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Private Equity's New Challenge

FOR MY ACCREDITED INVESTORS:

For more than two decades, buyout funds — or nonventure private equity funds — have been an important force in global corporate finance and restructuring. Top-quartile funds, in particular, have turned in consistently strong performances, generating attractive returns for their investors

That model, however, may soon look quite different. A convergence of market forces has altered the competitive landscape in which private equity firms have thrived. More and more, they are encountering heavier competition for opportunities to invest, often against new competitors. The rise of the auction sales process is eroding the buyout players' ability to gain privileged access to investments from their once-legendary networks of relationships. The creative financial-engineering skills once guarded by a few top practitioners have become commodities, and a tougher stock market has worked against players looking to purchase, restructure, and then quickly sell a company. Taken together, these changes threaten to lower median returns over the next five to ten years, compared with the public equity markets, and could make standout performance considerably more difficult.

An excess supply of capital. Throughout the 1980s and most of the 1990s, well-positioned players could rapidly deploy their capital because the demand for private equity financing generally exceeded the available capital. That situation has reversed dramatically, however. In the late 1990s, buyout funds collectively raised as much as $50 billion to $60 billion per year. Yet by the early 2000s, annual deployment had fallen to the $30 billion to $40 billion range (in equity value), and today a significant pool of capital — some $90 billion in the United States and €39 billion in Europe — is awaiting deployment (see Exhibit 2). The result is more competition for each new investment opportunity, more marginal or high-priced deals, and greater pressure from institutional investors to return some previously invested capital.

Commodity financial-engineering skills Vendors are beginning to use so-called stapled finance, where assets and businesses are auctioned with aggressive buyout leverage already in place or preapproved by the financing banks, for instance. Even the sales of businesses with lower leverage tend to attract multiple bidders, each with its own access to similar sources of debt through the financial sponsors' groups of large investment and commercial banks. Acquisition prices therefore tend to reflect most of the upside from leverage.

Cyclical difficulties in ensuring attractive exit. Particularly during the 1990s, strong equity markets frequently permitted buyout firms to use initial public offerings (IPOs) to divest their interests. Beginning in 2000 that became more difficult, as markets plummeted, and even today this approach is a harder sell. As a result, buyout firms increasingly are changing their divestment strategies. Some are selling via secondary buyouts, while others are holding onto their investments longer. Indeed, Initiative Europe has reported that average holding periods increased from 37 months in 2002 to 52 months in 2003. (Founded in 1988, Initiative Europe is a leading independent provider of specialist and in-depth information focused purely on European private equity and venture capital markets.)

Fewer pull-through opportunities for banks. Buyout funds within financial institutions can create value both by earning a basic investment return and by creating opportunities to pull through fee-based business such as M&A advisory and underwriting fees. Indeed, much buyout activity has been carried out within broader corporate-form financial institutions (predominantly investment banks) using both their own capital and that of third-party investors. A number of such bank funds historically have been very strong performers, although investors, unlike those in partnership-form peers, have suffered from double taxation of fund returns.

SOMETHING that must be DONE Some firms will want to focus on a limited number of industry segments. Truly superior strategic and operational insights and the development of potentially privileged networks for sourcing require deeper industry knowledge in today's environment. Firms that quickly develop their knowledge of a few narrowly defined industry segments and geographies will be better positioned to translate this expertise into a perspective on value-creation potential, transaction price, and potential returns.

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