Private equity in Europe: Preparing for the next wave of buyouts

The business activities of European private equity firms almost ground to a halt in the summer of 2007. By contrast, in the record-breaking year 2006 the industry had increased the volume of investments made by over 50%, and the first half of 2007 could still be described as very successful. The causes of this drastic decline are the current aftereffects of the financial market crisis, the anticipated slowdown of economic growth and an increasingly tough situation in the stock market. All these factors will keep up the pressure on the market over the coming year – this is the conclusion of a recent report by Roland Berger Strategy Consultants entitled "Master the next buyout wave: European private equity outlook 2008". For investment companies, proactive portfolio management and a lean restructuring approach to the companies they acquire are the key factors for success in the current crisis.

"The key question is whether European private equity firms can sustain their value creation and returns over the next few years as well," says Hendrik Bremer, finance expert and Principal at the Vienna office of Roland Berger. In 2006, the top quarter of investment companies achieved returns of just under 40%. In previous years, average returns in the industry were around 14%. The global impact of the US housing market crisis, higher lending rates, the unfavorable stock market situation and slower economic growth make it unlikely that such results will be achieved in 2008.

Active involvement is a key success factor

"In a tough market, the largest increases in value can be achieved during the holding period of the acquired companies. But investors need to be actively involved," opines Bremer. Experience in the US shows that in restructuring projects with a passive investor, after two years an average return on investment of just under 30% can be achieved. When a private equity firm gets involved in management, an ROI of 65% can be achieved. "Active involvement in restructuring and strategically realigning the company is the key success factor – especially in tough times," says the finance expert. He advises investors to act swiftly after acquisition, place their "own" managers in management or find new ones and carry out projects to optimize business.

Sascha Haghani, Partner in the consultancy's Corporate Performance competence center agrees: "Internationalization and professionalized management in a restructuring situation is now more instrumental than ever, given the current market situation." He highlights that smart, strategic restructuring is one of the few ways to still generate growth. NPL Investors, for instance, pursue a strategic approach, which includes active involvement in the development of value generation in the underlying from the start. They pursue a comprehensive tactic, that includes strategic, operative and financial restructuring. This, in turn, has a positive effect on the receiving company: It profits from the investor's financial restructuring know-how and has the added pressure to refocus on pooling strategic knowledge to create growth. This generally results in a rapid, positive effect on assets, income and liquidity, with the beneficial side-effect of building trust between management and investor. Thus, Haghani recommends investors should use an 'industry logic' that encompasses these core elements.

Market paralyzed by lack of confidence

The US housing market crisis has made the general situation much worse. In previous years, investments and takeovers were usually financed by cheap bank loans. In leveraged buyouts, private equity companies put in just 30% equity on average, borrowing the rest. In addition, criteria for granting loans became increasingly lax. European banks are finding it difficult to sell down their exposure in the capital markets due to the current lack of confidence, and are now sitting on EUR 30 to 40 billion of leverage loans. As a result, investment companies are having to finance their projects themselves to a greater extent – deals are now smaller and takeovers are often shelved.

Investors increasingly conservative

The tough market conditions are also making investors much more conservative. "The focus remains on late-stage buyouts, while startup and expansion financing is declining in volume across Europe," says Bremer. In 2006, buyouts accounted for as much as 69% of the market, while startups and expansions were down to 8 and 16% respectively. In 2001, startup finance still accounted for 15% of the market while expansion accounted for 25%. This trend applies especially to the German market, where buyouts already make up over 80% of the market. Expansion and startup funding only make up around 8% each. In Austria, too, the proportion of buyouts is increasing strongly (from 13% in 2005 to 40% in 2006), but is still well below the European average. Corporate expansions are the main target of finance in Austria, making up 51% of the market.

Another factor impacting the private equity market is the large volume of cash in the market. In 2006, the funds raised reached a record EUR 112.3 billion, versus just EUR 71.2 billion worth of investments. "You can also add EUR 33 billion in divestments to this figure of over 100 billion. There was a lot of pressure to make suitable investments even before the market slump. We expect to see even more excess cash in 2008," says the finance expert. Especially in small markets like Austria, is it hard to find suitable takeover targets. High demand and a relatively small supply of suitable companies increase competition and acquisition prices. The era of "lucky buys" is over throughout Europe.

Rising interest rates have little impact

The continued increase in interest rates will also impact the private equity market. "Of course low interest rates tend to favor investment in companies. The trend was foreseeable and most private equity firms have taken the necessary steps to hedge their bets," says Bremer. But investment companies now have to achieve higher earnings to cover their loans. According to Bremer, the greatest impact can be seen at the investment targets themselves. "Some companies could run into trouble through over-indebtedness, for example."

The consultants consider the situation in European stock markets to be much more serious than rising interest rates. Lower growth rates are expected over the coming year, making the conditions for exits less attractive. "Many investments are ready for an IPO, but the conditions are not right. So many investment targets will not be sold or will be sold to other investors," explains Bremer. Restructuring the core business of investment targets will thus become more important in achieving a good sale price.