“Credit crunch” and “liquidity crisis” were two of the more common labels applied to the turmoil that struck global financing markets in the middle of last year, but the variety of definitions conjured indicated that the world was confronted, initially at least, by a kind of amorphous phenomenon that was difficult to pin down and analyse. It had the ability to strike fear into hearts while somehow concealing why everyone should be so afraid.
It was the balance sheets of the leading investment banks that first began to reveal the nature of the beast as those with significant exposure to subprime mortgages and securitised credit started to filter out news of multi-billion dollar losses, a process that continues – and, indeed, continues to worsen – to this day. For private equity professionals as for others, the road ahead was initially shrouded in fog. But when the fog began to lift, it was the larger buyout funds that appeared to have most cause for concern. Bruised by their dalliance with high-risk investment areas, the banks no longer had any inclination to keep fuelling the mega-buyout boom.
By the end of the year, the statistics were telling the story. Data provider Dealogic revealed that global buyout value in the second half of last year fell 62 percent to $220.9 billion (€150.4 billion), from $575.2 billion in the prior six months. The main reason was by now clear: the almost total absence of available debt funding for multi-billion dollar deals.
THE DREADED ‘R’ WORD
At the current time, there is little reason to suppose that the larger deal market will be in a position to resume ‘business as normal’ anytime soon. Since the hiatus began, LBO firms have typically predicted a period of around 12 to 18 months before they can hope to go into expansive mode once more on the new deals front. As an aside, it is worth noting that leading economist Anatole Kaletsky predicted in a recent article in the UK's
Mid-market specialists, by contrast, have been decidedly chipper for some time. Although some upper mid-market deals may have been affected by volatility in the debt markets, on the whole the mid-market has been immune. Here, the banks are more comfortable about lending given the relatively modest amounts of leverage involved, and are also keen to demonstrate that they are still open for business.
Despite this, fear is also creeping into the mid-market ranks in the early months of 2008. With the credit crunch arguably losing some of its power to shock, it is now the “r” word looming in peoples' thoughts: and those in the smaller deal market need no reminding that the whirlwind of economic recession would not fail to sweep them into the vortex. (See In Europe, p. 10).
Volatile economic fundamentals also bring an increased risk of rising default rates, which in turn would provide compelling evidence that the industry had entered a down cycle. As Mark Vickers, a London-based partner at law firm Ashurst, says: “If the current crunch deepens and becomes a default crisis, then things could get much worse.” Perhaps in that case the best course of action might be to follow Vickers' advice of living on a beach in Thailand for three years “until all the problems have washed through the market”.
For some, the beach might appear a favourable option to the fundraising slog in 2008. Of course, it depends who you are. Even at the deal-starved larger end of the market, the best managers will no doubt still be able to put forward a convincing case as to why investors should part with their money and back new funds. Questions will be asked about whether $10 billion would suffice rather than $12 billion given current market conditions, and some of the more respected LPs may even feel sufficiently emboldened to question fund economics (if only at the margins). Bottom line: the top performers will not find themselves lacking friends. For “me-too” funds, particularly perhaps in the highly competitive mid-market space, 2008 could be decidedly more challenging.
For some GPs, the year ahead in theory holds much promise – both for doing deals and raising funds. Distressed specialists and mezzanine investors are among those for whom the booming market of recent times has not been something to celebrate and who will be anticipating better times ahead. With competition easing and valuations adjusting down, 2008 may turn out in retrospect to be a year when fortunes were made.
“Investing in a potential downturn is not an activity for the fainthearted – both timing and skill are essential if you are to catch the falling knife by the handle,” says Tony Mallin, chief executive at private equity firm Star Capital Partners in London. “However, we believe that by 2012, 2008 and 2009 may well be viewed as vintage years for those with the right investment strategy.”
RIDING OUT THE STORM
Also hoping for a vintage year will be certain politicians, trade unions and all those who have grouped under the “anti-private equity” banner. Last year was largely a good one for them as the industry failed to entirely shrug off accusations of asset stripping and personal greed voiced against a backdrop of increasingly bold and colourful PR stunts – think camels and churches, for example. It would be dangerous for private equity to assume that, with the focus having switched to market-related issues, the battle for the image of the asset class has been put on hold. Far from it. A single default of a high-profile portfolio company in 2008 would provide enough ammunition for the critics to hijack the agenda once more.
By no means divorced from this public clamour, regulators will continue to keep a close watch on private equity in 2008. In the UK, the Walker Report will be advanced as a credible method of industry self-regulation; in the US, buyout executives will hope to stay protected from those politicians who would like to see carry schemes taxed more aggressively; while GPs operating in emerging markets will have their fingers crossed that politicians and regulators alike decide to roll out the welcome mat for private equity rather than drawing a protectionist line in the sand.
Everywhere, hopes will be pinned on eventually riding out the storm. Says Sameer Al Ansari, executive chairman at Dubai International Capital: “Private equity is facing more challenges today than it has done in the past ten years, but I truly believe this is a temporary situation. The industry won't go away. Private equity has proven itself as a tremendous asset class generating superior returns. It will continue to do this in the future.”