Private Equity Outlook
The recent US financialcrisis had ripple effect on markets around the globe. Business activities of European private equity firms almost ground to a halt. A new study shows how investment companies can minimize losses in 2008.
Compared to the record-breaking year of 2006, when the private equity industry increased the volume of investments made by 50%, the second half of 2007 looks like a complete reversal of fortunes. While 2007 began with a promising start, the ripple effects of the US financial crisis, an increasingly difficult situation on the stock markets and an expected economic slowdown are putting a damper on hopes for 2008. Pressure will indeed remain high, a new study argues, but investment companies can still reap benefits during this tumultuous time, as long as they engage in proactive portfolio management and take a lean restructuring approach to the companies they acquire.
"The key question is whether European private equity firms can sustain their value creation and returns over the next few years," says Hendrik Bremer, finance expert and Principal at Roland Berger's Vienna office. Given the global impact of the US housing market crisis, higher lending rates and the unfavorable situation on the stock market, boom year results like in 2006 - where top tier investment companies achieved returns of just under 40% - are highly unlikely. The Roland Berger study, "Mastering the next buyout wave: European private equity outlook 2008" examines ways in which investment companies can still make strides, swimming against a difficult current.
Compared to the record-breaking year of 2006, when the private equity industry increased the volume of investments made by 50%, the second half of 2007 looks like a complete reversal of fortunes. While 2007 began with a promising start, the ripple effects of the US financial crisis, an increasingly difficult situation on the stock markets and an expected economic slowdown are putting a damper on hopes for 2008. Pressure will indeed remain high, a new study argues, but investment companies can still reap benefits during this tumultuous time, as long as they engage in proactive portfolio management and take a lean restructuring approach to the companies they acquire.
"The key question is whether European private equity firms can sustain their value creation and returns over the next few years," says Hendrik Bremer, finance expert and Principal at Roland Berger's Vienna office. Given the global impact of the US housing market crisis, higher lending rates and the unfavorable situation on the stock market, boom year results like in 2006 - where top tier investment companies achieved returns of just under 40% - are highly unlikely. The Roland Berger study, "Mastering the next buyout wave: European private equity outlook 2008" examines ways in which investment companies can still make strides, swimming against a difficult current.
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," Bremer says. Experience in the US shows that in restructuring projects with a passive investor, an average return on investment (ROI) of just under 30% can be achieved after two years. But things look better, when a private equity firm gets involved in management. Here, research shows, a ROI of 65% can be achieved. "Active involvement in restructuring and strategically realigning the company is the thus 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 had a obvious destabilizing effect. In previous years, investments and takeovers were usually financed by cheap bank loans. In leveraged buyouts, private equity companies were putting in just 30% equity on average, borrowing the rest. In addition, the criteria for granting these loans had become increasingly lax. Now, European banks are struggling to sell down their exposure in the capital markets due to a complete lack of market confidence resulting from the recent crisis. This leaves them sitting on EUR 30 to 40 billion of leverage loans. As a result, more and more investment companies are having to finance their projects themselves. This, in turn, results in smaller deals and often a postponement of planned takeovers.
Investors increasingly conservative
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. Only a year ago, things looked quite different: 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.
The large volume of cash in the market also has an effect on private equity. 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," the finance expert warns. In certain countries, suitable takeover targets might become a rare commodity. High demand and a relatively small supply of suitable companies will increase competition and up the acquisition prices. The "lucky buys" era across Europe seems to be well and truly over.
Rising interest rates have little impact
If private equity firms act prudently, they can avoid the degree to which an increase in interest rates will effect their companies, the study argues. While low interest rates tend to favor investments in companies, most private equity firms have already taken the necessary steps to hedge their bets. Now, they have to look toward achieving higher earnings to cover their loans. Investment targets themselves might face the biggest difficulties in adjusting to higher interest rates: "Some companies could run into trouble by over-extending their debt, for example," Bremer says.
But much more serious than rising interest rates, the consultants warn, is the worrisome situation on the European stock markets. 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. Thus, restructuring the core business of investment targets will become more important than ever, in an effort toward achieving a good sale price, the experts argue.
"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," Bremer says. Experience in the US shows that in restructuring projects with a passive investor, an average return on investment (ROI) of just under 30% can be achieved after two years. But things look better, when a private equity firm gets involved in management. Here, research shows, a ROI of 65% can be achieved. "Active involvement in restructuring and strategically realigning the company is the thus 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 had a obvious destabilizing effect. In previous years, investments and takeovers were usually financed by cheap bank loans. In leveraged buyouts, private equity companies were putting in just 30% equity on average, borrowing the rest. In addition, the criteria for granting these loans had become increasingly lax. Now, European banks are struggling to sell down their exposure in the capital markets due to a complete lack of market confidence resulting from the recent crisis. This leaves them sitting on EUR 30 to 40 billion of leverage loans. As a result, more and more investment companies are having to finance their projects themselves. This, in turn, results in smaller deals and often a postponement of planned takeovers.
Investors increasingly conservative
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. Only a year ago, things looked quite different: 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.
The large volume of cash in the market also has an effect on private equity. 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," the finance expert warns. In certain countries, suitable takeover targets might become a rare commodity. High demand and a relatively small supply of suitable companies will increase competition and up the acquisition prices. The "lucky buys" era across Europe seems to be well and truly over.
Rising interest rates have little impact
If private equity firms act prudently, they can avoid the degree to which an increase in interest rates will effect their companies, the study argues. While low interest rates tend to favor investments in companies, most private equity firms have already taken the necessary steps to hedge their bets. Now, they have to look toward achieving higher earnings to cover their loans. Investment targets themselves might face the biggest difficulties in adjusting to higher interest rates: "Some companies could run into trouble by over-extending their debt, for example," Bremer says.
But much more serious than rising interest rates, the consultants warn, is the worrisome situation on the European stock markets. 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. Thus, restructuring the core business of investment targets will become more important than ever, in an effort toward achieving a good sale price, the experts argue.
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