Here is a suggestive list of some of PE's lasting features – but also of some issues that might cause the industry to change.
PE will continue to be a highly cyclical, boom-and-bust business
Data provider Preqin points out that in 2010 the total number of active PE fund managers decreased for the first time since records began, while the European Venture Capital Association (EVCA) reports that capital raised by European PE funds dropped 80% in 2009. These facts underline the deep impact of the crisis, but they are not outlandish from an historical perspective. Fundraising fell almost 50% in previous market busts during 1990-1993 and 2000-2002, and each time capital inflows to PE went on to reach new highs in subsequent years. The industry's activity, whether measured by capital raised or invested, has always been strongly pro-cyclical. The crisis has not changed the structural demand for PE (from pension funds in need of high returns to cover future liabilities) nor the structural supply of potential PE targets (resulting from family firms facing succession problems and from corporate groups refocusing on their core businesses). In all likelihood capital will start to flow again to the industry in the next years. In fact, a recent Preqin survey indicates that 62% of Limited Partners (LPs) expect to make new commitments to PE in 2011.
PE performance is counter-cyclical: the best vintages occur in crisis years
Funds started in previous downturns of 1989-1994 and 2000-2003 display by far the best historical performance, with internal rates of return (IRR) in the low 20s for the median funds and in the high 30s for the top quartile funds. Two features of the PE market explain this. First, entry and exit values of PE investments depend on prices of comparable assets in capital markets, so buying during a downturn and selling during a boom pays off handsomely. (PE fund managers will not necessarily admit it, but correlations between PE fund IRRs and equity market returns are higher than what appears at first sight). Second, in boom times there is “too much money chasing too few deals”, potentially causing General Partners (GPs) to overpay for targets sold in auction processes. The implication is that investors should avoid 'jumping on the bandwagon' in times of boom and should stick to GPs that have exhibited enough strategic discipline in the past to say no to excessively priced investments.
Operational expertise is important in generating high PE returns
Recent research finds that the three sources of value creation in buyouts (namely, leverage, increase in EBITDA, and changes in multiple) roughly account each for one third of total observed value creation. However, the proportion of value creation due to operational improvement has increased over time, in detriment of the proportion due to leverage. One reason is that (at least up to the crisis) leverage became increasingly commoditized due to the demand of debt funds and other investment pools for LBO debt. The availability of large loans at low spreads means that GPs bid higher prices for the assets they are buying, benefiting sellers but competing away any advantage brought by favorable debt terms. The recovery will undoubtedly bring the return of some more leveraged structures, but the competition effect just described means that operational value creation will continue to distinguish the top funds.
PE ownership is associated with superior firm performance
There is by now considerable evidence that PE ownership increases the economic efficiency of European firms. Leveraged buyout (LBO) targets exhibit higher increases in operating margins, higher productivity, and increased capital efficiency relative to comparable firms. PE-owned firms have stronger corporate governance practices and more reliable reporting systems, while boards of PE-backed companies are smaller, meet more frequently, and have a smaller proportion of insiders. There is no evidence that LBOs hurt employment, even though job growth in PE-owned firms appears to be lower than comparable firms (France is an exception in that at least one study finds higher job growth in PE-owned firms). All this indicates that the importance of PE in the European economy will probably continue to increase, even if the industry suffers from a chronic bad image problem.
Good funds will continue to be good funds
The 2009 performance data for French buyout funds shows a risk-unadjusted IRR of 29% for funds in the top quartile, an impressive performance that makes France one of the most successful PE markets in the developed world. However, the two lower quartiles (that include 50% of the funds and 56% of capital called) report returns of 0.9% and -15%, respectively. In fact, available academic evidence for US and Europe shows that the average PE fund earns, on a risk-adjusted basis, returns just about enough to compensate for its cost of capital. Simultaneously, PE funds exhibit “persistence in performance”: a top performing fund in a given year is statistically speaking highly likely to continue being a top performing fund in subsequent years (that is not the case for other asset management vehicles like mutual funds). Recent research also indicates that LBOs backed by more experienced, top-quartile GPs pay lower spreads on their debt, face lower loan covenants, and have longer maturities. Investors considering initiating or increasing their exposure to PE should take these facts into account, and concentrate their efforts in funding the best GPs.
The balance in the LP-GP relationship will probably evolve in the direction of LPs
In a recent important contribution, Andrew Metrick of Yale University and Ayako Yasuda of University of California Davis create a realistic simulation model based on actual fund contractual data that uses as inputs compensation arrangements (management fees, carried interest, transaction fees…), and deal characteristics (leverage, portfolio concentration, investment risk…) to analyze the economics of PE funds. The authors show that about 60% of revenue accruing to the typical buyout GPs comes from fixed revenue components such as management fees that are not sensitive to performance. In the light of this result, and especially in the wake of the crisis, some LPs might try to extract contractual concessions from GPs in the next wave of fundraising. The next years will say whether they will be able to do so.
Transparency will probably increase
As the PE industry grows in importance, it cannot expect to remain outside public scrutiny. Over the years, scholars have pointed out the existence of concerns about potential conflicts of interest. Areas of concern include self-reporting of valuations of portfolio companies by PE funds, evidence of possible insider trading in the market of credit derivatives of companies involved in LBO transactions, and collusion between PE funds involved in club deals. PE market participants will have to address these and other issues as they arise, or regulators will step in to impose transparency to the industry. In Europe, the Alternative Investment Fund Managers directive, requiring outside valuation and audit of portfolio companies as well as disclosure of strategic intent by PE owners, is already a step in this direction.
Private Equity has shown itself to be highly adaptable to changing circumstances, and resilient under conditions of economic stress. One thing we can definitely expect is that the industry will continue reinventing itself in the years to come.
