Why size doesn't matter

Many private equity firms are now fighting for survival, and professionals are starting to look over their shoulders and ask who will be left standing in two, three or five years' time. At times like these, when private equity is thrust into the spotlight and firms' futures are called into question, it is tempting for disparate factions within the industry to start pointing the finger at those above them in the deal-size food chain and read them their last rites.

At EVCA's Investor Forum in Geneva in March for example, mid-market professionals could be overheard saying it's the large buyout firms who exacerbated the credit crisis and they who will end up paying for it, as large, aggressively leveraged companies battle against ever-tougher trading conditions.

Such finger-pointing, whether it comes from within the industry or from politicians, trade unions or the media, is likely to increase as the sustained lack of credit and weakening cash flows translate into greater numbers of corporate casualties. Large buyouts will draw the most attention – understandably, given their high public profiles and large stakeholder spheres – and with the attention will come the lion's share of criticism.

Unsurprisingly, mega-funds reject such attitudes as scapegoating. “Everybody keeps saying the big funds are in the worst trouble,” says one member of a high-profile large buyout firm, “but I don't see why. For the mid-market firms, life is just as difficult now.”

He has a point. Take deal flow for instance: there isn't any, whatever asset size you're talking about. Earnings visibility is so poor that no one can realistically buy or sell with any degree of confidence in their pricing. That goes for both large buyouts and the mid-market.

But deal flow is not currently the primary concern. It's the boom-time deals now underwater that will be the deciding factor in many firms' futures.

The mega-buyouts of the world such as EMI and Gala Coral, where recent write-downs have been measured in eye-catching billions, will continue to grab the headlines. However, the fact is private equity firms of all sizes ended up taking massive financial risk during the heady days of the credit bubble.

When private equity was a cottage industry, most deals were built on a premise of buying into businesses in need of either fresh capital or restructuring. In other words, private equity invested in companies that were ripe for it. Then came the boom, and buyouts of all sizes became a commodity. Large funds emerged to chase big corporations, but in the mid-market too, a multitude of firms started chasing a finite number of investment targets. Whether or not these targets where particularly suitable for private equity financing became less important. And as competition for assets increased and capital became ever cheaper, enterprise values soared.

Now the world has changed, and many GPs are focusing on recovering the equity in their portfolio companies. Are mid-market players more likely to pull through this than the big ones?

As earnings diminish, low gearing becomes a valuable attribute. In this respect mid-market deals generally have the advantage. And when it comes to refinancing, the lower absolute numbers involved with smaller deals should become an important factor – refinancing €100 million of debt is now a far more realistic prospect than €1 billion.

Other elements, such as the proliferation of club deals and the fact that large portfolio companies can become political footballs, will also complicate the lives of those tending portfolio companies in the mega category.

On the flipside, there is safety in size. The stability and earnings diversity afforded by being a large business with multiple business lines means the assets in many large buyout portfolios have a survival advantage. Large businesses may also have more options in terms of non-core assets to sell. Furthermore, if your business owes the bank €10 million and can't pay, you have a problem. If your business owes the bank €1 billion, the bank also has a problem and a greater vested interest to preserve value in the business.

In the final analysis, survival will depend on each portfolio company's individual circumstances. But anyone looking for a generic prediction of what will happen next in private equity should bear in mind it's not just a case of big funds feeling the pressure. Mid-market groups will have to battle hard as well. Finger-pointing at larger houses may provide some psychological relief, but it won't make it easier to get through the crisis.