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It may seem hard to be sanguine aboutthe sector’s long-term prospects. With returnsunder pressure, private-equity rmswill struggle to perorm.
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The megabuyouts(deals valued at more than €5 billion)that absorbed so much o the sector’s capitalsince 2004 are nowhere to be ound. Somelimited partners—in particular, sovereign-wealth unds—have shown a willingness tobypass private-equity rms and strike outon their own. With an estimated $470 billionin committed but unused unds, the sectoraces an enormous challenge just ndingways to invest. Finally, its portolio companies,with their high debt levels, may becomenancially distressed and deault in the evento only small downturns in sales and
EBITDA
.
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Recent bankruptcies o severalprivate equity–backed companies hintat how dark the uture may be.Yet the prognosis isn’t entirely bleak. Inour experience, the sector’s strengths havecome not rom its use o leverage butrom its ability to marshal resources, bothhuman and nancial; its strong incentivesto adapt quickly; and its active ownership.Opportunities do exist: megadeals mayhave vanished, but not medium-sized or all-equity deals. Moreover, private-equity rmsare well poised to stand in as a new class o shareholder in the overturned public-equity market, in developing economies, andin nancial institutions. Despite the currentdiculties, it bears remembering that the bestprivate-equity rms have persistentlyoutperormed both their private-equitycounterparts and the public-equity markets,in good times and bad, over the past twodecades. The winners will be rms with thewits to adapt to a much harsher environment.Is there lie ater leverage or private equity? The global nancial system is struggling towork its way out o disaster: banks are fat on their backs, equity markets have plummeted,and a business culture built on leveraged portolios has come unhinged. The uture o private equity is one o the more intriguing questions or corporate nance and corporategovernance alike.
 The future of 
private equity
 
These funds face a credit-constrained world; they must adapt to thrive.Conor Kehoe andRobert N. Palter
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Even the venerable 2 percent managementee and 20 percent carry structure may bevulnerable as limited partners respond to thecurrent crisis and the weakening peror-mance o buyout unds.
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Earnings beore interest, taxes, depreciation,and amortization.
 
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McKinsey on Finance
 
Spring 2009
3 
See Alexander Groh and Oliver Gottschlag,“The risk-adjusted perormance o 
US
buyouts,”Groupe
HEC
,
Les Cahiers de Recherche
,Number 834, January 2006; and Viral V. Acharya,Moritz Hahn, and Conor Kehoe, “Corporategovernance and value creation: Evidence romprivate equity,” working paper, January 2009.
4 
See Gregor Andrade and Steven N, Kaplan,“How costly is inancial (not economic) distress?Evidence rom highly leveraged transactionsthat became distressed,”
 Journal of Finance,
1998, Volume 53, Number 5, pp. 1443–93.
Managing the downturn
Right now, the rst priority or the vastmajority o private-equity rms is mitigatingthe recession’s impact on portoliocompanies and, to some extent, on cash-strapped limited partners.Yet contrary to common perceptions, thechallenges portolio companies ace do notresult rom levered risky investments.The average private equity–owned company,despite its higher initial leverage, is onlyslightly riskier than an average public-marketcompany. Indeed, although the typicalleveraged buyout starts with more than twicethe leverage o its public-market counter-part, its leverage is oten lower on exit.
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Inaddition, research shows that private-equity rms tend to buy steady companieswhose volatility, beore the extra leverage,is about two-thirds that o companies listedon public markets. Portolios tend to beconcentrated in companies and sectors lesssusceptible to the eects o booms andbusts—a critical condition or supporting thehigher initial leverage the private-equitymodel has typically deployed. Not surprising,private-equity portolios, though spreadacross most industries, are underrepresentedin the battered construction, automobile,and nancial-services sectors. We expect therevenues and beore-interest earningso private equity–owned companies will allless than those o companies listed inpublic markets.Moreover, private-equity rms also enterthis downturn with much strongeroperational capabilities—either in house orthrough external support networks—thanthey had in previous downturns. In theshort term, all the committed but unusedcapital could be turned to advantagei it were deployed in overstretched portoliocompanies. And the lessons o the 1990downturn, when the debt levels o privateequity–owned companies were muchhigher, suggest that even i such companiesgo into bankruptcy, they are morevaluable than they would have been withoutprivate-equity ownership,
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despite thecostly process o managing the reorganiza-tion. That’s good news or employeesand customers, i not equity investors.There will o course be ailures, even inthe short term, and each private-equity rmshould move aggressively to reduce thethreats in its portolio’s cash, cost, and riskposition and to mitigate their eects.What’s more, since exits are now very dicult,it will be necessary to learn how to manageportolio companies beyond the normalthree- to our-year cycle, without lettingreturns slip. Some private-equity rmsare already addressing this problem bysimulating an internal sale when the initialvalue creation plan runs its three-yearcourse—in other words, orcing themselvesto take an outsider’s perspective to identiymissed opportunities. These rms review suchcompanies and their industries andappoint new internal teams, i necessary,to develop another value creation plan,to change management, or to conduct a due-diligence process as i the rm were buyingthe business anew.Finally, many private-equity rms thatexpanded their stas and opened new ocesduring the recent investment surge mustnow make do with less. Even the topperormers can expect smaller unds andlower ee income in the next ew years.
Contrary to common perceptions, the challenges portfolio companies face do not result from levered risky investments 
 
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Private equity–owned companies aren’t alwaysmarked to market, yet the investors’ publicsecurities are—so the value o the latter appearsto have declined much more.
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See Viral Acharya, Conor Kehoe, and MichaelReyner, “The voice o experience: Public versusprivate equity,” in this issue.
Managing investors
Private-equity rms will need to managetheir relationships with investors careully.Limited partners are not protected rom thegeneral downturn. Some are having dicultymeeting their commitments to provideunds—in particular, because reduction in thevalue o quoted equities has mechanicallyincreased the percentage o assets allocated toprivate equity.
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Further, the diculty o exiting rom portolio companies means thatmoney rom private-equity unds is fowingback much more slowly than might havebeen expected. Some supposedly liquid assets,which limited partners could otherwisehave sold to nance private-equity cash calls,aren’t nearly as liquid as had been assumed.Except in extreme circumstances, limitedpartners probably won’t deault—they’d risklosing the cash they have already subscribedand access to top unds—but they maypressure private-equity rms to reduce ees,commitments, or both i investmentopportunities don’t open up soon. In thenear uture, limited partners may alsodemand improved terms beore subscribingto new unds and invest lower amounts inthem. Private-equity rms should act strate-gically in these situations by giving somelimited partners more fexible terms i theyexperience short-term diculties. Thisapproach could play an important role inmaintaining relationships with attractivelong-term unding sources.A relatively new class o private-equityinvestor—sovereign-wealth unds—needsparticularly careul nurturing. These long-term investors constitute a very large groupin the aggregate, with $3 trillion in totalassets in 2007 and a projected $8 trillion inthe next decade. By the end o 2007,they had committed about $300 billion to theprivate-equity sector, but they can bypass itentirely i they wish by investing their cashdirectly. Their recent direct investmentsalready include the stakes that the govern-ment o Singapore and the KuwaitiInvestment Authority took in Western bankslast year, as well as the holdings o direct-investment arms such as Mubadala Develop-ment (Abu Dhabi) and Temasek Holdings(Singapore). It can be tricky or sovereign-wealth unds to be assertive and activeowners, though, especially in Western com-panies. Investing through private-equity rmsraises ewer political hackles, but the rmswill need to sharpen their value proposition.By and large, the sector is well preparedor these challenges. Active ownership is itsbiggest competitive advantage overcompanies in the quoted market: the bestprivate-equity rms are more eectivebecause o their stronger strategic leadershipand perormance oversight, as well as theirability to manage key stakeholders.
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Firmsmust continue to hone these skills andto ensure that they are applied consistently.Even the better rms have a great deal o opportunity or improvement—particularlyin attracting partners with the right operatingskills, getting a better balance betweennanciers and active owners, adding peoplewho have experience in downturns, andreviewing the current portolio with the rigortraditionally devoted to new investments.
Finding new ways to invest
In the long term, the math o deploying theindustry’s $470 billion in committed butuninvested capital looks challenging. Fortypercent (about $240 billion) o the equitycapital that private-equity rms investedrom 2004 to 2007 nanced 55 megadeals(2 percent o all private-equity deals).It could take a long time or megadeals toreemerge i recently completed onesperorm less well than quoted companies
The future of private equity
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