28 July 2008
In looking at key factors in the global private equity market over the past 18 months, there is a number of issues shaping the future of the industry, including the effect of the credit crunch, the role of sovereign
wealth funds (SWFs) and the increasing importance of emerging markets.
The credit crunch has resulted in rising costs of leverage and, in certain cases, the absence of availability of debt finance. This means private equity can no longer so easily use leverage to enhance returns. Instead it has been forced to go back to its roots and focus on extracting value from portfolio companies, which is the traditional model.
All this activity is taking place against the backdrop of possible increased competition from SWFs, which are at an all-time high in terms of available capital. SWFs are no longer restricting themselves to investing in their home economies – including Kuwait, Abu Dhabi and Singapore – but are instead increasingly looking outward as they seek to invest their petrodollar cash mountains. They continue to diversify their investment strategies by investing in emerging markets such as China and India and leveraging the fall in asset values partly caused by the weak US dollar.
It is interesting to note that SWFs are themselves evolving in the marketplace as well. First, they have moved from being mere investors in private equity funds to taking stakes in private equity firms. This was shown in China Investment Corporation’s investment into JC Flowers. Second, there is evidence that some SWFs are morphing into something close to private equity firms. They are recruiting similar types of financial professionals to those employed in private equity firms. They already have professional management and are highly diversified in their investments. All of these factors make them formidable competitors.
However, on the flipside, they face barriers to entry caused by fear-led protectionism, especially when seeking to invest into strategic industries. Examples of failed transactions include the Dubai Ports deal and the Air New Zealand deal. Further, the drive by Western markets to bring in tighter global regulatory standards and transparency requirements will pose challenges for SWFs.
As for private equity firms, they are in a state of change. They are moving away from deals in mature markets to focus on emerging markets such as Brazil, Russia, India, China, the Middle East, Africa and Asia. There is a number of driving factors behind this shift. Emerging markets have forecast high growth rates of around 8-10 per cent, compared with forecast growth in the US of 1-2 per cent. Private equity is looking to invest in these fast-growing economies in order to maximise the opportunities for high returns, which were previously afforded to them by cheap leveraging, but now denied them because of changes in the market.
It is noteworthy that some of the top 50 private equity houses, including Carlyle Group and Cerberus, have opened offices in Dubai. This is not just to facilitate fundraising in the region, but also to source deals. Emerging markets are less affected by the credit crisis and it is still possible to source relatively cheap debt finance in these markets.
Private equity firms are also looking for alternative sources of finance, such as pension funds, SWFs, hedge funds and regional banks. By diversifying their strategies and launching their own distressed debt funds, hedge funds and other alternative investment products, they are evolving from traditional private equity houses into alternative asset managers. There is a strong focus on extracting value from existing portfolio companies and there is evidence that private equity houses are staffing up with financial professionals in order to deliver results in this area.
In the Cayman Islands, activity remains high. It is interesting to note that fund-raising for the first half of 2008 is a mere 3 per cent short of the $137.2bn (£68.48bn) raised during the first half of 2007. It is difficult to know with certainty what proportion of this is attributable to Cayman. What is clear is that there is still plenty of activity in the market despite the credit crisis, while private equity seems to be a growing practice area for at least some of the offshore firms in Cayman.
The changes and trends in the market show up clearly from some noteworthy activity in 2008. For example, Carlyle Group recently closed a $1.4bn (£698.79m) fund to buy distressed debt. This shows a move to take advantage of bargain basement prices caused by the credit crunch, as banks attempt to dispose of their debt to restore balance sheets. This is one sector that has been attracting private equity investment recently. Similarly, there have been rumours that players such as Carlyle, TPG, Apollo, Blackstone and others are working on deals for distressed debt, most notably working with Citigroup to snap up $12bn (£5.99bn)-worth of Citigroup’s leveraged loans.
There are two main points to draw from this. First, it shows the new world in which private equity is operating and what new opportunities are currently out there. Second, it shows that, despite the credit crunch, private equity still has significant capital to work with. Carlyle also recently closed the largest equity investment ever made in France by a single private equity firm – its e1.1bn (£870.62m) equity investment in telecommunications companies Numericable and Completel.
Telecoms and infrastructure are two of the areas that are attracting private equity. As for failures, M&A is the hardest-hit sector. Some $11bn (£5.49bn) worth of deals were cancelled in one month of 2008 alone. The $9bn (£4.49bn) takeover of Australian explosives maker Orica by a consortium of Blackstone and others was a recent casualty. The main cause has been the lack of available credit. Financial sector deals have also been hit hard, with Kaupthing cancelling its acquisition of Dutch investment bank NIBC.
There are many moving parts to what is happening in the private equity industry at present. Private equity is, on the one hand, going back to its roots in focusing on portfolio companies, but at the same time evolving by diversifying, moving into emerging markets in a big way and seeking new sources of finance.
The credit crisis has given birth to a new age in private equity.There is much to worry about in these turbulent times. However, the future also holds many opportunities for those private equity firms that adapt.
Richard Addlestone is a partner in the private equity group at Walkers