Point of View

Institutional investors’ allocations to private equity have been largely unaffected, and have even increased, despite the events during the past year that brought activity in the market to a crawl. This is because private equity has never been about the past or the present, but about the future. What can investors expect during the coming months?

“Private equity firms are very good at capitalizing on market dislocations because they have a long-term focus on their investments,” says Bob Morgan, director of Northern Trust’s private equity division.

“In almost any economic environment, private equity investors tend to be more patient,” adds Raj Vora of Northern Trust’s private equity division. “This allows companies to effectively ignore quarterly results and pursue long-term objectives to drive growth.”

A long-term outlook for private equity has been necessary in 2008 because of what most experts believe are shorter-term economic issues. The subprime mortgage contagion, which first spread to corporate credit during the second half of 2007, continued to wreak havoc as liquidity dried up and stifled deals. Compounding the difficulties, public equity markets fell briefly into bear territory. In addition, both recession and inflation concerns continue to stoke investors’ fears.

These challenges have at least temporarily altered the current private equity landscape. According to Standard & Poor’s, both purchase prices and leverage multiples increased significantly in 2007. Increases occurred for large- and middle-market buyouts, American and European deals. Rather than build sound businesses, many private equity firms found it easier to generate returns by using considerable leverage. Those firms are now in a difficult economic environment with a highly leveraged capital structure.

Falling valuations on the larger end of the buyout market compounded recent difficulties, contributing to failed deals involving audio equipment-maker Harman International, United Rentals, student-lender Sallie Mae and Penn National Gaming. Other deals had to be renegotiated, such as Clear Channel Communications and, most recently, Canadian telecom giant BCE. The latter deal, worth an estimated US$51 billion, is the largest private equity buyout, topping the purchase of the energy utility company TXU for $44.3 billion in late 2007.

While the mega-deals get most of the press, there is actually more volume in the small- and middle-markets. These deals, too, are suffering in a less-liquid environment. The mega-deals, however, generally have required publicly traded debt and large syndicates of lenders for financing, while smaller buyouts can be completed with local banks and private financings. This dynamic has led several institutional investors to look more closely at small- and middle-market buyouts.

“In a less-liquid environment, purchase prices tend to fall,” Morgan says. “We believe lower valuations are good for investors who seek opportunities today. This is particularly true for investors in the smaller end of the market who are typically investing at lower multiples to begin with.”

Another appeal of private equity is that it is considered to have a lower correlation to an investors’ publicly traded portfolio. “Private equity as an asset class isn’t highly correlated to the public market, adding diversification for investors,” Morgan says. “In addition, some private equity activities, such as venture capital and buyouts, aren’t highly correlated with each other.”

Investors Still Hungry for Private Equity

These advantages, as well as the fact that private equity has historically outperformed publicly traded stock, may be among the reasons why many institutional investors are increasing their private equity allocations even in this difficult environment.

Certainly, institutional investors have not satisfied their appetites for the asset class. Assets of the largest private equity managers grew 89% to $70.38 billion in 2007, according to Pensions & Investments magazine (May 26, 2008). Distressed debt, energy and infrastructure all grew impressively. Investors are also looking for geographic diversity. A survey by the Emerging Markets Private Equity Association (EMPEA) found that 74% of limited partners plan to increase their commitments to emerging markets during the next three to five years.

Private Equity Trends

As 2008 comes to a close, two trends are expected to continue, while two emerging trends highlight investor attitudes.

First, all signs point to the continuation of the liquidity crunch and tight credit, at least into the beginning of 2009. “You can still fund debt,” Vora says, “but not at the same levels as a year ago, and it will cost you more. In the short term, these two dynamics work against returns for investors.” The overall environment, however, is still relatively calm and functional at the smaller end of the market, where many regional lenders are not facing the same financial issues as the larger Wall Street firms.

Second, depressed values have created potential above-average returns for investors in some market sectors. “Although limited liquidity and more expensive credit may restrain leveraged buyouts into the start of 2009,” Morgan says, “we believe purchase prices should continue to fall.” In addition, distressed debt has emerged as an early potential bargain, and an alternative for private equity cash on the sidelines. “We’re seeing money flowing into the entire financial sector,” Morgan adds. “There are opportunities at very attractive prices.”

Third, institutional investors are growing increasingly enamored of international private equity, not just in developed economies but in emerging markets as well. However, Morgan cautions investors to look before they leap. “Europe is a mature private equity market with a reliable infrastructure, reliable exit routes and a strong legal environment supporting it, so good opportunities can be found there,” he says. “But private equity markets in BRIC (Brazil, Russia, India and China) countries haven’t reached the same level of maturity, yet. Yes, there are opportunities in emerging economies, but you have to be very careful about your choices.”

Finally, some investors have latched onto the next big thing — sectors such as clean technology, alternative energy, life sciences and infrastructure. In this case, investors might learn from recent history: the rise in the 1990s and subsequent fall of a mass of dot-com companies. “If you look back right before the Internet bubble burst, everyone was investing in telecom because we had to have bandwidth,” Morgan recalls. “In some cases, those deals performed significantly below initial expectations. You have to be careful with themes or trends and remember they add a significant amount of risk.”

“Infrastructure private equity deals often have a look more like bonds than equity,” Morgan adds. “We tend not to invest in infrastructure funds because of the return expectations.”

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