What are the challenges that face private equity around the world?

Private equity - at least the large buyout space - is today faced with four main challenges: performance, financing, raising new capital, managing existing investors.

Performance

Many of the large buyout deals concluded between late 2005 and the first semester of 2008 appear to have been overpriced and overleveraged. Aggressive debt packages were often structured on the basis of rather rosy projections and often with insufficient due diligence to identify important issues (key contracts, manufacturing capital expenditure needs, etc.). While the relatively loose covenants originally obtained by private equity sponsors seemed to the advantage of the equity investor, it also led to weaker control mechanism for banks and the underlying companies. This means, possibly, that bigger risks were in fact taken than would have in a "normal" market. Today, as a many economies around the world tend to weaken, many of the underlying companies’ performance seem to perform below plan. In some cases, on a mark-to-market basis, this translates in deals loosing their full equity value. This is most visible in certain sectors (automobile, retail, leisure) but possibly in many other "defensive" industries (healthcare or food). The real question today is whether these investments will survive the pressure of their debt repayments in the short to mid-term, and be able to live through the cycle to regain value. So long as the companies are not bankrupt and not sold, their equity sponsors’ equity loss are only virtual. And the good news for some of these recent deals is that they often benefitted from long term financing with no intermediary repayment obligations. Until then, private equity fund managers can only hope for better times to sell (before their bullet payment comes due), and generate equity gains.

The fact remains nonetheless that not all funds will be profitable in 2009 and, yes, that one can loose money in buy out transactions (a possibility that seemed so slim back in 2006-2007). Private Equity is an attractive asset class when managed by dedicated professionals. It is also an illiquid asset class and needs to be assessed with a long term view. Hence, performance needs to be analyzed before making hasty conclusions.

Financing (today's deals)

With regards to new deals, today's credit markets are still making it very difficult for private equity managers to find leverage for large - as well as middle market - buyout deals. This means that it is challenging for these groups to put money to work. Only those private equity sponsors using no or little leverage are able to execute deals. Some groups have managed to raise their own debt funds to by-pass their needs for banking financing but this only works for smaller amounts and for a limited time. This, by the way, is also being criticized by limited partners who see it as a pure strategy drift. In the end, to generate the expected returns, equity sponsors will eventually need to find refinancing solutions for their deals - the sooner, the better!

Another important deal closing factor is pricing. On average, it still appears that price expectations from sellers have not yet come down where buyers would want them to. It is only a question of time before expectations meet. Given the need for many industrial groups to reorganize themselves, or private equity funds to find exit solutions for their holdings, prices will eventually come down. If this occurs when financing becomes again available, it will mean lots of attractive opportunities for private equity players (especially if interest rates remain as low as they are today). Private equity groups that have raised money (and hold large pools of un-deployed money) and have built strong networks with such potential sellers are best positioned to reap the early benefits of the situation change.

Difficult fund raising environment

A large majority of investors around the world have decided to put their deployment on hold or at least reduce the amount of money to put at work on the markets. In fact, many of them are selling their private equity fund interests via the secondary market with a view to bring their portfolio profiles in line with their overall portfolio allocation strategy for the short to mid-term. Sellers are disposing of mature as well as more recent vintages, targeting the right balance between their exposure objectives and liquidity requirement. For those who are still investing in primary funds, their selection processes have become more stringent and are taking longer. Raising new funds in this environment is very demanding not to say impossible for teams with poor performances and lack of strategy dedication. It is quite possible that some teams will disappear in this environment as they fail to raise their next fund. Industry consolidation is hence on its way in many regions of the globe.

Another development we have observed is how early secondaries (the purchase of very recent unfunded funds on the secondary market) have canibalized part of the monies available for primary deployement. Indeed, buying a secondary interest in a fund less than 20 or 25 per cent called, basically consists of a primary commitment in this funds. Great opportunities are being seized in the market by savvy investors... and not necessarily at the absurd prices leaked in the press.

LPs defaulting (something new)

As it was the case with the internet bubble burst in 2001, the market has observed the resurgence of limited partner defaults. For such investors, there are usually two reasons to default: (1) internal liquidity constraints or (2) willful default (activist). In both cases, one will hope that they anticipate that moment early enough and access the secondary market to find the needed liquidity or dispose of the non-core relationship. In the case of LPs going broke too quickly, they are rare and often result from poor anticipation and portfolio management skills. The secondary market, when approached in a timely and efficient fashion, can often provide optimal solutions to limited partners in situations of distress or looking to rebalance their portfolio. As mentioned earlier, the market can also provide early release solutions to investors in recent funds (very unfunded). Finding buyers in today’s market requires market insight and extensive transaction experience but can still prove successful for both sellers and buyers..

Overall, the main challenge facing private equity around the world is to continue to prove that it can be a powerful creator of value for investors. While large buyout has attracted many of the headlines (good and bad), it is far from being the only one strategy available to investors in that space. Today’s market is a healthy reminder that one needs carry out careful diligence when looking to invest in the asset class and be certain to allocate across multiple strategies and teams with demonstrated track records. For professional investors as well as experienced agents, the market is certainly challenged but also is bringing great opportunities to the surface in such spaces as the lower or middle market buyout, distress, turnaround or special situations strategies in Europe and North America as well as in promising more emerging markets like the Middle-East or Asia. At the end of the day, private equity remains a people business. Finding the right people that you can entrust your money with is, and always has been, the top challenge for investors.

Do you believe that PE sector in the Gulf has reached maturity phase?

What does it need to grow and prosper in this region?

No, private equity, as generally understood, is just at its beginnings in the Gulf countries. Yet, if private equity means private investments in private companies, then it has been around for ever in the Gulf. Companies have been mostly financed by families.

To grow and prosper, private equity needs local acceptance by business owners and managers, more interest from LPs outside the region and healthy financial markets.

Beside the cultural acceptance of Private Equity, the two main issues faced by managers are the legal framework in each of the Gulf countries which in most of the cases does not allow the ownership of local companies without the burden of a local sponsor. Corporate Governance is also a main important issue and the acceptance of corporate governance rules by regional entrepreneurs can add a big plus to private equity investments.

We heard the term "dry powder" and “un-invested money” – how much do you estimate the un-invested liquidity around the world is; and

What do we need to regain trust and return the money back to the market?

We estimate that there is about $1 trillion of un-invested money at the private equity funds' level globally - without taking into account potential defaults from LPs...

More difficult to estimate is the un-invested capital at the LP level. Indeed, the 'denominator effect' has significantly reduced the investment capacity of most LPs. It has even created a whole new population of sellers of private equity fund interests (as already mentioned).

Confidence will be back when macro indicators start to show some improvement in the overall economy (housing markets, consumer spending, industrial output ...).

What are the attractive sectors for PE in the Gulf region?

Attractive sectors for private equity in the Gulf are sectors that can benefit from the high population growth rates across the region: retail, education, healthcare.... Infrastructure is also a very attractive space for PE players in the region.

Where are the Middle East's PE funds investing the money now?

As mentioned above the Middle East cannot be identified as one homogenous region. Key geopolitical facts to keep in mind are that Saudi Arabia is the heavy weight in terms of economy with a rather small population whereas Egypt is more of an emerging economy in terms of GDP but representing the majority of the region's population.

These two countries represent two core markets in the region to which must be added the UAE and the other kingdoms/emirates (Qatar, Bahrain, Kuwait and Oman).

The market opportunity is actually quite compelling in those basic sectors such as education, healthcare etc… where the growth potential is significant. The key word here being growth

Are PE firms going to play a bigger role in the governing of companies it will invest in, over the coming period to avoid falling into future economic crisis?

Private equity investors are by definition active shareholders. We could even say the most active form of shareholders. While some groups took advantage of a very favorable debt market to generate extraordinary returns during a limited period, they also promoted a very unhealthy environment which leads to today’s problems. That being said, private equity firms are not the source of the economic crisis, they are the victims. More importantly, what is happening today is a great reminder to investors around the world that creating value is not the result of some easy formula. It requires work, diligence, careful monitoring, and discipline. It requires setting efficient governance rules. This is the way private equity should be: hands on and proactive investing to create value through business improvements rather than pure financial engineering. Most 'true' private equity investors are active owners and, as such, assist management in creating value. This is certainly a key element in today's world and should remain so until the next bubble appears...