Private Equity Direct - Summer 2011 - Private Equity Crystal Ball — Looking to 2012 and Beyond
If 2010 was dominated by tight funding and a limited deal calendar, 2011 and 2012 are dominated by optimism. Private Equity firms are hungry to do deals. One result of the economic downturn is the much vaunted-cash stockpiles many companies are sitting on. That global stockpile was recently valued by Bain & Co at almost one trillion dollars and general partners are looking to put that money to work.
In addition, global debt markets have undergone a stabilization over the opening months of 2011 which is resulting in an increasing of leverage that some Private Equity firms are able to use in LBO situations. While there are many reasons for optimism, Private Equity market participants should temper enthusiasm with caution. As Hugh MacArthur, head of Global Private Equity at Bain, explains in his introduction to the recent Private Equity report. Confidence that the still-fragile economic recovery will gain momentum in 2011 is fueling optimism that conditions are in place for the revival in Private Equity deal volume to continue. Private Equity firms wielding vast sums of dry powder are eager to put capital to work, the supply and range of deals will increase and more stable debt markets are better able to provide financing than they have been since 2007.
More deals will be consummated, more deals exited, returns will be higher, LPs will commit more funds for future transactions. However, stronger Private Equity markets remain just one major geopolitical problem or sovereign debt crisis away from being derailed.
All signs point to a healthy 2011 and, as the market comes back to life, a potentially stellar 2012. Valuations increased throughout last year and buyers were prepared to pay a premium to get deals done. The problem is that with this eagerness to do deals some players are going to get burned if they fail to understand the new realities of the Private Equity market.
As has been the case with other areas of the financial world, regulators are likely to play a stronger role in the Private Equity market in the U.S. Having addressed many of the concerns in the public equity markets and corporate governance, the SEC and others are looking for new targets and Private Equity may well be in their sights. Lawmakers are considering tighter regulation of Private Equity firms and there is discussion on subjecting the Private Equity industry to the same filing and disclosure rules as other financial market players. This could reverse some of the advantages the industry has always had over fully registered equity markets.
Tightening regulation of the primary equity markets combined with a general contraction in that arena have driven many investors to the private equity markets. For example, Rule 144A IPOs – which are new issues done on private equity markets in the U.S. by foreign companies — have increased almost 20% in the past 10 years. Since companies accessing private equity markets are generally not subject to most securities regulation, like Sarbanes-Oxley and the 1933 Act, the rising regulatory and litigation burden being proposed in Washington may deter future growth.
One area of regulation that is attracting attention from Private Equity fund managers is the new compensation rules. The Private Equity Growth Capital Council has been vocal in its concerns about the potential impact of the rules and the need for executives of Private Equity funds to be excluded. The group is calling on the SEC to acknowledge that PR firms do not pose systemic risk to the wider economy and that investment timelines are typically longer-term.
Another challenge facing Private Equity investors is a return to some possibly risky practices that were common at the peak of the credit boom. As activity has returned and with a market starved of deals, many companies have been able to acquire funding through so called "covenant-lite" loans. These are loans that have few, if any, conditions attached to them. So far in 2011, "cov-lite" loans have accounted for almost one-third of all syndicated leveraged loans, which according to S&P is more than all such loans sold in 2010. So what is the problem? With few covenants, lenders (and investors) may have less recourse against borrowers and thus the risk of default becomes higher.
Many of the collateralized loan obligations written in 2006 and 2007 are maturing in 2012 and, as such, companies are eager to refinance transactions. Speakers on the Distressed Hedge Fund Panel at the recent Wharton School of Business Annual Restructuring Conference declared concern about "the return of some of the worst practices such as dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."
In addition to structural challenges, there is talk among the regulatory community that Private Equity deals may soon become subject to some of the SEC rules governing listed-company transactions. According to SEC sources, the Commission has harbored concerns about the lack of disclosure in Private Equity transactions and the potential for shareholder harm. The situation escalated earlier this year when Goldman Sachs offered a broad cross section of its private investor clients the opportunity to purchase shares in Facebook and other tech companies that are said to be preparing for IPO.
The crux of the problem is the number of people with access to the deals. The SEC requires private companies to disclose certain financial information if they have more than 500 shareholders. In order to get around this, sale of shares has typically been done through special entities that trade as a single unit (regardless of how many people actually invest in the entity). The SEC sees this as an end-run around the rules and is looking into closing the loophole and more aggressively enforcing increased disclosure rules. The proliferation of online trading services that specialize in the sale of shares in private companies — such as SharesPost and SecondMarket — is exacerbating the problem and creating a sense of urgency among regulators.
Private Equity firms and companies seeking funding will need to keep a close eye on this development. If transactions become subject to stiffer disclosure requirements companies may need to beef up accounting and audit capabilities, adding cost and complications.
TOP ISSUES FOR 2011
- Slow economic recovery and growth in traditional markets in the U.S. and Europe.
- Increasing flow of investment to developing nations like Brazil and China.
- Continued signs of strength and increased exit opportunities should prompt more Private Equity fundraising in H2 2011.
- Legal and non-financial contract terms like hurdle rates and carry structures will continue to shift.
Private Equity Direct - Summer 2011 Issue