SWITZERLAND

Based purely on the column inches devoted to the turmoil in the financial markets, it would have been easy for the casual observer to think that private equity was facing a serious crisis. With equity markets volatile and deals apparently impossible to finance at the large end of the buyout market – hitherto the engine room of the industry's rapid growth – would investors that have been pouring their money into the asset class think twice and switch it all to bonds instead?

Perhaps this may turn out to be the case with some of the more recent entrants to the market. But it was never going to happen with the Swiss investors who have been backing the asset class over many years, and through all stages of the cycle. Among these experienced groups, many of which have been busy expanding their activities and geographical reach in recent years, the message seems to be very much: business as usual. Not quite full steam ahead, perhaps, but something not far off.

LONG MEMORIES
One strength of these groups is their ability to take a longer-term view, having seen the industry operating through good times and bad. “It's important to put the whole thing into perspective,” says Thomas Kubr, chief executive of Zug-based investment manager and adviser Capital Dynamics. “Private equity is a very long-term asset class. For two years we've been waiting for the party to end – and this is not even an end, it's just taking a breather.”

He cautions against short memories. “Yes, the debt markets are tighter – there's less debt available and it costs more. But compared to two or three years ago, the terms are still very advantageous – pricing is still at historically low levels. This was a debt bubble, not an equity bubble – [The debt bubble] helped fund some fantastic deals, but we always said it was going to burst.”

Alfred Gantner, managing partner of alternative assets manager Partners Group, agrees: “We've been waiting for this correction to happen for the last two years.” But for a multi-strategy manager like Partners, it's not all bad news, he says: “On the debt side we're seeing a more normalised risk spread, so our credit guys see this as a very positive development. On the other hand, interest rates and credit spreads are still at historically low levels, so mezzanine returns are still relatively low.”

Rainer Ender, managing partner of funds of funds group Adveq, suggests that the problems are more significant in the US. “We've seen significant growth in the large buyout market since the start of 2005. These mega-deals have largely been in the US – usually public-to-privates – and the credit problems are mainly affecting activity in this space. So it's more of a US topic.” But has the recent turmoil made them nervous? “We're not nervous. We expect a slowdown at the large end of the market – but it comes from a very high starting point. It's a good and welcome correction.”

OPPORTUNITY IN DISGUISE
But what will this correction amount to? Several high-profile deals have already seen debt packages pulled, or terms adjusted – will LPs in the big funds be the ones to pay the price? “Deals will need more equity and pricing will come down. These two effects will act against each other when it comes to returns,” Kubr says. “It's hard to say where the net effect will come out – I suspect the lower prices will not be enough to offset the lower leverage, so returns are likely to come down.” However, this is something most managers have been expecting.

Indeed, Gantner subscribes to the view that the problems are really an opportunity in disguise. “We're seeing an increase in risk aversion in financial markets which leads to a repricing of risk premia – this is healthy. This is not a sign that the underlying companies or the broader economy are doing badly. Actually, our portfolio companies are developing very nicely. It's an opportunity for us to increase our mezzanine exposure in the secondary market to the companies we like best and improve yields.”

In some respects, the market looks more favourable, he says: “Recently, if a company was doing well it got recapped within one or two years, so you lost your best quality paper.”

All agree that the large buyout segment is facing a slowdown as the current deal pipeline slowly works its way through the system. But according to Kubr, this was also bound to happen sooner or later. “A lot of the low-hanging fruit has now been picked. Partly because more equity will be required, but also because large club deals are very difficult and complex, the slowdown at the upper end will be more severe. It could be a few years before we see deals like TXU again.”

But even if experienced managers can be relied upon to hold their nerve, will the same be true of their investors? “It's probably too soon to say,” Kubr admits. “We probably won't see the full impact until early next year. But in general terms we are happy to state that our clients are quite content – they may have to provide more information to their superiors, but since they understand what is going on, there has been no sign of panic.”

But even if experienced managers can be relied upon to hold their nerve, will the same be true of their investors? “It's probably too soon to say,” Kubr admits. “We probably won't see the full impact until early next year. But in general terms we are happy to state that our clients are quite content – they may have to provide more information to their superiors, but since they understand what is going on, there has been no sign of panic.”

As a result, Gantner says, the outlook is positive: “The subprime troubles may last for some time, but I don't think it has the capacity to really jeopardise significantly the positive global economic developments. I would personally be surprised if the banks have to write down more than 5-10 percent of their non-syndicated buyout debt exposure. If I do the math, that is far below their reported first half profits. By Q1, they'll be open for business again.”

Ralph Aerni, senior partner and chief investment officer at Zurichbased adviser/gatekeeper SCM Strategic Capital Management AG, feels that the effects of the credit crunch may be felt for as long as 18 months, in part because of sellers holding out for valuations that do not take account of the changed circumstances. However, he too is positive when it comes to private equity's fundamentals: “The last three years have been exceptionally good and a slowdown doesn't equate to a bad environment. There are still great opportunities and the global economy is growing. I don't see things changing too much.”

THE WEIGHTING GAME
Nonetheless, will there be any impact on allocation decisions? Ender suggests that even if investors remain positive about the long-term prospects of large buyouts, they may still look to use this opportunity to increase their exposure to other areas. “Because the large buyout funds have been coming back to market so quickly, investors got overweight just by continuing to re-up existing relationships. So now they want to re-balance their portfolio.”

One area he thinks will benefit is distressed debt. Adveq itself is currently raising its second opportunities fund to target this space. “Appetite from investors has been very strong, given the general uncertainty in the market. Fundraising started before the recent problems, but it has picked up in the last few months and we see some good interest now the summer break is over.”

The area is attracting increasing attention within the industry, with a deterioration of credit quality almost inevitable in the aftermath of the credit crunch. But Kubr points out that this is not necessarily a recent development. “None of the really good operators are new – they're just more visible again now.” Indeed, the best funds in the space are attractive investments throughout the cycle, he adds. “The good funds were able to make money even in good economic conditions – and they can make even more now, because they have more deal flow to work with.”

However, if investors are looking to get into the distressed space now, they might be too late – most operators have already raised their funds, in readiness for the approaching slowdown, and have no requirement for new investors. “It would be difficult to start investing in these funds now. You'd probably be about a year too late,” Kubr says.

Aerni says the current enthusiasm about the distressed space requires some context: “Distressed debt funds are seeing more opportunities and are undoubtedly excited about the current market, but any pick-up in activity will be from an extremely low level. Even if activity was to double, it would still be fairly low and would not justify a massive increase of an LP's allocation towards the distressed segment.”

Asia is another area that some of the big Swiss managers have been targeting this year, particularly Japan, a country where institutional investment in private equity remains a tiny proportion of the global total. In May, Adveq opened its first office in the country, while in July, Partners Group launched a joint venture with Japanese asset manager Sumitomo, which sought the tie-up following pressure from its pension fund clients. “It's an area where people have not been very active in the past and want to build up their exposure,” says Ender.

However, Kubr believes the opportunity there is overstated, at least relative to other markets. “Asia seems to be the hotter topic – and it will see high growth in relative terms, because it's starting from such a small base. If you look at the fundamentals, the growth of the industry in Europe is tremendous. In absolute dollar terms it is outstripping Asia by far, and it will continue to do so for many years.” But all agree on one thing – that diversification away from large buyouts is inevitable. “We strongly believe in diversification, and it's something we've been recommending all along,” says Gantner. “The safest, most efficient recipe for risk-adjusted returns is solid diversification: small and mid-cap buyouts, growth capital, Asia… A portfolio should not be built around three or four big groups.”

Secondaries should not be underestimated either, he insists. “It's a great hedge to keep some powder dry for the secondary market. So much new and inexperienced money has entered the buyout arena, we think there'll be very good opportunities to pick up 2005, 2006 and 2007 vintage fund positions in the coming years.”

THINKING BIG
One thing is clear – all the big Swiss asset managers have a truly global business these days. As Gantner says: “We have so many different nationalities now, and offices around the world – we see ourselves very much as a global alternative asset manager.”

This includes not only Europe and Asia but also North America, where Adveq opened its first office this year. “We've been operating in the US for the last ten years, but we've previously done it by flying in and travelling around,” Ender explains. “Now we're a 50-person company, we feel comfortable having five people out there permanently, to improve efficiency. It's a function of scale really.” More than 50 percent of its client base is still from German-speaking countries, but it claims to be seeing growth across the board.

This includes not only Europe and Asia but also North America, where Adveq opened its first office this year. “We've been operating in the US for the last ten years, but we've previously done it by flying in and travelling around,” Ender explains. “Now we're a 50-person company, we feel comfortable having five people out there permanently, to improve efficiency. It's a function of scale really.” More than 50 percent of its client base is still from German-speaking countries, but it claims to be seeing growth across the board.

It is safe to assume that if all industry participants demonstrated these qualities, much of the recent criticism would probably not have happened. “The industry has grown too big now to stay under the radar screen,” he admits. “We need to open up and explain ourselves better, because we have a good story to tell.”