PERSPECTIVE
SuperReturn 2010: Bumpy road ahead
for Private Equity investors
                                              ...
PERSPECTIVE
•	    The reduction in leverage, while accelerated by the credit-crunch, is not a recent phenomenon but a long...
PERSPECTIVE
While recovering, Western economies appear now structurally “out of steam”:

            - Debt / Disposable I...
PERSPECTIVE
 Dry powder vs deal volume

     US$ Bn

             1200                                                   2...
PERSPECTIVE
 Upcoming debt maturities


          Amount (US$ Bn)                                                         ...
PERSPECTIVE
Types of company

•	   Key opportunities include:
         - Industries and companies in need of balance sheet...
PERSPECTIVE
About Value Partners

Value Partners’ Private Equity       enhancement initiatives              For more infor...
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SuperReturn 2010: Bumpy road ahead for Private Equity investors

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In February the private equity industry came together in Berlin, Germany for its annual gathering of Limited Partners (LPs) and General Partners (GPs). Reassured by historical analysis of past booms & busts, some practitioners expect a new peak in capital allocations sometime this decade, while others quietly wondered if their investment houses would hold together long enough to enjoy the next wave of super-returns. One key message emerged loudly: future top quartile GPs will rely significantly less on financial engineering and much more on differentiated investment themes, deep sector expertise & insight, and renewed efforts on growing the EBITDA base of their portfolio companies. By Alfonso Marone, partner of Value Partners, London.

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SuperReturn 2010: Bumpy road ahead for Private Equity investors

  1. 1. PERSPECTIVE SuperReturn 2010: Bumpy road ahead for Private Equity investors In February the private equity industry came together in Berlin, Alfonso Marone Germany for its annual gathering of Limited Partners (LPs) and Partner, Leader of Private Equity Practice General Partners (GPs). Reassured by historical analysis of past booms & busts, some practitioners expect a new peak in capital allocations sometime this decade, while others quietly wondered if their investment houses would hold together long enough to enjoy the next wave of super-returns. One key message emerged loudly: future top quartile GPs will rely significantly less on financial engineering and much more on differentiated investment themes, deep sector expertise & insight, and renewed efforts on growing the EBITDA base of their portfolio companies. Background In this perspective we review and analyse some of the evidence emerged at SuperReturns 2010. While broadly confirming the conclusions we reached in a 2008 study, “Private Equity: the one trillion dollar question”, we believe that the supply / demand dynamics illustrated in Berlin imply a more bearish medium-term outlook for the sustainability of the LBO model and ability of the PE sector to clear the substantial “capital overhang” without compromising its returns. Private Equity outlook: our previous findings Changing rules of the game Outlook • Capital commitments • Capital concentration • Geographic diversification • Reward model (2/20) • Succession management • Debt leverage • Role of multiples expansion • Role of EBITDA growth • Holding period for the asset • Focus on portfolio Source: “Private Equity: the one trillion dollar question”, Value Partners (2008) Insights from the historical analysis Historical data series analysis presented by LP and GP representatives puts the current crisis into context and provides useful guidance for the future: • The private equity industry (in its wider definition, e.g. LBO, Growth, Turnaround, and Venture Capital) has already seen three major booms & busts (one every decade since the 80s) and every time the sector has emerged stronger, with a growth in capital allocations 1
  2. 2. PERSPECTIVE • The reduction in leverage, while accelerated by the credit-crunch, is not a recent phenomenon but a long term trend: the E/EV ratio has moved from below 10% in the 80s to 35% in the 00s, reaching an average of 50% in the most recent deals • There is a high correlation between the growth in total capital commitments and the decline in IRR performance, which for the top quartile funds in 2009 reached a low of 4% • At a firm level, based on US-data series, only top quartile funds are worth LPs’ money. Historically, the top 25% of the firms have produced nearly 100% of the returns, implying that almost three private equity managers in every four are net value destroyers • The same HBS study shows that there is strong persistence of performance for the top funds. However, when a firm grows the size of its funds, it generally sees a lower IRR as a result • Sector focus, allowing for greater industry insight and deeper relationships with management, translates into a greater improvement post-acquisition of a portfolio company’s EBITDA performance, and leads to a IRR 14% bp higher than that produced by generalist funds (study of 42 buyouts) • For that portion of IRR driven by operational improvements, revenue growth (organic or inorganic) explains 75% of the returns while cost cutting only accounts for a quarter. Equity contribution to LBO deals 52% 43% 41% 40% 40% 38% 36% 35% 32% 32% 33% 33% 30% 25% 26% 24% 23% 21% 22% 13% 10% 7% 1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: S&P LCD Q4’09, Silver Lake analysis The new macroeconomic backdrop USA, UK and Western Europe have traditionally absorbed the vast majority of private equity capital. Here between 2003 and mid 2008 a macroeconomic context of continued growth and substantial debt capacity has enabled investment strategies relying on balance sheet leverage, trading multiples expansion, and organic EBITDA growth. 2
  3. 3. PERSPECTIVE While recovering, Western economies appear now structurally “out of steam”: - Debt / Disposable Income: 110% - GDP growth rate projections: 0-2% p.a. In the new scenario, the pool of investment targets able to ride the same growth drivers of the past five years will inevitably shrink, leading to increased competition for the fewer suitable assets. The likely return of auctions for the attractive targets will inflate purchasing prices and transfer a larger portion of the value creation potential to the sellers; GP’s IRR performance will suffer. Instead the Emerging Markets present a substantially different picture: - Total GDP > Western Economies’ aggregate GDP - Debt / Disposable Income: 15% - GDP growth rate projections: 5-9% p.a. With macroeconomics so favourable, the untapped value creation potential is substantial; and traditional investment strategies may still work. Therefore, for those investors able to find their foot with local governments, regulators, and business partners, New World companies may offer a better investment platform than peers in Westerns markets. The gorilla in the room Yearly commitments to private equity have proven remarkably resilient; in fact, also in 2009, new allocations have been higher than any time prior to 2005. Private Equity Buyout Capital Fundraising US$ Bn 259 228 228 140 106 75 75 53 53 47 28 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Preqin, Thomson Reuters, Oppenheimer; Silver Lake analysis In contrast, the volume and dollar value of deals has dropped dramatically between mid 2008 and 2010YTD, leading to a substantial “capital overhang”, estimated in nearly US$ 1,100bn. 3
  4. 4. PERSPECTIVE Dry powder vs deal volume US$ Bn 1200 2,837 3000 2,658 1,093 1,079 1,005 1000 2500 2,211 2,146 806 800 1,769 2000 600 564 1,339 1500 410 400 1000 200 500 0 0 2004 2005 2006 2007 2008 Mid 2009 Source: PSP Investments, Mergers Markets, Value Partners The combination of capital over-supply and unfavourable macroeconomic outlook in the Western markets creates in the short to medium term a challenging environment for both GPs and LPs. Immediate sources of concern for the LPs Whilst assessing the long term prospects of the “PE asset class”, LPs are confronted with three immediate concerns: • The threat of “agency problems”: the capital overhang at the macro level means that many private equity managers are struggling to deploy their current capital commitments in full before hitting the fundraising trail, potentially undermining GPs’ ability to protect the size of their future funds. In this context the risk of overcapitalised GPs closing bad deals increases substantially • The collapse of distributions: following an average of $15bn returned to LPs each quarter between 2004 and mid 2008, GPs’ ability to make distributions post-Lehman Brothers dropped by 80%, falling to $3bn per quarter. The potential closing of the IPO window means that the pain for the LPs may continue during 2010 • The maturing of debt in LBO deals: 2013 will see a peak in debt maturities for deals closed at the top of the market. This will pose a significant threat to equity valuations and ownership structures, since refinancing is increasingly made more difficult by the multiple lending demands on Banks; a plethora of other debtors, including governments, corporates, and consumers will be competing for credit. 4
  5. 5. PERSPECTIVE Upcoming debt maturities Amount (US$ Bn) Leveraged loans HY bonds 482.2 460.6 405.8 61.7 98.9 342.5 45.8 49.9 226.5 25.3 420.5 169.5 360.0 361.8 292.6 95.8 201.2 73.7 2010 2011 2012 2013 2014 2015 Source: Credit Suisse, Citigroup (Some) implications and predictions for the medium term • Looking at historical analysis, it is not unthinkable that sometime in this decade yearly allocations will experience a new all-time-high (US$500bn, according to David Roux of Silver Lake). However the capital overhang must be cleared first, which may easily take 3-5 more years • Future deals can no longer depend on cheap credit; the increase in competition amongst GPs means that the value generated though financial engineering will be transferred to the seller at the auction blocks • Large buyouts, above US$2bn in Enterprise Value, will be the most affected by the negative dynamics produced by capital over-supply, reduced leverage, and weak economic outlook • In this context, in the short to medium term the private equity industry will undergo a severe rationalisation of GPs, with some LPs predicting that 25-40% of investment houses will be unable to raise funds at the next round • Private equity managers will adjust their dealmaking talent pool, increasing weight on business operations experts, industry strategists, and regional insiders, and de-emphasising the role of financial engineers • Capital allocations will increasingly move East and South, towards New World markets. Where will the private equity money go for 2010-11? The following provides a sample of the investment themes likely to be pursued in 2010-11: • Overall, with mega-buyouts out of fashion, at least for the foreseeable future, deal activity will continue to focus on the mid market, sub $2bn in Enterprise Value, resulting in continued competitive pressures which will be reflected on sellers’ price expectations 5
  6. 6. PERSPECTIVE Types of company • Key opportunities include: - Industries and companies in need of balance sheet repair or business model transformation, such as Financial Services and Healthcare. This segment includes over-leveraged assets from peak-time LBO transactions - Sectors that combine cyclical recovery and transformation upside, such as Media & Communications - Spin-offs of assets rated as “non-strategic” by upcoming Boards’ reviews of corporate portfolios; this category includes also partnerships with state-owned agencies Geographies • Emerging Markets (China and India, but also South America) and Western companies benefiting from growth dynamics in Emerging Markets Asset classes • Besides Growth-capital, for the bold and the multi-skilled investors, Credit as an asset class (“private credit”) and Turnarounds (at the operational level) will also be on the agenda. The latter has, however, been a source of disappointment so far, with specialist funds like OakTree in the process of shrinking their distressed funds due to lack of suitable opportunities. Our conclusions The Private Equity industry has been very resilient over the past three decades, and the structure of its terms with the LP community creates a natural insulation from the extreme pressure that the Hedge Fund sector came under in late 2008. While in general the over-leveraged Western world can only benefit from the availability of excess capital, the challenge for “PE equity” is to return at least 6-8% bp above the public equity markets to justify its role on a risk- adjusted basis; seen from this angle, the road ahead appears bumpier than historical analysis of capital allocation trends may suggest. However, for those that will manage the transition by adapting their investment strategies and operating models, the second part of this decade is likely to deliver substantial rewards. 6
  7. 7. PERSPECTIVE About Value Partners Value Partners’ Private Equity enhancement initiatives For more information on the issues Practice works with many of the across innovation, international raised in this note please contact leading American and European expansion, and operational alfonso.marone@valuepartners.com private equity houses to develop effectiveness. It comprises two or one of our offices below. investment themes, scout & sister companies: Value Partners Find all the contacts details on www. due diligence attractive targets, Management Consulting and Value valuepartners.com and assist value enhancement Team IT Consulting & Solutions. initiatives within portfolio Milan companies. We have supported With 14 offices across Europe, Rome multi-billion dollar buyouts in Asia, South America and London the UK, Europe and Asia, as well MENA, Value Partners expertise Munich as growth capital deals between spans corporate strategy and Helsinki $50m and $200m. We differentiate financial business planning, cost Istanbul ourselves from other firms by transformation and organizational Dubai assembling deal teams that development, commercial São Paulo combine strong analytics and planning, technology decisions, Rio de Janeiro sector focus with the experience, and change management. Its 3,100 Buenos Aires judgement, and relationships of professionals, from 25 nations, Mumbai former CEOs and other Senior combine a methodological Beijing Industry Executives. approach and analytical framework Hong Kong with a hands-on attitude and Singapore Founded in 1993, Value Partners is practical industry experience a global management consulting developed in an executive capacity firm that works with multinational within their sectors of focus: corporations and high-potential media, telecoms and IT, luxury entrepreneurial businesses to goods, financial services, energy, identify and pursue value manufacturing and hi-tech. 7

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