The recent financial turmoil accompanied by generally unstable asset valuations has created both a lack of appetite for pursuing exit opportunities and a lack of available exit options.
Industry reports show that the number of exits have decreased significantly since mid-2007, and although there are some signs that activity levels may be picking up, the number of exits are not expected to return to 2006-07 levels until at least 2010-11.
Despite this, the downturn is maintaining – and possibly even increasing – the pressure on private equity institutions to return capital to their limited partners.
So what options are available for exit, where is the current exit activity and how has the global downturn affected the viability of each option?
Industry data shows that trade sales provided the greatest number of exits in 2008. This option has become increasingly attractive during the downturn, with some private equity institutions lacking the funds for secondary buyouts and equity capital markets being less receptive to IPO activity.
A trade buyer or strategic investor sitting on cash without high levels of debt is ideally placed to take advantage of the private equity funds’ need to exit their investments. The merit to a private equity institution is greater deal execution certainty and valuations that might be enhanced by the commercial synergies that the trade buyer enjoys as a result of the acquisition.
Secondary buyouts provided the second most popular exit route for private equity investments in 2008. They have grown both in prominence and value as a byproduct of the wider credit crunch.
The benefit for the acquirer is that it buys in the knowledge that the investment has been in private equity ownership with the financial, legal and commercial disciplines that are typically imposed on the incumbent management. The sale process is also likely to be less protracted, with both the buyer and seller understanding the commercial and legal issues of a private equity seller. The opportunity also exists to create more flexible deal structures.
A recent Ernst & Young study of the largest European companies owned by private equity investors concluded that no IPO exits took place in 2008. Since the start of 2009 there have been just two European IPOs of e50m (£45.26m) or more by companies backed by private equity institutions.
The reason? Private equity institutions have been either unable or unwilling to sell their portfolio companies at heavily discounted valuations and the credit crunch has put paid to potential investors in the public equity markets. Add to this the fact that private equity institutions are not guaranteed a clean-break exit on flotation and may see a percentage of their shares locked up, and an IPO’s appeal is reduced.
However, investor confidence appears to be returning and the early indications are that an IPO as an exit route will increase in 2010.
Compounded by the global downturn, there may be instances where the exit value of an investment portfolio is unlikely to generate carried interest for the fund managers (carried interest is the sharing of capital gains 20-80 with the limited partners after the partners have been repaid the commitments they made to the private equity fund and received a preferred return).
As a result, an investment manager may be more focused on portfolio management than securing exits in the hope that, by riding out the recession, higher exit valuations may be available and carried interest may become a reality. Added to this, the investment management fee is based on assets under management and the pressure to return capital to limited partners is outweighed by the need for income and the preservation of the investment portfolio’s value. Even where carried interest is still a possibility, with exits proving difficult to execute through traditional routes and portfolio valuations coming under significant downward pressure, many private equity institutions are still reluctant to focus on exits .
This situation sits uneasily with the private equity funding model, whereby limited partners rely on exits either to fund future capital commitments in the private equity fund in which they have invested or to invest in other private equity funds. This change, if it continues, could create not only an immediate funding gap for existing private equity funds, but also in future years for the private equity industry generally, where a fundraising could be jeopardised.
Accordingly, for the time being private equity exit activity is extremely low.
The rate of exits will need to increase significantly in 2010 and 2011, not least because the pressure from limited partners will be impossible for many fund managers to resist.
David Baylis is a partner and international head of private equity and Ian Moore a partner at Norton Rose