Healthy wariness could benefit private equity

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 risk.

RELATED INSIGHTS

Kiki Yang: Asia-Pacific Private Equity Report 2017

INDUSTRY EXPERTISE

Private Equity

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 turned cautious.

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 will provide.

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 upside gains.

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.