The Deal

Private equity's new landscape

The worst for private equity may be over. But as the market improves, the more pressing question is...

Par Graham Elton and Hugh MacArthur

First published on septembre 18, 2009
min


The disproportionately influential world of private equity is undergoing a shakeout, as it has in past downturns. Many weaker firms will cease to exist, with our research suggesting that 20% to 30% are at risk in the aftermath. Why should anyone care? Because those canny PE survivors that emerge stronger and smarter actually represent good news for the rest of us. After all, these are the investors who helped rebuild underperforming businesses and pick new winners in the wake of every other economic downturn in recent memory—and without the support of taxpayers' money. Not all funds are well positioned to lead this activity, however. A recent survey found that one out of every four funds will likely need to restructure more than a quarter of its portfolio in the next three years. Meantime, while about $500 billion in "dry powder" is available for buyouts globally, more than one in five funds are at least 75% called on their most recent fund. They must sit on the sidelines until pension funds are ready to put more money into private equity. A PE firm's outlook also hinges on which part of the market it plays in. For small-cap and growth funds, the past year may turn out to have been only a speed bump. True, volume of smaller deals is down, but given the lower debt requirements and manageable size, these deals will come back first. For megacaps, on the other hand, this downturn has fundamentally changed the landscape. Not long ago, firms were competing to see who would be the first to sign a $50 billion deal. Funds that were competing in that space must alter their strategies. Among mid- and large-cap firms, the crisis will likely trigger a significant reshuffling. Rising to the top will depend on how quickly and sustainably a firm can develop three sets of capabilities: educated risk taking, genuine value enhancement for acquired companies and a more sophisticated approach to engaging top management at portfolio companies. Educated risk taking would seem an obvious requirement for any PE player until you consider what often passed for reasonable risk analysis in recent years. Today, with debt in short supply and priced at a premium, future returns will flow from superior insights about particular markets and specific businesses and a flawless investment process. As a result, we will see more funds focusing their attention on sectors that they are, or can become, expert in. Likewise, really adding value after the deal will be what makes tomorrow's buyouts pay off. Firms have to build—or know where to find—real capabilities in areas like working capital reduction, procurement, pricing and sales force effectiveness. It's also critical that they develop a repeatable model for success—an engagement approach that works in good times and bad. Although the focus now is on fixing troubled companies, more value ultimately flows from improving good companies than saving bad ones. Finally, retooling executive engagement rules means rewriting the old talent proposition that reads: "We will make you very rich very soon, so make it happen. If you don't cut it, you're gone." In the new landscape, firms must become more sophisticated and systematic about how they engage top talent—and keep it around. Ironically, over the past few years, corporations sought to learn the management lessons of the PE world. In this regard, the tables have turned. With maturity, the PE industry's returns will likely narrow. Stiff competition and a reduction in froth will take out the high notes. But a more disciplined industry will make fewer mistakes, weaker players will disappear, and the barriers to entry may grow. Unless there is a sudden rush of new money into private equity, we will see a period of more consistent returns for more demanding investors. And that's good news for all of us. Graham Elton is a partner with Bain & Co. and head of Bain's European private equity practice. Hugh MacArthur is a Bain partner and head of Bain's global PE practice.

The disproportionately influential world of private equity is undergoing a shakeout, as it has in past downturns. Many weaker firms will cease to exist, with our research suggesting that 20% to 30% are at risk in the aftermath.

Why should anyone care? Because those canny PE survivors that emerge stronger and smarter actually represent good news for the rest of us. After all, these are the investors who helped rebuild underperforming businesses and pick new winners in the wake of every other economic downturn in recent memory—and without the support of taxpayers' money.

Not all funds are well positioned to lead this activity, however. A recent survey found that one out of every four funds will likely need to restructure more than a quarter of its portfolio in the next three years. Meantime, while about $500 billion in "dry powder" is available for buyouts globally, more than one in five funds are at least 75% called on their most recent fund. They must sit on the sidelines until pension funds are ready to put more money into private equity.

A PE firm's outlook also hinges on which part of the market it plays in. For small-cap and growth funds, the past year may turn out to have been only a speed bump. True, volume of smaller deals is down, but given the lower debt requirements and manageable size, these deals will come back first. For megacaps, on the other hand, this downturn has fundamentally changed the landscape. Not long ago, firms were competing to see who would be the first to sign a $50 billion deal. Funds that were competing in that space must alter their strategies.

Among mid- and large-cap firms, the crisis will likely trigger a significant reshuffling. Rising to the top will depend on how quickly and sustainably a firm can develop three sets of capabilities: educated risk taking, genuine value enhancement for acquired companies and a more sophisticated approach to engaging top management at portfolio companies.

Educated risk taking would seem an obvious requirement for any PE player until you consider what often passed for reasonable risk analysis in recent years. Today, with debt in short supply and priced at a premium, future returns will flow from superior insights about particular markets and specific businesses and a flawless investment process. As a result, we will see more funds focusing their attention on sectors that they are, or can become, expert in.

Likewise, really adding value after the deal will be what makes tomorrow's buyouts pay off. Firms have to build—or know where to find—real capabilities in areas like working capital reduction, procurement, pricing and sales force effectiveness.

It's also critical that they develop a repeatable model for success—an engagement approach that works in good times and bad. Although the focus now is on fixing troubled companies, more value ultimately flows from improving good companies than saving bad ones.

Finally, retooling executive engagement rules means rewriting the old talent proposition that reads: "We will make you very rich very soon, so make it happen. If you don't cut it, you're gone." In the new landscape, firms must become more sophisticated and systematic about how they engage top talent—and keep it around. Ironically, over the past few years, corporations sought to learn the management lessons of the PE world. In this regard, the tables have turned.

With maturity, the PE industry's returns will likely narrow. Stiff competition and a reduction in froth will take out the high notes. But a more disciplined industry will make fewer mistakes, weaker players will disappear, and the barriers to entry may grow. Unless there is a sudden rush of new money into private equity, we will see a period of more consistent returns for more demanding investors. And that's good news for all of us.

Graham Elton is a partner with Bain & Co. and head of Bain's European private equity practice. Hugh MacArthur is a Bain partner and head of Bain's global PE practice.