bizzXceleration: Performance, Value and Profit

Strategic Theory and Outlook

The basic theory behind PE investing is that a firm combines equity from limited partners with leverage borrowed from commercial source, buys out existing companies, changes the capital structure, improves the performance of the company and then harvests the returns by either taking the revamped company public or selling it to a strategic buyer. On that theory McKinsey is anticipating that funds will begin flowing back into alternative investments but that outlook was developed before the full force of the downturn and the fallout was clear - which means it was originally optimistic but is now probably wildly so. Normally the best time for investment is during the downturns when multiples are low but because of the uncertainties, the crippled M&A and Debt markets and the troubles at portfolio companies that's not happening. And as a result of the systemic shocks limited partners are re-evaluating the terms, funding and control relationships. All in all this next decade will partly follow the old cyclic patterns but they will be more severe and call for more fundamental rethinkings than previous ones.

After-shocks of the Crisis

The impacts on PE activity and situation get a little clearer when we look at this next chart set which shows the situation with portfolio companies and the PE firms. Portfolio company debt is largely trading as distressed debt, which means it's in danger of defaulting, so that the estimate is that some 50% will go into bankruptcy. The not surprising consequence of very high multiples and excessive leverage. At the same time the PE firms have a lot of "dry powder" to invest - that is they should be well positioned to take advantage of these circumstances but in fact are struggling to do so. One implicit implication here though is that equity funding resources should be available. The question is what to do with them - what about debt funding, what new leverage ratios, how will the limited partners react and where will the returns come from? Both from damaged portfolio companies and in the future?

It's clear that Private Equity will remain a force but that force will be forced to change :). The interesting question is how, when and where.

Current State of the Deal-making Environment

We've got two chartsets to look at and the one that provides an overview of the level of activity and the impacts of the crisis is here. This next set tells a complementary story as well as telling us what the evolving structure of investments and the environment looks like. First off, in both developed and emerging markets, there was a huge falloff in deal activity and it doesn't look like it's repairing itself despite a lot of anecdotal discussion that things are "picking up". Perhaps but in the new normal we're going to see an extended period of sub-part deal-making, just as we did in past aftershocks. As the comments note the environment remains very challenging.

When you look at Investment types there's a strong emphasis on smaller opportunities, distressed debt and swapping investments around (secondaries) though there is a trickle of a return of investor money. Meanwhile, as we said earlier, the supply of dry powder is pretty large. It's jus that the financing and the deals aren't there.

Restructurings of Deal Engineering

This all has consequences not only for the rate and volume of deals but for their terms and structure, as this next chartset hopefully makes clear. The supply of loanable funding for leverage has dropped precipitously and will likely take a long time to recover and never come back to the levels it was at during the PE bubble of the 2005-2007 period. Whether it stays at these abysmal levels and how long is another question.

Meanwhile PE firms are having to put higher proportions of equity into the deals, lowering the potential returns significantly. They are also big drops in leverage (debt:equity) and pricing multiples. Those are changes we anticipate will become the new normal.

Considering everything that happened the fact that limited partners are planning to maintain PE investments in their portfolios is significant. Again, at the old levels? Not likely. But the biggest changes will be in the terms and conditions - fees will be reduced, reporting and transparency requirements will become much more stringent, sympathy for financial engineering pure plays will drop significantly and investors will become much...much choosier in which firms they invest in. As usual when a rising tide lifted all boats and then drained away it will be the good swimmers who will survive. And the good swimmers will be the operattionally capable firms!

Strategic Changes in the Business Model

This next chartset brings home that critical point. The structure of deals and the sources of future returns are going to shift, and have to, in very fundamental ways. PE Investment will remain an attractive option but if, and only, if the various firms look to new sources of return. Which in turn means new capabilities that haven't traditionally been part of their capabilities.

The old model saw those returns, at least in theory, result from multiples expansion, operational improvements and leverage. In the new normal without the impact of leveraged bubbles multiples expansion will be a thing of the past. And the amount of leverage will decrease while the cost will go up. This chart (from Credit Suisse's Alternate Asset group) suggests that operatonal improvement will become the dominant foundation of future returns. We think that's true and should always have been. If we have one quibble it's the argument that operational improvements were effective in the old model - perhaps in previous generations but not recently, given the levels of debt that were use in the bubble. Which of course also leaves two hangovers - the aforementioned bankruptcy risks, reducing portfolio returns, and a legacy of excessively high prices that will reduce future returns as well. In the various scenarios played out here the argument is boiled down to IRR's being reduced from 36% to 23%. Perhaps, again! But those 36percenters were, if they ever existed, anomalies. And 23% may still be optimistic.

The bottomline bottomline will be for that minority of firms that can meet the new challenges, grow revenue and improve operational performance there will be a decade of significant opportunities. That may be just the top decile of firms however. In which case there will be a lot of sadder and wiser investors as well as ex-PE folks wondering around the landscape.

And you need to think of Private Equity as being the exemplar for Alternative Investments in general. After the Tech Bubble burst Venture Capital, then the "golden child" of alternative investing went with it and has never come back. Earlier this decade there was a lot of talk about the possible death of Hedge Funds but the financial bubbles led to a lot of new entries - and subsequent failure of hundreds of funds. Across the spectrum of alternative investments there are real nuggets but none of them that rely solely on financial engineering and the quick flip will enjoy the same level of easy money and success that they've had. Whether those days are gone forever or just this decade thing will change. And the broader markets will reflect that - something that doesn't seem to have sunk in any part of the Finance Sector or in Investors minds, either.

Deals, History and Consequences

Buyout Firms Profited as a Company’s Debt Soared How so many people could make so much money on a company that has been driven into bankruptcy is a tale of these financial times and an example of a growing phenomenon in corporate America. Every step along the way, the buyers put Simmons deeper into debt. The financiers borrowed more and more money to pay ever higher prices for the company, enabling each previous owner to cash out profitably. But the load weighed down an otherwise healthy company. Today, Simmons owes $1.3 billion, compared with just $164 million in 1991, when it began to become a Wall Street version of “Flip This House.” Simmons is one of hundreds of companies swept up by private equity firms in the early part of this decade, during the greatest burst of corporate takeovers the world has ever seen. Many of these deals, cut in good times, left little or no margin for error — let alone for the Great Recession. A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s. Among them are household names like Harrah’s Entertainment and Six Flags, the theme park operator. Executives at THL counter that Simmons was the victim of hard economic times, not mismanagement or too much debt. For now, the Golden Age of private equity is over, the financiers say. In a speech to an industry gathering last spring. Mr. Schoen said that bankers and bondholders were reluctant to lend more money to the buyout kings. “We’re in a brave new world,” he said. “We can’t go back to where we were, at least not in this investment cycle, and probably not in my career.”

Debt Trips Up Hinckley, Venerable Yacht Maker Like other yacht makers, Hinckley lost substantial business when the economy turned sour. But Hinckley’s problems can also be traced to its sale to one, and then another, private equity firm over the last dozen years. With each sale, it took on more debt, which became onerous when business slowed. And the culture also shifted from a family-owned business to one controlled by outsiders. Beginning early this decade, near the peak of demand, private equity buyers poured money into yachting, convinced — wrongly, it turned out — that the business could weather any economic storms because its wealthy clients would continue to buy. Several other boat makers have run into problems, including Ferretti of Italy and the MasterCraft Boat Company of Vonore, Tenn. Hinckley may well survive this downturn, thanks to a strong brand name nurtured over decades of Hinckley family ownership and a loyal clientele, some of whom spend their summers near Bar Harbor.

Serious Money, Vanity Fair (May 2007)But, in my adult life, the event of the bubble bursting, taking us back, for better or worse, to the way we were, never happens. From the 80s on, when finance became the secret code of modern life, from hostile takeovers through leveraged buyouts, junk bonds, venture capital, the I.P.O. craze, and hedge funds, bubbles have only burst so the next can get even bigger. Private equity might be a dangerous rage, but what that promises, in addition to inevitable vulgarity, is that there will be more things that are private and there will be more equity. The outsize success of private equity, the tsunami of private money, the pure giddiness, not to mention faddishness, of P.E. deals, are the result, as most success is, of a market anomaly. When the stock market crashed in 2000, it left lots of businesses stranded and undervalued—unable to go public or raise new money. What’s more, with a lackluster stock market, pension funds and rich people had to find more promising places to put their dough. Hence, private equity got lots of money to buy these cheap companies. Then, with business improving, and the market rising, and valuations going up, they got to refinance these companies—taking money out and buying more companies. Which is where we are now—with private equity remaking the world financial order. Except that the outlandish success of private equity also means that nothing is cheap anymore—everything is overvalued. So what to do? Which all sounds a lot like a bubble—a sense of growing hyperbole. (“When it ends,” says Blackstone’s Schwarzman, he of the birthday party for 1,500 and a personal fortune of $15 billion or so, “it always ends badly. One of the signs is when the dummies can get money and that’s where we are now.”) Still, bubbles can go on for rather a long time. And the biggest money is made at the crest of the bubble. True, you don’t want to find yourself the only one standing when the music stops, but you don’t want to get out of the game too early, either. That’s the other message at the conference: bubbles come and go, but nothing short of a cataclysm can derail the ever expanding power and reach of modern finance. And, even here, speaking of cataclysms, neither 9/11 nor the last meltdown of the stock market has much interfered with business. So, barring a collapse of the entire international monetary system, the world will continue to be remade by ever smarter financial strategies—the line between equity holder and employee ever finer and harsher, the world of owners and renters ever more binary.

Trends, Issues & Problems

Mixed Signals For Private Deal Market The Alliance of Merger & Acquisition Advisors released the results of a survey Tuesday showing that the volume of deals among mid- and small-cap private companies has fallen off precipitously in the first half of the year. The survey, which polled AM&AA member deal brokers, advisers and acquirers, showed a 58% decline in the total number of transactions among private companies compared to the first half of 2008 and a 44% falloff from 2007. The news wasn’t all bad, as the total dollar volume of transactions was off by only 12% from last year and 22% from 2007. The average deal size grew to $13.5 million, almost doubling the $7.8 million average a year earlier, suggesting that smaller transactions are having a harder time crossing the finish line. Meanwhile, the average acquisition multiple across all industries was 4.69x Ebitda, according to the survey. The poll is largely in line with data from the broader M&A market, which has seen the number of transactions fall almost 28% year to date, according to Thomson Reuters. However, the data provider also tallied a 36% falloff in the dollar volume, which -- in contrast to the AM&AA survey -- implies that dealmaking at the top end of the broader M&A market has slowed. Perry Campbell, chair of the AM&AA market research committee, pointed to the difficult financing environment for the slowdown, but added that that performance issues also played a role. He told Mergers & Acquisitions that smaller targets, in the absence of compelling offers, “will pull a company off of the market, wait for things to recover, and then do it all over again” when the conditions improve.

Get Ready for the Private-Equity Shakeout For decades the world’s top private-equity firms have sustained above-average returns in the long run by focusing on fundamental value creation and, in particular, operational improvements… However, from 2003 through 2007, nearly all private-equity firms wee able to grow exponentially thanks to an unusually favorable financial and economic climate and, in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all industries, escalating asset prices, and the allocation of significant assets from institutional investors to private-equity funds. The recent financial and economic crisis has sent all these drivers racing rapidly in the opposite direction. The biggest impact of the perfect storm will be on the private-equity firms themselves. We estimate that around 20-40 percent of these firms will disappear; on the other hand at least 30 percent will survive. The fate of the remaining will hang in the balance. There are three main steps that private-equity firms should take: First, they should prepared all their portfolio companies for a long and deep recession, focusing on operational improvements. As the top-performing private-equity firms have shown, operational value creation holds the key to success. This will be the most critical differentiator in today’s recession, especially for the 50 percent of private-equity firms that are hovering between survival and extinction.

• The Advantage of Persistence: How the Best Private Equity Firms "Beat the Fade"

Driving the Shakeout in Private Equity The balance of power has shifted toward limited partners, and we expect that limited partners will exercise this power and guide major changes in how the industry operates. The topics under discussion are….transparency, fees, the use of dry powder for bailouts and the implementation of true active ownership. The clearest drive of success …is the capability to create operational value (true active ownership). Limited partners seek a deeper understanding of that capability…. [and] will base their future commitment decisions on that capability dimension – therefore it becomes a table stake for firms to survive.

Wealth Matters: Big Investors Grow Wary of Hedge Funds and Private Equity LESS than two years ago, anything considered an alternative investment seemed to have an automatic cachet. Investors were shoving one another aside to get into the top hedge funds and private equity offerings. Venture capitalists were raising money with ease to invest in companies, even if their ideas were merely interesting, not tested. But the collapse of the financial markets last fall showed the investments’ limits. Investors suddenly realized that they could not get access to the money they had put in or sell their investments for anywhere close to what they were worth on paper. Seemingly overnight, investors began to reassess the tradeoff between the promise of high returns that did not always materialize and limited access to their money. “Clients are concerned about liquidity, lock-up periods and fees,” said Rob Francais, chief executive of Aspiriant, a high-net-worth advisory firm. In other words, the very things that had made hedge funds, private equity and venture capital so exclusive are now a cause for concern. This new caution has led, at best, to greater discernment among the wealthy. But at worst, it has fostered an ostrich mentality. “If they can’t understand it, they’ll pass,” said Joe Curtin, head of portfolio analytics and consulting at U.S. Trust Bank of America Private Wealth Management. “That’s a significant departure. If the strategy can’t be explained in conversational terms, they’re not going to do it.” Like so many other things this year, learning such a seemingly simple lesson has been costly. And the wealthy have not been the only ones to find it out the hard way. Two of the biggest buyers of private equity in 2008, for example, were public pension funds, which bought 26.6 percent of all private equity, and corporate pension funds (14.2 percent), according to Dow Jones Private Equity Analyst. This means the retirement plans of many workers had exposure to the same securities that have so frightened sophisticated individual investors.

Private Equity Investors Grow More Cautious Investor sentiment toward the private equity industry has dropped sharply over the past year following its poor performance during the financial crisis and frustrations about a lack of transparency at private equity firms, according to a study released late Wednesday. While investors in private equity have become more cautious in the last year, investors still do not seem to be pulling their money out of the asset class, according to the survey from Coller Capital, which buys and sells interests in private equity funds. But investors have increased their due diligence of private equity firms before committing new capital, and some are pushing for more investor-friendly terms, the study found. (Read the full report after the jump.) Coller found that 70 percent of private equity investors, known as limited partners, plan to maintain their target allocations to the asset class over the next 12 months and nearly all of the limited partners surveyed said they believed 2010 would be a “good” or “excellent” year. “There is a clear indication from investors that they perceive the P.E. market is bottoming out and that we’ve been through the worst,” said Luca Salvato, a principal at Coller. “While there is caution going forward, there is a view that we are on an upward track.” The survey also found that investors’ expectations for returns over the next three to five years had fallen sharply, with 71 percent of respondents saying they expected net annual returns of less than 16 percent. Two-thirds of limited partners have also changed the way they manage private equity as a result of the downturn, according to Coller’s study. Roughly 60 percent of all respondents said they had changed their risk appetite and investment criteria and half of all respondents have demanded improved reporting from the firm they invest with.

Private equity investors get more wary over where to put cash Investors in private equity hit the brakes this year amid economic uncertainty, pushing fundraising to its lowest level since 2004. However, commitments continued to flow to the top funds. Capital raised in the industry globally slumped 65% year-on-year to $225.6bn in 2009, according to data provider Preqin. The average fund size fell 13% from $592m last year to $513m this year, Preqin said. The drought came as investment committees paused to come to terms with the changing global economy, and capital became more constrained. Meanwhile, demand for new funds was held back by the $1 trillion of uninvested commitments, or dry powder, as private equity firms struggled to allocate existing capital, according to Preqin. Fundraising took much longer this year, as investors and general partners spent longer on due diligence. The 25 largest funds took an average 14.5 months to raise funds in 2009 compared with 12.2 months last year and eight months in 2007. Cathleen Ellsworth, a managing director at buyout firm First Reserve, said: “Investors are demanding, they have a right to be demanding and will continue to be demanding – they’re tying up their capital and have a fiduciary responsibility and managers are put through a rigorous review.”

Coller Predicts LPs Will Shun Re-Ups Private-equity firms looking to make deals this year have had a tough time amassing debt for transactions. Coller Capital says they ought not bother looking to their LPs for any extra capital, either. The global investor in PE secondaries reports that almost 80% of limited partners will deny PE firms’ attempts to re-up funds next year. Coller Capital said growing sentiment that PE firms’ re-up terms are not substantial, lack transparency and may contain conflicts of interest is contributing to what looks to be an LP backlash. In North America, 28% of investors think the perception of the asset class has been damaged through the course of the recession; that number almost doubles in Europe and Asia. The Coller Capital report noted that two-thirds of LPs have changed the way they manage private equity as a result of the recession. “When we look back in a few years, I think we’ll see today’s upheavals as a significant moment in the maturing of an industry,” said Jeremy Coller, chief investment officer of Coller Capital. An Institutional Limited Partners Association report released in September called for better practices involving governance, transparency and partnerships. LPs and PE firms have increasingly clashed with the onset and gradual recovery from the recession; Norwind Capital was pushed away from one potential deal, Pensions & Investments reported earlier this year, after LPs objected to its planned platform launch in the fertility space. TA Associates, wrapping up its $4 billion fund, made concessions in the way of lower carried interest and a provision that redirects transaction fees to offset limited partner management fees. PAI Partners was forced to redeem nearly half of its most recent fund after a very public (and ugly) power struggle resulted in the firm tripping its key-man provision when heads of the investment firm departed.

• Sun Capital’s Investors Choose Maximum Fund Size Cut

Private Equity Fund-Raising Hit a Five-Year Bottom in 2009, Down 68% Last year was just miserable for private equity fund-raising in the U.S. Hitting its lowest point since 2003, it fell 68 percent to $95.8 billion across 331 funds, down from $300 billion across 508 funds in 2008, according to Dow Jones LP Source. No category of funds escaped the slowdown, except for secondary funds — a major outlier that saw a more than 50 percent increase in fund-raising. Here’s a summary of the other findings:…. What’s also interesting about the data is how it broke down by quarter. Going into the fourth quarter, there were definite signs that the economy was rebounding. Investors were clearly feeling more secure, and liquidity was starting to return to many markets. But, despite glimmers of hope, the downward trend in private equity persisted to the last. The fourth quarter actually saw the lowest amount of fund-raising all year long — even lower than the first quarter when everyone was still spooked by the downturn. Only $35 billion was raised by 75 funds in Q4 of 2009. It looks like limited partners are taking a bit longer to recover from the blow delivered by the downturn, having become more choosey about where to put their money. It’s unclear whether growth in 2010 will be enough to change their minds.

• U.S. Buyout Fund-Raising Falls 73% In 2009 “The theme of 2009 was not fund-raising but rather fund size reductions, LP amendments and annex funds,” said Nicolas von der Schulenburg, a managing director of Portfolio Advisors.

Corporate Debt Exploding? It's Hopeless As we have witnessed several times over the last three decades, today’s corporate financial crisis was born of excessive leverage, itself born of excessive optimism, what was called “irrational exuberance” during the last downturn. The current down cycle, like the cycles of 1990-1991 and 2001-2003, is defined by rapid corporate leveraging followed by a tumultuous crash made manifest by high corporate debt default rates, a shortage of liquidity and cratering financial markets. In past downturns, corporate defaults and a dearth of liquidity forced periods of deleveraging that sowed the seeds for the next expansion. Deleveraging was forced upon corporations via debt defaults; those defaults led to a restructuring of balance sheets, often times with the assistance of the bankruptcy courts. These restructuring plans greatly reduced the debt on struggling companies and reallocated the equity away from the original equity holders and into the hands of creditors. What makes this cycle different is that people are betting on blind hope. Struggling companies crippled by debt are not beginning the cycle of bankruptcies and deleveraging that is so badly needed to restore our economy to health. Rapid as it has been, the rise in corporate default rates has been slowed in this cycle by the debt holders who are coming up with admittedly creative and optimistic ways to avoid deleveraging. We have seen an increasing number of cases where lenders convert their entire loans to payment-in-kind paper on the hope that some day the struggling borrower will “grow into” its oversized liabilities and actually pay interest on its debt. We call these “hope notes” and we don’t use the term in a positive way. In the last 12 months, more than $160 billion of institutional leveraged loans (27 percent of the outstanding) has been amended. Right now, the most popular recipe for a troubled company is one part covenant loosening, one part “amend and extend,” and one part hope notes. This is not a recipe for success. I believe companies need to abandon hope and deleverage. It can happen in one of two ways and creditors and corporate issuers must step up to make this happen.

PE Industry Responses and ReThinkings

Don't dabble in distressed With the alarming rise in the number of business restructurings, plummeting stock prices and substantially squeezed margins, many investors are considering whether now is the right time to invest in distressed. Adding to the appeal is that private equity firms are actively raising new funds focused on distressed investing. According to Private Equity International, in the first six months of 2008, distressed funds raised an aggregate of $37.7 billion globally. When dealing with distressed investing, one cannot dabble. You are either in or out. Experienced players know the stakes are high and the level of return may hinge upon resolving a multitude of the target's operational and strategic issues. Funding and liquidity constraints, financial reporting issues, high turnover and the lack of formal controls are often associated with distressed companies. Therefore, interested players must have the proper turnaround talent, process and infrastructure to evaluate, plan and manage such investments.

• MacFadyen: Envisioning the Turn

Dealmaking Strategies for Middle-Market PE Firms -- How PE Investors Are Beating The Recession Enough with the doom and gloom. No question middle-market PE dealmaking has taken a nosedive.  No question it’ll be a long long time before we see again the pace of the past few years.  And no question the credit markets are in for a painful cold spell.  The pressures on many companies and their capital providers are the most severe as many have ever experienced. So if you prefer to spend the next year huddling under a rock, you’re going to have lots of company.  On the other hand, remember this -- that year you’re off the field means there’ll be more opportunities for those of us who forge ahead.  The fact is there are more PE investors actively working on deals than you may realize.  And of course, everyone knows that historical data shows that the most profitable portfolios are the ones built in bad times.  What distinguishes us contrarians is that we’re open to changing direction.  Some of us are looking at new sectors.  Some are focusing on distressed companies.  Some are turning to alternative financing sources to get deals done.  And some are working with portfolio companies on M&A opportunities. I promise -- if you join me at the MasterClass I’m chairing for The Capital Roundtable on April 23, I will show you creative and opportunistic strategies for snatching victory from the jaws of recession. At this full-day MasterClass you’ll learn all this and more --

• Where and how investment bankers and investors are looking for new deals.
• What are the best practices in structuring deals when credit is tight.
• Who’s lending at regional and community banks, insurance companies, and non-bank sources.
• When to consider asset-based lending, sale-leasebacks, and other ready alternatives.
• How you can successfully renegotiate and/or restructure terms with your existing lenders.
• Steps you can use to enhance the value of your portfolio companies.

Looking For The Positive Spin Even for a glass half full guy like me, it’s been tough lately to find something good to say about this market. What seems like the Neverending List of Negative News seems to grow on a daily basis. Just yesterday, the NY Times Dealbook referenced a report from Bernstein Research concluding that M&A activity is going to drop 25% next year and even more in 2010 before it bottoms out. Yes, the report said there are select industries that will continue to see healthy deal flow, but for investment banks and others whose business is linked to transactions, the general outlook for the next 18 months is about doing less with less. On a relative scale, the mid market continues to be a safer place to play than the large market, and that’s unlikely to change even as 2009 gets worse. And since we’re comparing, I would argue that versus their public counterparts, the story is arguably a bit more hopeful for private equity-backed companies. For one, PE-owned companies don’t face the risk of a stock-market dive that erodes investor confidence and buying capital overnight. Moreover, the fact that financial sponsors can’t realize ROI until they exit their investment—dividend recaps are pure fantasy at this point—means they’re more likely to think through the impact of layoffs and other cost-saving moves on the future value of the business. On the flip side, however, many PE-backed companies are highly levered at a time when cash is disappearing. Buyers who invested at the peak of the market—sometimes at double-digit multiples—could end up making ugly, short-sided decisions to recoup what is now a bad investment. So perhaps we're just dealing with varying degrees of pain.  But while that pain is unavoidable, the obstacles we're facing now will undoubtedly lead to some good. For those PE firms who pride themselves on operational expertise—and actually have it—this is their time to shine. Some of those hard decisions that we put off when things were going well will finally be made, and who knows? Maybe they’ll prove to be the ones we should've made all along.  As the old saying goes, success is often born of adversity. 

PE Portfolios Take Center Stage Private equity firms are taking strong measures to improve the operations and performance of their portfolio companies, according to McGladrey Capital Markets. The results of a private equity survey, announced on Friday, found that a large number of buyout firms -- 88% of respondents -- executed layoffs at their portfolio companies. In addition, 75% ordered salary freezes, while 71% were focused on improving business processes and 68% sought to reduce capital spending. Choppy debt capital markets and the economic downturn are driving private equity firms to focus on improving the bottom line of portfolio companies. As a result, many aren't seeking to take their businesses public or sell them. "If the performance isn’t there you’re not going to be selling any portfolio companies," said Hector Cuellar, president of McGladrey Capital Markets. "Given the overall economic environment, private equity firms are trying to focus on operations."  Indeed. Less than 20% of roughly 100 respondents polled expected to sell a portfolio company, division or product line in 2009.  In the meantime, financial buyers are also focused on working capital issues at portfolio companies. Investors, for example, are concerned about bill collections, credit monitoring and inventory management, among other areas.

Adapting to Market Transformation  Knowledge@Wharton: To begin with, I wonder if you could tell us a little bit about the 16-year career that you have had in private equity and some of the opportunities that you see today because of the crisis in private equity as well as some of the government funding coming in through the bailouts? Roberts: Private equity, like most alternative investment strategies, is cyclical. It is perhaps too simple to say -- but I think it's accurate -- that it is a good time to buy when valuations and multiples are low, and there is not a lot of available debt. In hindsight, it wasn't a very good time to buy when the opposite was the case, when lenders were throwing debt at everybody and when multiples were high. You now have a situation where it's very hard to borrow. That is forcing acquisition multiples down. There aren't a lot of sellers yet, but we believe there will be because of the necessity to de-leverage. So we think the next few years will be a very good time to be putting money to work in private equity and finding very good values. Knowledge@Wharton: What are some of the other trends that you are seeing, in a nascent form, in private equity these days? Roberts: I think everyone is having to adjust to at least two major trends. One trend is that most people have legacy portfolios, where they have companies they need to deal with and decide: Is this company worth nursing back to health? Is there a way of restructuring the balance sheet? How do I preserve value? Does it make sense to put capital in? A lot of private equity talent and energy is being devoted to that. I think the second trend is that the traditional leverage buyout is off the table, for now and for the foreseeable future. So when we're looking at transactions, by and large, we're looking at transactions that have no leverage, where you're buying all equity. And therefore, you have to come up with prices and returns that make sense in that context. We're finding some situations, but they're few and far between. Knowledge@Wharton: Do you plan to change your strategy at all in this environment? And if so, how? Roberts: You need to take two things into account in private equity, when you're pricing a deal. One is, you cannot count on leverage very much, if it all. And so you have to structure and price a deal with that in mind. Number two, you have to price in a continued downturn. It depends on the industry and the company, but you can't count on this turning around very quickly and all of a sudden there being a great economic recovery in 2010, for example. That leads you to price very conservatively and to be patient. But we are out there very aggressively looking, because in order to find the right situations, you have to look at a lot until you find the right ones.

Granahan: PE's Power Play I was thinking about this after seeing some data this week regarding private-equity overhang -- the difference between what PE funds have been able to raise over the past couple of years and what has actually been invested. It's now at $400 billion, an all-time high, and pros in the M&A world point to this as a sign that a PE-led buying binge may be around the corner. Some even boldly cite the fourth quarter as when the shopping spree will start. But try to rein in your optimism. While it's nice that there appears to be a handful of arrows in the quiver, there is also a compelling, if not groundbreaking, explanation as to why all that money is sitting on the sidelines: Not much looks attractive at the moment. Remember, even at a time when we already knew the economy and the debt markets were in the tank, there was no shortage of optimists saying that the deals, particular for strategics, would be too good to pass up. But the reality has been far different, whether it be the result of unrealistic seller expectations, lack of financing or simply the business of the target company falling off a cliff. "Dealmakers have to put down their pencils and dispense with historical spreadsheet analysis," said David Cohn, a managing director at Mosaic Capital and a member of the Alliance of Merger and Acquisition Advisors, which helped author a study on the overhang issue. "History now tells private equity little about the future." True enough, but one thing we can say about the future is that it has the potential to be starkly different from what the PE industry had grown accustomed to in the early part of this decade. More regulation, dicey tactical allocation decisions and the possibility that the commercial real estate market is teetering are just some of the issues that will need to be grappled with. Hopes run high, but reality may get in the way.

Pension Funds' Private-Equity Cash Depleted 59% While Paper Profits Shrink  U.S. pension funds contributed to the record $1.2 trillion that private-equity firms raised this decade. Three of the biggest investors, state pensions in California, Oregon and Washington, plunked down at least $53.8 billion. So far, they only have dwindling paper profits and a lot less cash to show the millions of policemen, teachers and other civil servants in their retirement plans. The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund -- among the few pension managers to disclose details of their investments -- had recouped just $22.1 billion in cash by the end of 2008 from buyout funds started since 2000, according to data compiled by Bloomberg. That amounts to a shortfall of 59 percent. In total, they haven’t reaped a paper gain from funds formed in the past seven years. The wisdom of those investment decisions hangs on the remaining value private-equity firms assign to companies they snapped up in 2006 and 2007, during the peak of the buyout boom. For the California, Oregon and Washington plans, that figure totaled $15.8 billion at the beginning of the year. While some investors say they’re confident the private- equity industry’s traditional practice of taking over companies will pay off, others have been shaken by a credit contraction that froze deal-making, eroded the value of the assets on private-equity firms’ books and prevented them from cashing out in public share sales. Now pension managers on both ends of the spectrum are looking skeptically at the so-called internal rate of return buyout firms calculate to gauge their results.

Harvard Endowment Fell 30% Harvard University, disclosing investment returns that trailed well behind the performance of the average college, said its endowment over the last year shrank by 30%, or $10.9 billion. The dismal returns at Harvard and other wealthy schools in the year ended June 30 have exposed weaknesses in their exotic and--as it turns out--high-risk approach to investing. The school's positions in such illiquid assets as private equity partnerships were pummeled in the past year, after stellar results over the previous decade. In the category Harvard calls "real assets," including timber, commodities and real estate, annual losses approached 40%. In a report released Thursday, Harvard showed it had trimmed its risk profile by raising cash, cutting by $3 billion its future commitments to invest in private equity and other investment funds, and reducing its real asset category to 23% from 26% of its model portfolio. It also said it had "clawed back" previous bonuses to its portfolio managers who performed poorly, and planned to bring more assets under internal management, which would give it the ability to move faster to sell assets and raise cash in tumultuous markets. Other wealthy schools, including Yale, Stanford, Princeton and MIT, have predicted losses similar to Harvard's. They all follow an investment model that deemphasizes traditional stocks and bonds and instead loads up on alternatives unavailable to the average investor. Yale and Harvard, pioneers in the method, had said that they could afford to take big risks because they were investing for decades, even centuries. Many lauded and copied the schools, saying they had found a high-return, low-risk strategy. But Eric Bailey, managing principal of CapTrust Financial Advisors LLC, a Tampa, Fla., firm that advises college endowments, says, "If it looks too good to be true it probably is." Mr. Bailey says typical colleges outperformed Harvard last year because they stuck to a plain-vanilla approach -- often 60% stocks and 40% bonds. That strategy would have generated a roughly 13% loss in the year ended June 30. Harvard currently aims to have only 4% in U.S. bonds -- one of the few safe havens over the last year. Harvard cut by more than half the percentage it aimed to hold in U.S. bonds since 2005.

• Yale Endowment Down 30%

Investment Indigestion at Stanford Stanford University is holding a garage sale. Not the desks-and-chairs kind. Instead, Stanford is selling stakes in funds run by the biggest names in private equity at deeply discounted prices. While no one will confirm the names aloud, they are of the caliber of Henry R. Kravis, Stephen A. Schwarzman and Leon D. Black. During the boom times, Stanford Management, joined other endowments in a rush to plow increasingly large percentages of their funds into private equity, real estate and other illiquid investments — committing some $12.6 billion of the university’s endowment. But then the market soured, and Stanford’s endowment lost $4.6 billion in value in its last fiscal year, a decline of 27 percent. So it now seems to be suffering from investor’s remorse. Its plan to sell part of its stakes in private equity firms — a bid to raise $1 billion or more — appears to be an attempt to cut losses on current investments and a way to get out of committing more money to future deals. One executive involved in the auction process, first reported last week by LBO Wire, a news service of Dow Jones, called it “the biggest fire sale in private equity, ever.” A potential buyer said, “For someone in our business, it’s a rare chance to get a portfolio of this quality and of this size.” Even so, Stanford’s decision will send a chill through the halls of endowment offices at other universities. By trying to sell such a large position all at once, Stanford will invariably depress prices for any institution considering a similar move. Virtually nobody in the industry would talk on the record about Stanford’s planned sale. Everyone contacted was a buyer, adviser or consultant — or wanted to be — and considered this deal to be the third rail of the endowment industry. One question that has vexed the endowment industry is how to determine the value of portfolios. At the end of every quarter, private equity firms typically send out current valuations of their portfolios and the endowments accept them at face value. But what happens if Stanford is able to sell its stake at only 50 cents on the dollar, for example, when K.K.R. is listing it at 80 cents? If other endowments hold similar stakes, what happens to their value?This is still a hypothetical, because unlike investment banks, endowments don’t have to mark to market. Instead, they value their assets on a hold-to-maturity basis, which means they should not have to reduce the value of those portfolios in the short term. But if things get worse, will they have to?

Can KKR Make Like Berkshire Hathaway? Kravis thinks Berkshire, with its piles of cash and trove of publicly traded shares with which to make acquisitions, is nothing less than "the perfect private equity model." That the storied dealmakers at KKR are acknowledging their shortcomings says much about the state of the leveraged buyout business. Kravis and Roberts could try to wait out the rough patch, nursing their wounds and promising investors they'll do better once the deal environment improves. Instead they're reshaping KKR's three-decade-old playbook. The financial crisis has taught the granddaddies of private equity many things. They must be nimbler and quicker. They must move beyond the audacious leveraged buyouts that have come to define private equity in the popular imagination—most famously, their 1989 acquisition of RJR Nabisco. They can't rely solely on debt to pay for their deals. They need, as Kravis puts it, "more control over our destiny." The two have cooked up a four-part plan to make it happen. First, they're building an in-house investment bank to serve KKR's portfolio companies. Second, they're taking KKR public, with shares expected to be on the New York Stock Exchange (NYX) in early 2010, in hopes of one day using the newly minted stock to make acquisitions and invest in the firm. (It listed 30% of KKR in Amsterdam in October.) Third, while Kravis and Roberts certainly aren't abandoning buyouts, they're placing more emphasis on minority stakes and joint ventures with companies in a broader array of sectors. Finally, they're adopting new management techniques to preserve KKR's tight-knit culture as the company expands. Other private equity firms see the value in KKR's emulating Buffett. "This makes sense for them," says John Canning, chairman of buyout shop Madison Dearborn Partners. "A firm that big can't rely [solely] on historical methods of capital raising anymore. Things change." If Kravis and Roberts get this experiment right, their strategy could point the way for other buyout firms. Even bankers acknowledge the need for firms to move beyond leveraged deals. "Private equity will become broader and broader," predicts Morgan Stanley CEO John J. Mack. "Instead of buying companies and restructuring them, they will have a whole panoply of investments."

External Responses

Towards A Common Regulatory Regime? After the G-20 Summit, it seemed that the world was in some agreement that hedge funds, and probably private equity funds too, need regulating. But as various governments start taking concrete steps towards new regulation, it’s clear that there’s still lots of room to disagree. The European Commission, which has so far proved to be the most in favor of regulating private equity, is expected to unveil a report on regulating hedge funds and PE firms on April 28. According to our colleagues at Private Equity News and others who have reviewed a draft of the report, it is expected to include provisions on minimum capital requirements, how much leverage a fund can have, and disclosure of some information on portfolio companies. A spokeswoman for the European Commission declined to comment. The U.K., however, seems to be taking a different approach. An official at the U.K. Treasury Ministry said the ministry doesn’t believe private equity has presented any systemic risk so far. He added that since it is outside of the euro zone, the U.K. has some leeway in adopting European Union laws. “Because London is a financial center, we’d like to maintain that independence,” he said. A paper submitted by U.K.’s Financial Services Authority last month named hedge funds among systemically significant entities, but didn’t mention private equity firms. The largest private equity firms already disclose some details about their own organization and their portfolio companies in the U.K. In the U.S., there are still few details. Congress is expected to come up with two pieces of legislation in the next few weeks, including one on a single systemic risk regulator, said Steven Adamske, a spokesman for the House of Representatives’ Financial Services Committee. He declined to elaborate on whether private equity firms will be included in the legislation. “There will be more hearings” on the issue, Adamske said. In prepared testimony before the committee last month, Treasury Secretary Timothy Geithner said hedge funds, private equity firms and venture capital funds over a certain size should register with the Securities and Exchange Commission and be subject to certain disclosure obligations.

The Private Equity Meltdown Myth Michael Gross, a founding partner of the private equity firm Apollo Management LP who is now at a hedge fund, recently asked a group of business students at Northwestern University this question: In three years’ time, what might the private equity and airline industries have in common? His answer: From day one, neither will have ever made a return for its investors. It’s hard to imagine another industry that has suffered quite the unmasking that private equity has. Hedge funds underwent a calamity, but their basic business of buying and selling stock still works in a leaner world. The business of providing investment advice and making trades—the meat and potatoes of investment banking—will exist even if no independent investment bank does. But private equity firms are another matter. Once, they purported to be in the business of buying troubled companies and turning them around. They contended that they could manage the companies better away from the public glare of shareholders. When money was loose and leverage was king, private equity firms thrived. No more. In the wreckage of the bust, they have been revealed as hapless corporate stewards and gullible investors. The competition for the highest-profile debacle is stiff. Add to that the reality that private equity firms generally don’t make their money by choosing good investments. They make it on an amazing Technicolor array of fees: management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the bubble years. So it would be natural to assume that private equity is in trouble. Yet, in one of the richer ironies of the Great Recession, private equity firms are poised to flourish. They’ve raised money for new funds and locked it in before investors have had a chance to fully realize how disappointing the returns will be on the last ones. Capital is king now, and many private equity firms have enough money for 10 years. The private equity industry is shaping up to be a great example of why it can be rewarding to do irrational things in a bubble.

How Private Equity Could Rev Up the U.S. Economy It's been a rough two years for private equity firms, those freewheeling and much-vilified financiers who buy companies only to sell them later for a profit. The buyout boom that ended in 2007 wasn't pretty; many of the deals made at the height of the frenzy have been disasters. Bankruptcy courts are littered with private equity blunders, including household names Chrysler, Tribune (TXA), and Linens 'n Things. Such high-profile blowups heightened private equity's reputation as a group of fast-buck artists who are better at destroying companies than running them. But a strange thing has happened. While the experts were proclaiming—and maybe even celebrating—their death, private equity firms were quietly bulking up their war chests and readying themselves for a new wave of deals. By some measures they're stronger than ever: Firms are sitting on a record $1 trillion with which to make new purchases, according to research firm Preqin. "They are showing up at the party with a wheelbarrow full of cash," says Donna Hitscherich, a professor at Columbia Business School. Slowly and deliberately, firms are mobilizing their forces to exploit huge opportunities being created by the recession. Some big buyout firms, filling the void created by the financial crisis, are acting like traditional investment banks, providing loans to troubled companies and even advising executives on mergers. Some firms are aggressively hiring and firing buyout specialists, turning the cold eye they usually train on companies onto themselves. Other firms are prowling bankruptcy courts in search of cheap assets or are capitalizing on government stimulus spending. The next few years will be dismal for many firms, no question. Buyout shops may be sitting on piles of cash for new purchases, but their portfolios also are stuffed with companies at risk of folding unless they can refinance their debt. Boston Consulting Group estimates that 20% to 40% of private equity firms will disappear altogether in the next few years. But the wiliest players have inoculated themselves from the worst of the pain. During the boom years, firms used a number of slick tricks to extract money from companies right away and ease potential losses. First they loaded the companies they bought with debt and kept the proceeds for themselves. Then they collected ongoing management fees from those same companies. Often they did both.

• Masters of This Universe

ILPA Issues PE Guidelines The Institutional Limited Partners Association unveiled a set of guidelines for the private equity industry, billing the effort as a drive to better align the interests of LPs, sponsors and portfolio companies. The ILPA, in the 15-page document, focused on best practices involving governance, transparency, and the partnerships. Taken in the context of the current environment, the effort would also seem to underscore the push by limiteds to be more vocal in pressing their rights with sponsors. In July, for instance, Norwind Capital was reportedly forced to backtrack from an investment after its LPs, according to a story in Pension & Investments, blocked efforts to launch a platform in the fertility space. The publication identified Harvard and Yale as the limiteds in question and noted that style drift was the reason cited. Even the outperformers are dealing with more vocal LPs. TA Associates wrapped up its latest fund at $4 billion in August, well ahead of its target, but the firm made some concessions in the way of lower carried interest (20%) and a provision that redirects transaction fees to offset limited partner management fees. The ILPA, meanwhile, listed a number of principles designed to guide limited partner and sponsor discussions. Many of the items reflect current issues facing both GPs and their investors. For instance, the ILPA noted that changes to the tax law that personally impact members of the general partnership “should not be passed on to limited partners in the fund.” This, ostensibly, looks out to potential changes to the tax treatment of carried interest. Also, another suggestion targeted clawbacks, stating that these provisions “must be strengthened so that when they are required they are fully and timely repaid.” Moreover, the ILPA guides GPs to maintain a “substantial equity interest” in the funds, taking the form of cash, and suggests that all transaction and monitoring fees should “accrue to the benefit of the fund,” which is in line with the modification made by TA Associates. The ILPA also discussed governance and transparency best practices, which hearken on past efforts from the association and other similar organizations to create a boilerplate approach for reporting performance and calculating fees.