Private Equity – New Decade, New Start

17 January 2011

At SL Capital the big question we are constantly asked by investors has been "is the private equity buyout model broken?" The past two years have seen a wave of issues for pension fund investors in the asset class.  Write downs, falling returns and a lack of liquidity resulted in a reassessment of the rational for investing in private equity.

Historically buyouts have been successful due to alignment of interest and the motivation this gives to improve corporate performance.  Company management are motivated by the gains that result from improving revenue growth, efficiency and profitability through to an exit.  The private equity fund managers are incentivised, through carried interest from the profit on a portfolio of investments, to support management by providing strategic and operational input and advice. It is clear that companies removed from the restrictions of quarterly stock market expectations can focus on generating real value growth over a longer timeframe.

This alignment of interests and focus on improving performance has served the asset class well.  The recession of 2008 and 2009 was all about private equity fund managers working hard to defend and protect their portfolio companies, through their ability to quickly reduce costs, adjust market strategies and renegotiate debt terms with their financiers.  These actions prevented the widespread company defaults that were predicted by commentators and allowed private equity portfolio's to enter the recovery ready to take advantage of growth opportunities.

As a result, private equity portfolio valuations rebounded rapidly in 2010 on improved company profitability and the impact of strengthening stock markets on fair value.  Liquidity improved markedly towards the end of 2010 as trade buyers returned, private equity funds saw value and global IPO markets opened for high quality assets.

At the start of this new decade, the private equity model has rebooted.  Deal flow increased in both value and volume in 2010 and this will continue through 2011 and beyond.  Returns from the maturing 2006 to 2008 vintages will improve and new investments in private equity will outperform historic averages.  Capital will be returned to pension funds that can be reinvested in a smaller pool of high quality surviving managers.  These funds are returning to the market to raise capital and debt availability now allows larger, but not mega, deals to be contemplated.  The smaller end of the buyout market has not missed a beat during the crisis and will continue to provide returns that merit the additional risk.

Private Equity has recovered on numerous occasions, but challenges do remain.  Increased regulation will test its resilience.  However, the asset class is flexible, able to adapt, innovate and can provide attractive returns primarily due to the quality of the people attracted to its challenges and opportunities.  This is core to the continued success of private equity.

As CalPER's CIO was recently quoted as saying, "It's really hard to imagine a worldwide market system not providing a return to riskier sources of capital"1.  Private Equity is a contributor of enhanced returns with measured risk and so continues to merit its place in a pension fund portfolio.

Relevant Statistics:-

• European buyout activity in 2010 tripled in value from €18.3 billion to €49.0 billion
• The volume of European Buyouts increased in 2010 to 505 deals from 433 deals2
• Private Equity backed IPO's in 2010 reached a total value of €21.6 billion2
• 70% of private equity managers in the US market saw their portfolio's increase in value during 20103
• Since 1986, the best returns generated in private equity have occurred in recessionary periods4

Graeme Gunn, Partner, Standard Life Capital Partners.

1. 1 Quoted by Joe Dear Calper's CIO, In Bloomberg Markets October 2010
2. 2 Centre for Management Buyout Research
3. 3 BDO USA Survey
4. 4 SL Capital analysis, based on a number of US and European private equity return statistics.