Will Private Equity Survive?
May 29, 2009
Arguments can be made both for the impending death of private equity and for its eventual rebirth, said James Kilts, ’74, partner in Centerview Partners. On one hand, over the last three years the industry paid too much for companies, banks allowed companies to take on too much debt, and acquisition and fundraising opportunities evaporated, Kilts said.
On the other hand, the current “correction” of private equity markets was overdue, the industry’s $2 trillion to $4 trillion in buying power will be sought at more attractive prices, and the U.S.’s 15,000 large private companies will continue to need capital, he said. Kilts, after whom the Kilts Center for Marketing is named, moderated a panel at the 57th annual Management Conference at Gleacher Center on May 29.
Private equity experienced an “incredible run” that began in the mid-1980s, but is headed for a “dark period,” said Eric Gleacher, ’67, chairman of Gleacher Partners LLC. Many of the most significant factors in the success of private equity are impaired, including the abilities to leverage, raise money, motivate management, and exit deals to create successful investments, said Gleacher, after whom the Gleacher Center is named.
“The private equity industry can be divided,” he said. “The medium- and smaller-sized deals and firms are going to be fine. They’re characterized by more leverage and less debt, and will go on as normal. The real problem is with the larger private equity firms and how they’re going to deal with those four significant factors. The solution of morphing their business into something else is problematic, because their investors invested in private equity, not distressed or minority investing or the like.”
The larger the investment in private equity compared to investment in the stock market over any two-year period, the lower the initial return on investment, said Steven Kaplan, Neubauer Family Professor of Entrepreneurship and Finance. “The more money that’s raised, the lower the IRR is,” Kaplan said. “Plugging the cycle into this regression, the returns on private equity vintages 2006, 2007, and maybe 2008 are likely to be very negative.”
However, to borrow from Mark Twain, the demise of private equity is greatly exaggerated, he said. The very cyclical industry faced similar negative claims in 1989-90 and 2001-02, the latter period of which was soon followed by the recent boom, Kaplan said. “We are at a cyclical bottom that happens when a lot of money goes in and returns are poor,” he said.
Private equity will come back because it will compares well with other asset classes, Kaplan said. Hedge funds operate under a “mismatch” between their capital and investment sources, while investment banks financed long-term investments with short-term debt, he said. Private equity’s two main advantages are a sensible duration that matches the investment horizon of 10 years and the primary need to simply beating public equity, where investments have lost 40 percent over the last few years, Kaplan said. “Some firms will make money and beat the S & P,” he said. “They will fundraise and get back to a world like 2004 or 1997, where there is a healthy private equity industry.”
From 2005 to 2008, private equity learned several valuable lessons, said Nick Alexos, ’88, managing director of Madison Dearborn Partners, LLC. Among those, Alexos said, are:
1. The high-leverage market is very fragile. “The data was there,” he said. “That level of leverage will not be back for maybe 10 years plus.”
2. Exit multiples were inflated. “The number one issue we’ve learned is the emphasis on exit is the primary issue,” Alexos said.
3. The auction process short-changed deals. “They missed the gestation of the business and numbers and the scrutiny of another pair of eyes,” he said.
4. Always keep a close eye on limited partners, many of whom overcommitted capital in the recent frenzy.
The industry requires apprenticeship. “Keep in mind how long it takes to develop the skill set and discipline,” Alexos said.
— Phil Rockrohr