What does the future hold for private equity? In the context of the downturn, PE houses will clearly have to adapt. There is no longer room for firms only looking for a quick exit and although some investors will continue their dedication to PE investment, leaders of private equity-backed businesses believe that most investors will reduce their commitment to these funds. Will we see private equity firms become more specialised, niche players? Will changes across the market be long-term or just temporary, allowing private equity to ride out the storm?
Clearly, difficult market conditions have created the need for private equity firms to make changes. Martin Balaam, former CEO, Redstone plc explains: "Firstly, PE houses are ensuring that their current investments are sound and free from the clutches of the banks. Many will have had to spend significantly more time with existing investments than they ever imagined which will have pulled resources away from new business. Cash that would have been spent on new investments has been utilised to reduce debt levels of the existing portfolio. Secondly, debt levels are significantly reduced. 18 months ago you could borrow at seven times EBITDA (earnings before interest, taxes, depreciation and amortisation) with very light covenants and bullet repayments in the future. Now you would be looking at two to three times EBITDA with strong covenants and a straight line repayment of debt over three to five years. This both reduces the amount PE firms can bid for a company and their internal rate of return. So, businesses need to be valued at four to five EBITDA to be viable propositions. Most would not sell their business at these multiples unless absolutely necessary."
In this environment, PE houses will also have to relook at some of their existing deals. As Ian Edmondson, Chairman and Managing Director, Dunlop Aircraft Tyres Limited says: "The private equity market is inevitably going to change, I believe that it will revert to the structures of 10 to 15 years ago. Short-term deals done at the peak of the market will have to be restructured, either forcibly in many cases or voluntarily." Without this action, firms will face difficulties raising new funds. Simon Flamank, President and CEO, TV-Loonland AG explains: "Many PE firms are meeting with resistance when trying to raise new funds from their General Partners as they may already be over-invested and having to write down the value of their investments which may have been bought at over-inflated valuations."
There are, however, still opportunities and PE houses with the foresight to adapt will capitalise on the market changes. In an environment where funding is difficult to come by private equity could offer the solution. Shalini Khemka, Investment Director, Lloyds Development Capital (LDC) has this advice: "For corporates looking to raise funding or to grow through acquisition, private equity can be invaluable. Particularly in the current climate, where pure debt financing is extremely difficult to secure, private equity provides a life support that such companies can use to regroup and focus their efforts toward becoming increasingly profitable."
Shalini continues: "Private equity houses are always willing to open up their networks and share commerical knowledge and experience to promote value creation. Even among mature companies, private equity has some real advantages over public offerings.
"Companies that are privately held aren't subject to the same reporting requirements that public companies face, saving the expense of compliance. Also, while private equity investors are just as concerned about making a profit as any other investor, their willingness to wait in order to maximise profits gives management teams the time they need to implement strategies for long-term success. By focusing on performance beyond the next quarter's results, private equity groups allow businesses to go the distance with their strategic plans without fear of facing a revolt from public investors."
That said, the relationship between PE houses and management teams is clearly going to change. Investors will have a much greater proportion of any new investment so they will want to work more closely with management teams. Martin explains: "With very few acquisition opportunities, there will be more discussion around organic growth so PE houses will be very interested in looking at how organisations are expanding organically, seeing this as less of a risk and certainly more deliverable than expansion through acquisition presently."
There are plenty of options for organisations looking for PE funding if they feel it is the right option. As Martin explains: "The main advantages are, if you are a fundamentally strong business, PE houses will back you in most cases, even if that means injecting more cash to sort out the bank debt. Additionally, given that valuations are so low and acquisitions are difficult, there will be a higher willingness from the PE house to look at funding organic expansion which would be almost impossible to sell if you were on the public markets."
Patience is really the key for companies looking for private equity investment because, as Simon points out, "there are just so many opportunities out there, you should hold out for the deal that ultimately works best for your business." Ian reiterates these sentiments: "Those companies looking for PE funding at the current time will have to be patient as the market comes to terms with the changes required to accommodate the new reality."
For more information on the topics raised in today's update, please see the Write-up of our latest Private Equity CEO Breakfast, where leaders discussed issues including understanding and sourcing private equity along with packaging and valuing. Private Equity: The Nature of the Beast is the Write-up of another event offering best practice advice on navigating the PE minefield.
Our next Private Equity CEO and NED Breakfast will be on 30 September. If this event is relevant to you, please contact me directly or your Relationship Manager.
I look forward to seeing you soon,