As 2010 began, private equity looked mired in a deep cyclical
downturn. Leverage to finance new buy-outs had all but dried up.
Some portfolio company balance sheets were in tatters. Many
institutional investors, burdened by liquidity problems and faced
with mounting paper losses, expected private equity to remain stuck
in the doldrums.
What a difference a few months make. Although credit markets
remain uncertain and the animal spirits of a strong economic
recovery are subdued, pessimistic investors could be missing a
unique window of opportunity. Bain & Company estimates that
industry average returns on private equity investments made this
year could run between 13 per cent and 15 per cent, with the best
well-outperforming that benchmark. While that may look pale in
comparison to gains generated during the boom years, such returns
could far outpace those from the lacklustre public equity markets
and near-zero-yield fixed income investments - with little more
The favourable conditions are rooted in a healthy wariness born
in the excesses of the recent past. Instead of stretching to place
big bets on risky multi-billion-dollar mega buy-outs and then
loading them up with debt, private equity firms and lenders have
Private equity firms are backing solid companies with promising
growth prospects that have weathered the recession well and have
limited market and operating risk.
The $1.5bn acquisition, in January, of UK retailer Pets At Home
by KKR illustrates PE's flight to quality. A long-time leader in
the specialist pet products market, the company added more than 100
new stores over the past decade, including 24 during last year's
harsh conditions. Bucking the economic downturn, the company
upgraded its online shopping site and expanded its lucrative
veterinary services business, all while increasing same-store sales
by nearly 9 per cent and pre-tax earnings by 36 per cent through
the end of March.
For their part, banks are offering debt to finance private
equity deals, but are conservative on the levels of leverage they
Good-quality assets financed relatively conservatively give
investors in today's deals better ballast to withstand market
turbulence. However, the flip side is there is less potential for
Acquisition prices for attractive assets are expensive
(typically between eight and 10 times Ebitda - earnings before
taxes, depreciation and amortisation), driven by high public market
valuations that set sellers' expectations and stiff competition
among private equity firms.
Also, with lenders reluctant to allow private equity borrowers
to leverage up too far, private equity firms need to commit far
more equity to the deals they are closing in this investment cycle
than they did a few years ago. Instead of leveraging with 70 per
cent debt as was common during the peak years of 2006 and 2007,
buy-outs in 2010 are being financed with about equal amounts of
debt and equity.
The combination of high prices and less leverage will put a lid
on returns. But we also believe these low-risk deals will be among
the first to benefit when debt starts to flow more freely again.
Private equity owners of high quality assets purchased in 2010 will
be able to refinance on attractive terms, enabling them to claw
back potential gains.
Not all private equity firms will be able, or willing, to
capitalise on these unique conditions. With the economy still
fragile, firms that focus on riskier turnround and distressed-asset
deals may find themselves in inhospitable territory. Others that
have little capital to invest may opt to stay on the sidelines,
nursing their dry powder until fundraising conditions improve.
Finally, firms that must hit a high hurdle rate for returns
before they are eligible to share in a deal's profits will find it
unappealing to invest in transactions perceived to offer lower risk
and lower returns.
Firms that do choose to plant seeds in this rare vintage year
will need to work harder to make smart buys and justify the higher
prices they are required to pay by adding value to the companies
they acquire. They need to strengthen their due-diligence
processes, enabling them to develop a distinctive view of a deal's
upside potential and downside risk - proprietary insights that can
give them an edge in winning auctions. Then as new owners, they
need to deploy operational skills in partnership with management
that enable them to capitalise on the opportunities they uncover in
their due diligence.
To seasoned industry watchers accustomed to the big,
high-leverage deals of recent years, the scaled-down environment of
2010 may not look all that promising. But for investors attuned to
today's market realities, risk-adjusted returns may be the most
attractive they will see for a long time.
Hugh MacArthur is head of the global private equity practice
at Bain & Company; Graham Elton is head of the private equity
practice for Europe, the Middle East and Africa.