Private Equity: 'Is the Golden Age Behind Us?'Published: July 14, 2010 in Knowledge@Wharton
Before introducing the panelists taking part in a session during the recent Wharton Global Alumni Forum in Madrid called "Relaunching Private Equity," moderator Raffi Amit summarized the challenges of both venture capital and private equity at a time when investors have become more conservative, returns are down, and transactions have declined in both volume and value.
Entrepreneurs are finding it difficult to raise money, which has an impact on innovation and new development, he noted, while early stage investments are at a low level due to uncertainty over exit strategy, and the time -- and money -- needed to get to liquidity. "Obviously that brings down returns, which makes it harder to raise more capital for a new fund," he said.
With respect to later stage private equity and its dependence on leverage, "The question is whether the golden age is behind us," stated Amit, professor of entrepreneurship and management at Wharton. "Will leverage for buyout return? If so, when and at what pace? What investments will PE firms pursue?" Looking at transaction levels, he pointed to a sharp decline in the number of mergers and acquisitions and IPOs in 2010. Globally, according to a report in The Wall Street Journal, 295 companies raised $42 billion worldwide in the second quarter of 2010, compared with 274 that raised $51.5 billion in the first quarter, an 18% decline in dollar volume. Many companies are continuing to put off IPOs in the hopes that prices will recover.
Overall, it will take longer for returns to come in than they have historically; one private equity participant has suggested that investors are lowering their expectation for returns to where they were five years. A Boston Consulting Group study estimates that up to 40% of private equity firms will close down in the next several years.
Amit added that bankruptcy in the U.S. has gone up dramatically, which brings about further uncertainty in private equity and affects industries ranging from real estate to automotive to transportation. So what are private equity players doing? One answer is they are moving to emerging economies, Amit said, citing a sharp increase in the percentage of investment in these areas.
Teamwork, Talent and Strategy
From 1994 to 2002, panelist Angel Corcóstegui was global CEO and first vice chairman of Banco Santander Central Hispano (today Banco Santander), a position which included a direct role in managing several complex bank mergers. In 2006, he founded Magnum Industrial Partners in Madrid -- the largest PE firm in Spain and Portugal.
During remarks to the audience, he shared some of the lessons learned over the past four years, starting off with "when you work in a banking institution, as I did for many years, and you want to know something, you push a button and you get the answer. In a small PE firm, you [find the answer] yourself." Second, "you have to select your partners very well. You are not the boss. You are part of a team." In Corcóstegui's case, he started out by recruiting two founding partners. One was head of McKinsey in Spain and Portugal, the other a Portuguese entrepreneur. "Partners are important," he noted. "Get as much talent as you can from the very beginning.
Third, define your strategy. In Magnum's case, the firm identified its market as Spain and Portugal and focused on buyouts. "We wanted to get majority, not minority, control of acquired companies," Corcóstegui said. As for the firm's size, "we chose to raise about $1.2 to $1.3 billion in 2007 because we wanted to be in the upper middle market. You need to have a big fund to be in that space. Small size PE firms in Spain are part of a very crowded [universe]. In our target segment, we knew we would have more room to operate."
As for investors, he advocates a diversified investor base that is in it for the long term. "Otherwise you will be in trouble," Corcóstegui stated. Magnum has 41 investors from around the world, including Japan, the U.S., Saudi Arabia, Canada, Spain and Portugal. The founding partners committed about $25-$30 million in the firm to cover start-up and fund raising costs. In addition, the founding partners committed a significant amount as pure investors, because "If you don't commit [your own money], how will you persuade others to commit?"
Commercial, accounting and legal due diligence are very important when making acquisitions, Corcóstegui said. Reasonable levels of debt are also important -- "With one exception, we do not put more than 50% leverage in our companies" -- as are transparency and communication with investors. At its last shareholders meeting, Magnum had more than 90% attendance by investors from all over the world, Corcóstegui noted, adding that the company gives its investors a lengthy report on its activities every quarter, sends them the entire valuation of the portfolio fully audited once a year and does a semi audit at mid-year. "Whenever we make an investment, we call our investors in advance. We spend a lot of time with them, including personal visits."
Finally, Corcóstegui said, PE means "active ownership. You have to actively manage your companies. That doesn't mean manage them yourselves, but finding the right people to do it. In addition, you have to align the interests of your investors with the managers.... When we acquire a company, our best choice is to keep the current management. We bought an engineering company in 2007; 10 of the managers wanted to stay. We bought 60% of the company; they bought 40%. We look for managers with an entrepreneurial mind because this is about creating value."
In response to a question from Amit about the difficulty -- and expense -- of raising debt capital these days, Corcóstegui responded that money is available for excellent companies. Magnum bought a wind power company in Portugal for $1.5 billion in 2008, just 10 days after Lehman Brothers collapsed. "We were asked how we were able to raise the money at this time. It was because the company had the right performance, the right price, 85% debt and 15% equity, and it was an outstanding asset."
Panelist Isaac Devash, managing director of Devash Investments and Consulting in Tel Aviv, offered his thoughts on the venture capital business, including his response to comments from colleagues who tell him that "the days of venture capital may be over." On the contrary, Devash said, "venture capital is not only here to stay, but is crucial to the development of mankind." Devash, who has 14 years of international private equity and venture capital experience and has worked as an investment banker with Credit Suisse First Boston, noted the developed world's progression from the agricultural revolution to the industrial revolution to the current "information age revolution." Innovation -- in areas ranging from energy to medicine to nanotechnology -- "is not just here to stay, but will accelerate because we can share information instantly, with millions of people. That amount of collaboration" will lead to new ideas and advances in industries around the world.
Yet while venture capital isn't disappearing, he said, it will need to change, including, for example, by lowering both the entry level and the management fees. "We have to adjust the model so that it is sustainable." Reflecting the difficulties within the venture capital industry, Devash also pointed out that "great people are migrating from funding venture capital to funding private equity.... At some point I wanted to deal with avian flu. I found a great technology where you don't need to give a vaccine every year, but only every seven years, like tetanus. I knew no [venture capitalists] would fund it because it would take forever [to get to market]. So I ended up going to angel [investors] and divided the investment between 25 people."
Amit concurred with the need for change, asking the audience to consider models that are "viable from the perspective of the limited partner, the investor, as well as from the perspective of the entrepreneur, the innovator. If less money is coming in, and it takes longer to bring an innovation to market, that will have adverse effects."
Competing for the Same Assets
Panelist Antoine Dréan, founder and CEO of private equity companies Triago (New York, Paris and Dubai) and Mantra (Paris), focused some of his remarks on opportunities in the secondary market, whichhas grown from a few investors looking to acquire existing stakes in private equity funds from other fund investors to becoming a full-fledged asset class. The secondary market "is definitely here to grow," he stated, because participants "understand that buying a secondary is about the same thing as buying into a new fund, except you can look at what's in there and sometimes you can get a good price. So it's a [viable] way into private equity outside the usual fundraising cycles." In addition, secondaries are a useful tool for managing portfolios.
As for private equity in the long term, it will be "a bloodbath," he said. "Private equity takes a long time to die, and a lot of management companies are making fees every day from their limited partners. They have no real incentive to leave the space. We are predicting that about 50% of the buyout funds could disappear. That's a big number, but if you look at how many funds are competing today for the same assets, you may feel there are just too many people looking for the same thing."
Yet despite a somewhat downbeat assessment, a lot of money can be made in private equity, Dréan added. "Many investors still believe in private equity, and many groups still provide very good return." As for venture capital, he predicted significant growth in the next few years. "At some point, if there are a few success stories on the venture capital side -- especially with life sciences -- it may put venture capital back in the limelight."
Meanwhile, he suggested that the "real operational people are back in favor ... people who know what they are doing. Some investors are saying they want teams who are able to buy businesses even if they are not for sale." Also in favor are emerging markets because of their relatively high growth rates. "Investors understand they won't get much return from the leverage effect. If they want to get what they used to have, it's about investing in growth economies."
For panelist Olivier Marchal, managing partner, Bain & Company EMEA in Paris, "private equity is a cyclical business. So the question for me is not will it recover -- it will -- but how?" Looking at the European market, he cited a "very slow but real recovery of deal activity quarter after quarter. The deals are different, often smaller, with much less leverage than in the excess years.... There are a number of issues ahead of us. One is a lot of dry powder that couldn't get invested in the last two years -- more than one trillion dollars." He predicted that it will take four to six years for those funds to be put to use. "So there is more money than ever chasing fewer deals than ever .... It is going to be a very competitive market." He also forecast lower returns, "close to the mid teens for private equity funds."
Marchal -- who is active with Bain's private equity practice in France, working with investment funds on idea generation, strategic due diligence and portfolio company improvement -- says he does not foresee the "blood bath" predicted by Dréan but agrees that private equity will be a very selective industry. "What will limited partners look for in the future? For firms that are interventionist and focused on creating value post acquisition, and that have the ability to do extremely high quality due diligence. That seems basic in private equity, but it is not what this industry was about during the last 15 years.... If you don't manage to strike the right deal at the right price, you shouldn't be in that business. The other thing is you need to create value, and you do that, not two years after the deal, [but from] day one. You need to be prepared to push the button on a new strategy" or a new management team.
Panelist Felipe Oriol, president of private equity firm Corpfin Capital in Madrid, readily acknowledged that "things have changed. We are back to basics of all kinds. Pricing is more reasonable, leverage is more reasonable, terms and conditions are back to normal markets. So in that sense, I don't see a deterioration. We are back where the good management teams will have a chance to really make it."
Corpfin Capital was founded in 1990, but "we are reinventing ourselves," Oriol said. "You can't be the same as you were five years ago. We are enhancing our activities; we are looking at private equity real estate, looking for interesting assets we can buy. We are entering the market in a very solid way." The company is also looking at venture capital opportunities, including in Internet-related initiatives. "There is life ahead for private equity," he stated.