubled portfolio companies of other private equity firms as they come into market at steep discounts.