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COMMUNITY UPDATE

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With the debt market currently frozen, private equity (PE) can play a significant role in helping indebted but operationally sound companies. The death of cheap debt does not necessarily herald the death of private equity if PE models can evolve to something based less on debt.   

So how will the private equity model change? At a recent Criticaleye breakfast for CEOs of private equity backed companies delegates discussed how PE firms will have to perform more than just 'financial wizardry' in the current market.  As Edward Fitzmaurice, CEO, Hastings Direct explains: "The success of the private equity model in the early part of this decade was mainly based on cheap debt and financial engineering. We now need to move on from this model. It should still be possible to generate good returns from investing in sound businesses that will benefit from the upturn in the market, but this will need to be done with new types of funding." David Cheyne, Former Group Finance Director, Somerfield Stores Ltd. has this to add: "The private equity model is here to stay but we may see increased focus on creating value from driving sustainable business improvement in their portfolio companies now that quick wins from restructuring and refinancing are not available."

What's clear is that until banks re-enter the market, sources of funding will remain restricted. Mike Barley, Managing Director, Close Asset Finance, part of the banking division for Close Brothers Group, provides an overview of the banking landscape. He says: "The reduction in lending capacity in the domestic and international banking markets is likely to continue to a lesser or greater extent for at least a year and probably much longer. Regulator demands for improved capital ratios in banks are only now becoming clear and it will take time for banks to raise capital or for profits to recover. As a result, many successful businesses experiencing increased demand for goods and services will find themselves cash constrained. Recovery in the economy will depend upon those businesses finding alternative funding solutions. Private equity players and business angels will be spoilt for choice with excellent investment opportunities."

Opportunity aside, this still doesn't address how the PE model is set to change. Leaders seem to agree that private equity will need a much deeper understanding of the operational side of the business as well as the financials. A new model might include building a customer plan alongside the usual restructuring plans. Some believe that we are already moving in this direction. Mark Prince, Managing Director, Jacuzzi UK comments: "Private equity brings a track record of business assessment and improvement to the party that does not exist in more traditional debt providers. Those more traditional vehicles that do possess such competency are currently so risk averse as to negate their capability. My view is that the involvement of private equity teams in the due diligence of fundamentally sound businesses adds a sense of security and sign of confidence that can attract lenders in. It will certainly speed up investments and in some circumstances create available debt where none would have been forthcoming."

Others may argue that PE firms have a responsibility to the companies they invest in, especially at this difficult time. In any case, if cheap debt is dead then success or ROI will depend heavily on investors' ability to improve the business performance and productivity. Tim Farazmand, Managing Director Deal Origination, Lloyds Development Capital explains: "Private equity is likely to be a key source of development capital in the current climate. Debt is available but on a much more conservative basis than in recent years and only for companies with properly funded balance sheets. Private equity can play a key role in ensuring that companies are appropriately capitalised and able to take advantage of both organic growth and acquisition opportunities as they present themselves." 

If PE investment can restructure effectively it will be successful, especially as the economy starts to recover and companies seek investment to grow. As John van Rossen, Partner, Transaction Advisory Services, Ernst & Young says: "The combination of deep corporate finance experience, extensive contacts with banks and other lenders and operational knowledge, position private equity well to assist companies with various levels of stress through this difficult period. As soon as there is a line of sight when this downturn may be over and as leverage conditions ease, I would expect transaction activity driven by private equity to pick up."

These transactions may even prove to be key indicators as to which businesses will be most successful throughout the recession. David Cheyne explains: "Private equity has always been good at identifying businesses with 'value upside' opportunities and this will continue. That said, I see three trends emerging. Firstly, with very little debt available, private equity will have to increase the equity component in deals. Secondly, there will be an increased focus on strengthening management teams to ensure that business performance and efficiency is optimised so the business is positioned to gain first mover advantage when the recovery comes. And finally, when the debt markets do recover we will see private equity refinance current deals to replace an element of their initial equity with debt."

Matthew Blagg, CEO, Criticaleye