Private equity: outlook for 2010

Private equity has contracted sharply in the wake of the financial crisis. According to figures from Zephyr, a private-equity database, the deal volume in 2009 was 55% lower compared to 2008; the number of deals was 38% lower. Now, the economy is doing better and some confidence has returned to financial markets. How will private equity fare this year? Let’s explore a few issues: 

Debt financing

Global high-yield spreads, which are a good indicator of lending conditions, have returned to pre-Lehman levels, yet they are still 300 to 350 bp higher than in mid-2007. Lending has thus improved but it is nowhere near as lush as during the boom years. Leverage ratios are likely to remain in rather modest territory as a consequence.

Fundraising

Many PE funds have collected much more capital during the boom years than they could invest. This “dry powder” has helped to bring up higher equity contributions to new deals, to inject equity into ailing portfolio companies and to put up with a time of meagre fundraising. Yet, the combination of an economic recovery, slow as it may be, and low interest rates otherwise may well renew the appetite for private equity among institutional investors.

Deal flow

The recovery means a more stable outlook for many potential target companies compared to last year. This makes new deals more attractive to vendors as well as private equiteers since it removes some of the uncertainties of valuation. The flipside is of course, that buyouts at fire-sales prices are less likely than last year. Yet, there is a strong need for restructuring and modern management practices in a post-crisis economy. Delivering those is and should be the core competency of private equity.

Regulation

The financial crisis will produce a regulatory response. Steven Davidoff at the DealBook blog gives an overview of what is being discussed with respect to private equity. For instance, President Obama said on January 21st that “Banks will no longer be allowed to own, invest or sponsor hedge funds, private-equity funds or proprietary-trading operations for their own profit”. How that will affect the private-equity industry depends on the details which are not yet public. Bear in mind that fundraising from banks has dropped sharply anyway. What is worrying is the lack of distinction between private equity and other, arguably riskier asset classes such as hedge funds. That may indicate a more restrictive stance once further regulation is being developed.

Overall

Last summer, I’ve argued that reports of private equity’s death have been exaggerated. I stand by that view. The financial and economic environment is still difficult and fragile and the regulatory response is not yet clear. Despite that, I believe, the private-equity industry can take advantage from the restructuring needs that will arise and prove that its business model is based primarily on management skills and not cheap money.