Private equity firms have enjoyed extraordinary growth and returns over the last five years, but the collapse of the world's debt markets and the deepening economic crisis have brought this boom to an abrupt end, with potentially severe consequences for private equity firms, the companies they own (so-called portfolio companies), and the real economy.
Research from the Boston Consulting Group and the IESE Business School indicates that at least 20% and possibly as many as 40% of the 100 largest leveraged-buyout (LBO) private-equity firms could go out of business within 2 to 3 years. Disturbingly, most private-equity firms' portfolio companies are expected to default on their debts, which are estimated at about USD1billion.
Private-equity firms have typically sustained returns by focusing on value creation and operational improvements. Over the past five years, nearly all private-equity firms were able to grow thanks to an unusually favourable financial and economic climate and, in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all industries, escalating asset prices and the allocation of significant assets from institutional investors.
The recent financial and economic crisis has sent all of the above drivers racing rapidly in the opposite direction. The world's debt markets have virtually ground to a halt. Given that the financial sector is under pressure to deleverage, this situation is unlikely to improve in the near term. Until the third quarter of 2007, most industries enjoyed strong earnings growth. Today, most industries have negative EBITDA growth and the situation is likely to get worse. From 2003 through 2007, EBITDA multiples grew and private-equity firms were able to earn a good return from this appreciation. In 2008, the drop in share prices has changed this situation dramatically, pushing multiples below the level of the previous 3 to 4 years. Finally, institutional investors are reducing their private-equity asset allocation.
The net result of the financial crisis is that many private-equity firms' portfolio companies are expected to default on their debt obligations during the next three years. The question to be asked is: "How will the defaults affect the global economy?" The overhang of LBO debt on banks' balance sheets may be small as banks have already offloaded or written off most of their LBO debts and the discounted value of the debt is transparent for any bank. Furthermore, there is a market for this type of debt. The identity of the holders of the remaining debt which is not sitting in the balance sheets of banks and buyers of distressed debt is difficult to answer because this debt is not transparent. During the debt bubble, the banks that initially signed the debt syndicated the largest part thereof to hedge funds and other institutional investors. The pure size of the write-offs and the lack of transparency of the investors behind those institutions could be a source of a shockwave. However, our view is that the large number of defaults at portfolio companies is unlikely to trigger a real economic shockwave. Moreover, our view is that these companies, even though they may be defaulting, will have the same chances of survival as companies not owned by private-equity firms. The breakup of the business would not benefit the equity and debt holders. However, significant restructuring is already evident at most portfolio companies with massive cost cutting and many difficult layoffs. This trend is certain to continue for the foreseeable future.
The biggest impact of the perfect storm will be on the private-equity firms themselves. It is estimated that around 20% – 40% of these firms will disappear. Those that survive will consolidate the market, lay the foundations for superior long-term returns by investing in cheap assets during the down-turn and emerge with an even greater focus on operational value creations. Perfect storms are perfect moments to do deals.
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