Private equity in Europe: The market situation remains tense – analysis by Roland Berger Strategy Consultants

• In 2008, investment volumes dropped by 27%
• Forecasts for 2009 show a further decline by up to 40%
• Key success factors: Careful examination of each acquisition, active management of portfolios and quick implementation of necessary restructuring actions
• In 2010, more and more attractive companies will be coming on the market

European private equity firms have been hit especially hard by the financial and economic crisis. In 2008, investment volumes dropped by 27% and the forecasts for 2009 show a further decline by up to 40%. Despite cautiously optimistic economic forecasts for 2010, the market environment will remain tough – according to Roland Berger Strategy Consultants as indicated in their current "European private equity outlook 2010" analysis. Key success factors for surviving the crisis include carefully examining each acquisition, actively managing portfolios and quickly implementing the necessary restructuring actions. In 2010, more and more attractive companies will be coming on the market, thereby providing PE firms with new opportunities.

In 2008, investment volume dropped considerably in almost all Western European countries. Especially affected were Great Britain, where the market plunged from EUR 20.9 billion down to EUR 13.75 billion (-66%), and Austria (-62%). According to Hendrik Bremer, Partner at Roland Berger Strategy Consultants' Vienna office, the private equity market in Austria now has a volume of only EUR 330 million and thus trails Poland (EUR 630 million), Hungary (EUR 480 million) and the Czech Republic (EUR 440 million). In the wake of the crisis, PE funds are also struggling with sinking returns. The internal rate of return (IRR) fell from 17.1% in 2007 to 11.6% in 2008. Additional declines are expected in 2009. "Only the best funds are currently able to meet investors' high demands. Performance differences between funds will become increasingly noticeable, so that we can expect a shakeout in the market in 2010," says Dr. Sascha Haghani, Partner and Head of the Corporate Finance Practice Group at Roland Berger.

Several larger companies that currently have available capital can use the crisis to their advantage by making anticyclical investments. In contrast, a lot of smaller PE funds are in trouble: "It's currently tough for them to raise capital, and they can't sell existing investments at a reasonable profit," says Haghani. Funds raised will drop significantly. During the first six months of the year, they reached a historical low with a total of only EUR 5.7 billion. Simultaneously, divestments will shrink by roughly 50% for the second time in a row.

To make matters worse, banks today are more hesitant to provide the necessary M&A financing. This is especially evident in plummeting leverage ratios. Whereas the total debt ratio a company could use to acquire a company in 2007 was six times its EBITDA, this figure was just fivefold in the first six months of 2009. "We expect that the amount of own equity used to acquire a company will continue to rise due to the fact that obtaining loans will remain difficult," according to Haghani. In the future, returns will not be generated by debt, but instead by improving operational performance. However, PE companies still have to adjust their business models according to the changing market conditions.

Investors remain conservative

The challenging market environment means that investors have become increasingly conservative since late 2007. In 2008, buyouts constituted 70% of the market while startups and expansions dropped to 5% and 7%, respectively. In 2001, the market share of startup financing was still at 15% while expansion financing made up 25% of the market. On the other hand, there has been an emergence of financing for growth programs: this did not play a role prior to 2006, but in 2007 it constituted 5% of the market and even jumped to 14% in 2008.

The macroeconomic environment and developments on the stock exchanges are essential for the recovery of Europe's private equity markets. Lower growth rates are expected in 2010, making the environment for exits less attractive. "The right conditions for IPOs are simply not in place at the moment. The sales pressure is still not strong enough for secondary buyouts. Bargains are not yet available in the distressed market and only in exceptional cases for transactions in insolvency. This means that a secondary buyout is possible only with major markdowns," explains Roland Berger Partner Dr. Gerd Sievers. The focus of fund managers is expected to shift from the exit phase to the acquisition and holding period. What this means for acquisitions is that synergy potential with other portfolio companies and operating levers will play a much bigger role. Active strategies focusing on cost-cutting and growth have already proven their value in the past for generating superior returns. "Although many companies have already carried out restructuring programs over the past few years and were repeatedly involved in secondary buyouts, the current economic crisis is still making restructuring and adjustments necessary."