Expect Europe's Private Equity Market to ContractPublished: January 12, 2011 in Knowledge@Wharton
In a keynote speech at the Wharton Private Equity and Venture Capital Conference titled, "A New Dawn: Investing in the Post-Crisis World," Dalip Pathak, manager of Warburg Pincus' London office, which oversees the firm's business in Europe and India, offered a global view on the economic crisis and private equity's role in capital investment around the world going forward.
Pathak said that the crisis comes at a time when the entire world economic order is being restructured with new emerging powers, including China and the other so-called BRIC countries -- Brazil, Russia and India -- leading to even more uncertainty than would have come with a typical business cycle.
"China and the other BRIC nations are confounding the ability to forecast cycles," he said, explaining that in addition to the hard down cycle, investors now have to try to factor in the impact of new economic forces. "The world is restructuring and will continue to restructure. We are going through a period that is internationally challenging and there are victims to the restructuring," said Pathak. "We are not in a situation of stable equilibrium. We are in a very dynamic situation and it is going to stay that way. We have to think of our business model in that context."
He added that private equity investors must stress test their models because "nightmare scenarios do exist and happen more frequently than you expect."
Pathak, who was chief of mission of the World Bank's International Finance Corporation Thailand before joining Warburg Pincus in 1994, then ticked off a list of crises that have rocked financial markets over the years. He pointed to the dissolution of Soviet Russia, the Asian financial panic, the U.S. dot.com bust and, most recently, the possibility of sovereign debt defaults in Greece and other European nations. "Even though these downturns happen every three or four years, somehow we forget about it or we ignore it."
As a result of the crisis, Pathak said that the private equity industry will certainly contract. In Europe, there will be fewer firms managing somewhat smaller funds. Firms will need to put more equity into deals. "In the longer term, the industry will return to growth and the survivors will be better companies in a sense," Pathak predicted. "They will have the dry powder and [be] better managed. [It] will be a better industry."
Private equity remains a relatively young industry in Europe and will grow stronger in the future, although current returns are driven by investments made at the peak of the private equity boom in 2006 and 2007 and are "not great," he pointed out. "We hope '09 and '10 will be great," he continued, noting that "the assets we are seeing now are pretty interesting" although in some sectors the market seems to be ahead of itself.
Pathak said that he keeps hearing that "Europe is finished," but he countered that because Europe is the largest market in the world, even a slow growth rate of 2% a year would provide more incremental earnings than 8% growth in India. "While people are all excited about India, there is a lot of intellectual property in Europe. There are great universities and high-growth subsectors." The economic downturn, he added, is feeding growth in value retailing, online retailing and outsourcing businesses.
A Change in Leadership
A generational change in leadership is underway in European private equity companies for a number of reasons, Pathak said, predicting that the churn will continue in the current year. The main reason, he explained, is that some firms made huge mistakes and limited partners "are upset and need a scapegoat. They are not willing to pony up the money for new funds unless there is some indication of change at the top."
At other firms, managers are stepping down because they feel they have made enough money and the last downturn was such a "major shock" that they need time off. When the person at the top leaves, he observed, their protégés also tend to leave, sometimes to start their own funds. As a result, growth-oriented funds are hiring.
As for investment opportunities, many firms are focusing on follow-on investments in their own portfolio where some managers are looking for new capital to make opportunistic acquisitions. "Those are the investments they know best," Pathak noted. And European firms are now starting to follow the trend of taking a minority stake in companies, which began in India and spread to the United States. Growth opportunities still exist in Europe, he insisted, adding that "forecasts of the death of European private equity are premature." Opportunities exist for PIPE financing (PE company investments in publicly traded companies) and buyouts, but without much leverage, he said.
However, "the fundraising environment is tough," Pathak conceded. Companies are still raising money, but few are closing funds. "There was a significant panic of limited partners. Limited partners are liquidity focused and appreciate distributions, and I think the industry is focused on making these distributions. If the distributions are not forthcoming, the LPs don't have money to put into funds." He predicted that in the next two to three years, funds will start flowing into new allocations.
"The most bizarre thing is that for some reason the European regulators have decided to come down heavily on this industry," he said. Regulators have proposed some "fairly absurd" rules in the wake of the financial collapse and the industry is waiting for more clarity on exactly what new rules will emerge.
To put his overall comments into better context, Pathak offered an overview of Warburg Pincus, which was founded 40 years ago and has already weathered many economic slumps. He said, "In every downturn, liquidity is key -- liquidity in the investment companies and liquidity in the firm." Warburg Pincus has enough cash to "coast" for three years, he said, in part due to its diversification and expertise in industries such as energy and health care.
"We have made a lot of money in the past five years in energy. Health care is also resilient," he said, noting that valuations for health care companies in Europe have dropped by only 5% because of the crisis. And as the population continues to age, he maintained that health care will become even more important.
Warburg Pincus is not a major leveraged buyout firm, which also protected it from the worst of the global crisis, said Pathak. "This has served us well, but this is not to say other models do not work," he noted.
He added that the ability of Warburg Pincus to weather the crisis also has been largely due to its major positions in Europe, China and India. The firm was an early entrant into the Asian market. "We have a dominant position in these markets and India and China have to some extent significantly saved us," he said.
Crisis in Europe
Pathak then turned to the crisis in Europe, noting that the boom in European private equity finances between 2003 and 2007 was driven by leveraged buyouts fueled by liquidity. As loan volume increased, so did the number of buyouts. "The world has been awash in liquidity for many years, primarily driven by imbalances in the world with the rise of China and the surpluses in the Middle East," he said. "The Western world has not managed it that well."
As leverage buyout activity increased, deal values grew increasingly larger and were financed by larger loans, he explained. "Most of us who have dealt with banks in Europe literally had to say to the banks, 'We do not want to take this money.'" When banks offered to finance deals at eight times EBITDA (earnings before interest, taxes, depreciation and amortization), he said, private equity firms agreed to finance at six times EBITDA. "Most of the firms in Europe have been fairly thoughtful and are in good shape. We didn't take all the money thrust upon us by the banks," he said.
At present, deal flow is picking up and Pathak said his firm is now busier in Europe than it has been for several years. He noted that Warburg Pincus sat out on much of the deal-making in 2006 and 2007 because of concerns about market conditions. The firm largely pulled back from new deals and limited financings to companies already in its portfolio.
"Despite the uncertainty, I'd rather be in today's market than the one in 2006 and 2007," he said, adding that a large backlog of assets that sat unsold in the past two years because of the crisis will have to come onto the market soon to return investments to partners. "Private equity has to sell," he said. "Big private equity is driving the disposals."
Another factor driving the sales is the changing tax policies in the United Kingdom that will encourage investors to sell assets. However, just as more assets come on the market, competition for transactions is sharply reduced because banks have cut back on financing for highly leveraged sales.
Today, there are fewer private equity players in Europe than there were during the boom years and some firms are running out of cash, Pathak said. Meanwhile, the environment for raising cash is strained and private equity firms are holding back on new investments. At the same time, valuations are better and financing has improved since the depths of the crisis in late 2008. Debt financing will remain limited for the next three to five years, he predicted.
The high-yield bond market has already regained strength in the United States and is now picking up in Europe, he noted, although a lack of bank interest in providing bridge financing makes bond placement more difficult. "Some of us are capable of and willing to fund certain deals with 100% equity," he said, stressing that liquidity is key.
Looking back on the crisis, Pathak said that he saw how good management is critical to survival in a downturn. "We have in our own portfolio [a mix of] companies. One is falling off the cliff and the other is hanging in there over the last few years, due less to the sector and more to the competence of management. Good managers figure a way out."
He added that he also learned from the crisis that "unpredictable dislocations do happen." Companies must always build in a margin of safety for events that cannot be expected. "Don't think that just because you have assumptions and have validated the assumptions that something you haven't thought of isn't going to cause a problem," he said. "The virtuous cycle of leverage and valuation does not last forever."