Remaining positive
Despite the upheaval in the financial markets and the consequent shake-out of the industry, many private equity practitioners are optimistic.
Most private equity funds are structured as partnerships. There are limited partners (LPs) who have limited liability. There is also a general partner (GP) who takes on the liability and runs the partnership. The general manager also appoints the investment managers.
For those limited partners with cash to invest, many are increasing their allocation. Faure says: “Post-recessionary times are a good time to buy companies because they are priced attractively.” Holmen concurs: “There are institutional investors exploring new GP relationships and LPs who are increasing their commitments with managers who have been performing well.”
Creating value
While many long-term investors can see the value in buying assets at the bottom of the market, there is no denying that the private equity world has undergone a profound change. “The three major drivers of private equity value creation are profit growth, financial gearing and positive multiple arbitrage,” says Markus Golser, senior partner at Graphite Capital.
But the relative lack of credit makes it more difficult to create value through financial gearing, while in the prevailing lacklustre economic and financial environment it has become harder to dispose of an asset at a significantly higher multiple than the one at which it was acquired.
Golser says: “The major value driver for a private equity investor is to increase the profitability of the company.” In many cases that means the company either has to be able to grow its market share by acquiring its competitors, or it has to expand its market overseas.
Holmen agrees: “Investors want private equity managers which can produce top quartile returns over a number of economic cycles.” This ability to deliver returns in both bad times and good has, unsurprisingly, become an increasingly important requirement for investors. Private equity managers must have a compelling strategy that can deliver high returns and can execute that strategy with a stable team of high quality investment professionals and the fee structure also has to be appropriate. That compelling strategy will vary according to each company but it might, for example, include expanding a product or service into a different market where the manager has relevant experience and a strong network of contacts.
Even if an investor is confident that they have the ability to pick a top quartile manager, the current market conditions mean that they will have to have more patience about realising the gains from their private equity investment. The slowdown in the financial markets mean that it takes much longer to exit an investment than it did before 2007. With the IPO market barely open for business and limited available credit, there are simply fewer assets around then there was in the past.
James Fillingham, director at PwC, says: “The returns will take a long time to come through. It will take a long time to raise new money, invest that money and then realise those assets.” For long-term investors with the skill to pick the top performing managers of the future and the patience to wait for those returns, private equity remains a worthwhile asset class capable of generating an above average reward.
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