Private equity fund values took a battering in 2008, begging the question: has the buy-out industry hit rock bottom?

Private equity fund values took a battering in 2008, begging the question: has the buy-out industry hit rock bottom? Andrew MacLeod talks to industry players about their predictions for the year ahead.

Michael McDonagh, a corporate finance partner in KPMG’s Private Equity group, is finding reasons to be cheerful as he surveys the prospects for mid-market transactions in the coming year. In his view, the market hit bottom in the last quarter of 2008, and is likely to remain there until the third quarter of the current year, as private equity houses lick their wounds, draw a deep breath and count the considerable cost of the gathering recession.

According to some observers, many investors will be on the receiving end of some very bad news in the coming weeks, as letters drop onto the mat informing them that the investments they made at the height of the boom have now shrunk by as much as 30 per cent.

McDonagh takes a glass-half-full view of the situation and reckons that, although we may have to wait a while for the jam to return, bread-and-butter deals should be back on the menu come the second half of the year.

He says, “The market hit bottom in the last quarter of 2008. In terms of transactions, it was as quiet as it could get, and is likely to remain that way for the first half of 2009.”

Tight cash flows
Any recovery will depend on a number of factors, says McDonagh: “In the mid-market, there will be debt available for the right transactions, although there are very few to look at. However, activity will return, subject to an alignment of price expectations as much as anything.”

Even in the hardest times, a certain number of transactions trickle onto the market, albeit reluctantly. Often these are dictated by the harsh side effects of the downturn, as firms struggle to maintain cash flow.

McDonagh calculates that, come the half-year turn, transactions will be driven more from choice as investors better understand the economic climate’s impact on company results, and discover a freshly whetted appetite for investment. “They will be able to take a much more rigorous view of the risks they are taking, and how to price those risks,” he says.

He warns, however, that there will be no return to the heady days of the past few years, and companies seeking private equity funding will have to accept that they must sacrifice more equity than they might like. It follows, therefore, that since private equity houses will be in a position to drive a harder bargain, money invested now will be well spent. “Perversely, money invested in 2009 will see some very good returns indeed,” McDonagh explains.

Guarded optimism
Over at Preqin, a private equity research organisation, managing director Mark O’Hare is also in optimistic mood – and his bright outlook is backed up by statistics. “Our prediction for this year is that things aren’t quite as gloomy as everybody else thinks they are,” he says.

He also points out that, although PE has received a pretty bad press over the past year or so, the evidence reveals that it has provided better returns than any other asset class: “Admittedly, there may be some nasty shocks coming, and the way PE funds are valued means that they will become evident over the next three to six months when general partners (GPs) put a value on their portfolios.

“There are a lot of limited partners (LPs) sitting in their offices and waiting for the bad news to land on their doormats, but it remains to be seen how extensive the problem will be,” says O’Hare.

“Our view is that it is largely funds from the 2005-06 vintage that will be badly hit because they were invested most heavily in 2006-07. Even then, not every fund will be a loss-maker.”

A buyer’s market
Preqin believes that, when the dust dies down, investors will look around and see that private equity has suffered no more than any other asset class. “Once the paralysis we are in has passed, LPs will start committing again to new funds,” says O’Hare. “We are in a hiatus, which will be followed by a short ‘nuclear winter’ in which few funds are raised, but sometime soon – possibly in the second half of the year – things will come back.”

Meanwhile, the time has come to make hay. O’Hare says there have rarely been better opportunities to “buy low and sell high”, which is a compelling reason for investors to commit to funds.

For managers who have already raised funds but not yet invested, the immediate future is positively golden. “The opportunities are phenomenal,” O’Hare says.

McDonagh would agree. “History shows that the returns that PE houses make from money invested at the bottom of the cycle are the best returns they get,” he comments. “That’s a reason to be cheerful – and they are very hard to find these days.”

Hot investments
Preqin’s Mark O’Hare singles out a number of hot areas where he believes there is opportunity for well-informed investors:

• Distressed debt funds – He believes these are going to do “incredibly well” as the economy recovers over the coming months and years: “There are lots of companies going into liquidation, no matter what their ownership, and that situation presents opportunities.”

• Turnaround funds – These also view the current climate as fruitful as liquidations increase. Woolworths and Waterford Wedgwood are prime candidates for this type of investor, and there will be many
others as the recession deepens.

• Mezzanine funds – O’Hare feels these are making a strong comeback after several years out in the cold. Until recently, there has been so much cheap cash sloshing around in the system that mezzanine specialists have found few opportunities. He believes this will change.

• Emerging markets – He particularly tips these to perform well: “In the current crisis, the risk premium has gone up and people are shying away from emerging markets, but if you stand back and look at the fundamental growth story in these markets, it’s much more robust than in the developed economies.”