The document discusses the outlook for private equity investors based on insights from the SuperReturns 2010 conference. It notes that (1) future returns will rely less on financial engineering and more on operational improvements, sector expertise, and growing portfolio company EBITDA. It also finds that (2) the large amount of uninvested capital and challenging macroeconomic conditions in Western markets will make it difficult for private equity firms to achieve past returns in the short to medium term. However, (3) private equity has historically rebounded after downturns, and future high returns may be possible later in the decade if firms adapt their strategies and markets in emerging countries are tapped.

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
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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.
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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.
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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 $3bn per quarter.
The potential closing of the IPO window means that the pain for the LPs may continue during 2010
• The maturing of debt in LBO deals: 2013 will see a peak in debt maturities for deals closed at the top of the
market. This will pose a significant threat to equity valuations and ownership structures, since refinancing
is increasingly made more difficult by the multiple lending demands on Banks; a plethora of other debtors,
including governments, corporates, and consumers will be competing for credit.
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5. PERSPECTIVE
Upcoming debt maturities
Amount (US$ 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
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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.
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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
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Founded in 1993, Value Partners is practical industry experience
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firm that works with multinational within their sectors of focus:
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