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Navigating the New World of Private Equity

Navigating the New World of Private Equity

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Published by: manishkayal on Nov 02, 2008
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Navigating the New World of Private Equity—A conference summary
by William Mark, lead examiner, Supervision and Regulation, and head, Private Equity Merchant Banking Knowledge Center,and Steven VanBever, lead supervision analyst, Supervision and Regulation 
The Federal Reserve System’s Private Equity Merchant Banking Knowledge Center,formed at the Chicago Fed in 2000 shortly after the passage of the Gramm–Leach–BlileyAct, sponsors an annual conference on new industry developments. This article summarizesthe 2008 conference held on July 9–10.
Chicago Fed Letter
The current financialenvironment presents bothchallenges and opportunitiesfor private equity firms.
begin our 2008 conference, CarlTannenbaum, vice president, FederalReserve Bank of Chicago, offered somebroad remarks on the financial environ-ment and how it has affected privateequity.
The recent financial turmoil hasdramatically altered the landscape forprivate equity, particularly in the buyout sector.
The diminished outlook for cor-porate profitability has altered projectedreturns and payback periods for invest-ments in both the public and private do-mains. Leverage is less available and lessattractive as a financing source for trans-actions.
Financial institutions have re-acted to stress on their balance sheetsby tightening terms, raising prices, andreducing the availability of credit.Despite these challenges, Tannenbaumnoted that the faltering economy and theperception that investors may have over-reacted to it have broadened the poolof opportunities for private equity firms.Newer opportunities include investing infinancial institutions and clean technol-ogy and buying distressed loans and secu-rities.
In this way, private equity firmshave contributed to restoring marketsand economic activity to normality.
New landscape of private equity
 Avy Stein, of Willis Stein and Partners,surveyed the current state of the privateequity industry. Fundraising for bothbuyout and mezzanine funds is still solid.
 However, the amount being invested inprivate equity deals is considerably belowthe level of last year; this is due to theabsence of large deals. The current mar-ket is characterized by lower leverage,lower deal volume, different investment strategies, and greater difficulty in findingexit opportunities. According to Stein, lenders are workingthrough the huge backlog of leveragedloans they were unable to distribute inthe latter part of 2007. Solutions to thisbacklog are beginning to take shape,including sales of these loans to privateequity firms, write-offs, development of new funding vehicles, and the raisingof extensive amounts of new capital by the banking industry.Some private equity firms, Stein said, havealtered their investment strategies to re-flect the changed realities. Such firms arecurrently emphasizing the middle market,
 minority (noncontrolling) investments,public companies, emerging markets,leveraged loans and other debt instru-ments, and distressed securities.Looking ahead, Stein argued that privateequity is becoming a mature market, withincreasing segmentation and competition.Reputational concerns surrounding
The private equity industry is working to define its place inthe financial landscape, both domestically and internationally.
the image of private equity will persist.Finally, skilled operating management of portfolio companies will continue tobe the most important ingredient forsuccess in private equity.To succeed in the current private equity marketplace, it is important to recognizeand understand the trends driving to-morrow’s decisions, as well as the per-ceptions of peer investors, and to tailorstrategies accordingly. A panel led by Steven Pinsky, of J. H. Cohn LLP, ex-plored industry professionals’ percep-tions of the current environment. Thepanelists included Brian Gallagher, TwinBridge Capital Partners; Thomas Janes,Lincolnshire Management; JosephLinnen, The Jordan Company; andMartin Magida, Trenwith Group. Thepanel presented and discussed survey findings and industry statistics onmergers and acquisitions (M&A) andsector trends, valuations, and fundraising.For example, over the past year the in-dustry with the highest value of privateequity placement was the financial sector;energy, health care, and financials areexpected to be the three “hottest” indus-tries over the next year. In addition, theconsensus among panelists was that val-uations will continue to trend lower, andlower leverage ratios will continue tobe a factor for the next year.Ghia Griarte, Saints Capital, presentedtrends in the secondary market for pri- vate equity.
Over the past few years, thismarket has grown rapidly, with the typesof sellers and the industry sectors rep-resented becoming much more diverse.Currently, limited partners (LPs) andgeneral partners (GPs) are increasingly adopting the secondary market as a port-folio management tool. With traditionalexit markets largely closed by the recent financial turmoil and overall marketsset for a slowdown, secondary-market firms expect to benefit from the cyclein the coming years. However, contin-ued downward pressure on secondary-market pricing is expected.The limited partners’ perspectives onthe current landscape of private equity  were explored by a diverse panel. Thepanel was moderated by John Kim, Court Square Capital Partners, and featuredMichael Dutton, California PublicEmployees’ Retirement System; SaleenaGoel, AlpInvest Partners; John Morris,HarbourVest Partners; and Jen Wilson,Thrivent Financial. Panelists indicated that staff size and required expertise at LPs varied widely, depending on each LP’sstrategy. They generally agreed that com-pensation should be based on investment results. Regarding selection of GPs, LPsgenerally want to pick the top-quartile ortop-decile performers, but to do this they need to develop a thorough understand-ing of all the players based on indepen-dent research into specific transactions.Sovereign wealth funds are becoming in-creasingly prominent in the environment of private equity.
These funds are quitediverse in their age, size, expertise, andpotential impact. Finally, hedge fund andprivate equity fund strategies continue toconverge in a number of areas, includinginvesting in distressed securities.
Leveraged finance market
The supply and terms of leveraged fi-nance are critical determinants of thelevel of buyout activity. Meredith Coffey,Thomson Reuters, surveyed recent trendsand prospects in this market. In the past few years, money has poured into thisasset class, causing it to grow rapidly andU.S. merger financing, especially inbuyouts, to hit record levels.In the third quarter of 2007, the supply of leveraged loans peaked, just as demand was evaporating as part of the spreadingfinancial turmoil. The resulting sharpdrop in loan prices was followed by an-other one in early 2008, as accountingrules requiring write-downs to currently depressed market values triggered a vi-cious cycle of loan sales and further pricedeclines. Consequently, loan prices inrecent months have shown an unprece-dented volatility. In addition, the volumeof U.S. M&A lending has fallen sharply, with leveraged buyouts (LBOs) hit hard-est. Currently, LBO loans are smaller, yields on these loans have soared (reflect-ing greater risk aversion), and leveragemultiples have contracted slightly.In the second quarter of this year, theloan market rallied sharply. However,secondary-market prices of LBO loans,“covenant-lite” loans, and second-lienloans are still depressed.
Currently,lenders are more worried about thestate of the economy and the prospect of rising defaults than about supply–demand imbalances and market disrup-tions. In some ways, the buyout market resembles the conditions last seen inthe early to mid-1990s.
New investment strategies
In the current environment, traditionalprivate equity funds are adjusting theirstrategies to become more opportunistic,investing in combinations of private equity stages (e.g., start-ups as well as more-established companies) or even hedgefunds and nonequity instruments. Evenfunds that have stayed with private port-folio companies are venturing into newindustry sectors. A panel of GP and LPinvestors explored some of these “hybrid”fund strategies. The panel was moder-ated by Sajan Thomas, of Thomas CapitalGroup, and it featured Edward Hortick, VCFA Group; William Ruh, CastleCreek Capital; and Elizabeth Tulach,The Boeing Company. With regard to new sectors, the U.S. finan-cial industry will continue to need con-siderable infusions of new capital. Thisincludes small- and mid-sized banks, which are easier for investors to evaluatethan the more-opaque large banks. Pan-elists also reported considerable interest in infrastructure and natural resourcesinvestments. The longer-term nature of these projects can be suitable for certaininvestors with long-term liabilities (e.g.,pension funds). Still, whenever strategicshifts (such as the more recent interest in clean technology) are dictated by ad- verse market conditions, there is a riskthat fund managers may venture too farfrom their proven strengths.
Charles L. Evans,
; Daniel G. Sullivan,
Senior Vice President and Director of Research 
Vice President,
 financial studies 
 Jonas Fisher,
 Economic Advisor and Team Leader 
macroeconomic  policy research 
Richard Porter,
Vice President 
payment studies 
Daniel Aaronson
, Vice President 
microeconomic  policy research 
 William Testa,
Vice President, regional  programs, and Economics Editor 
Helen O’D. Koshy,
Kathryn Moran, and Han Y. Choi,
; RitaMolloy and Julia Baker,
Production Editors.
Chicago Fed Letter 
is published monthly by theResearch Department of the Federal ReserveBank of Chicago. The views expressed are theauthors’ and are not necessarily those of theFederal Reserve Bank of Chicago or the FederalReserve System.© 2008 Federal Reserve Bank of Chicago
Chicago Fed Letter 
articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gainand provided the source is appropriately credited.Prior written permission must be obtained forany other reproduction, distribution, republica-tion, or creation of derivative works of 
Chicago Fed Letter 
articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 oremail Helen.Koshy@chi.frb.org.
Chicago Fed Letter 
and other Bank publications are availableon the Bank’s website at www.chicagofed.org.
ISSN 0895-0164
In the first luncheon keynote address, Jacques Nasser, One Equity Partners(and former president and CEO of theFord Motor Company), explored privateequity investment strategies that target the auto industry. This industry is beingadversely affected by many trends in thecurrent economy, including high energy and commodity prices, falling consumerconfidence, and tighter credit. However,each of the three segments of the autoindustry (manufacturers, suppliers, anddealers) has significant structural andoperational weaknesses that could pres-ent opportunities for private equity firms.Nasser also proposed a broader andlonger-term strategy—with investmentsin a range of new technologies that wouldbenefit energy security and environmen-tal protection while generating profitsfor both the automotive sector and theprivate equity industry at large.
Globalization continues
Private equity firms continue to explorenew opportunities in Europe. SusanBoedy, Thunderbird School of GlobalManagement, moderated a panel on thesubject, and it included Paul Carbone,Baird Private Equity; Kurt Geiger, formerly of the European Bank for Reconstructionand Development; Mark O’Hare,Private Equity Intelligence; and HelgePetermann, Capital Dynamics. Europeanfunds have delivered strong returns formany years. Private equity investment inEurope is roughly similar to the amount invested in the U.S., but the Europeanmarket is much more complex and dif-ferentiated by region and country. Forinstance, Eastern Europe continues todemonstrate strong demand for privateequity, particularly for the growth andexpansion capital variety, yet many re-gions in Europe remain underpenetratedby private equity. In 2007, Europeanfundraising was dominated by buyout,real estate, infrastructure, and mezzaninefunds. The regulatory environment variesconsiderably by country, with the UK generally favoring industry self-regulationand countries on the continent favoringmore direct government regulation. Venture capital is relatively underdevel-oped in Europe. Panelists attributedthis to the general lack of geographicalclusters that combine human and finan-cial capital, technology, entrepreneur-ship, and academia (such as Silicon Valley in the U.S.). European returnshave yet to be significantly affected by the credit crunch. Regarding the future,the large number of family-ownedEuropean firms with succession issuespresents great opportunities, particularly for buyouts. However, European coun-tries often have structural impedimentsto private equity strategies, such as restric-tive labor laws. Panelists agreed on theneed to find experienced local partnersin order to successfully navigate thecomplexities of European markets. Another panel focused on the rapidly emerging market of China. This panel wasmoderated by John Crocker, Citigroup,and featured Christopher Lane Davis,of McCarter and English; Gary Lawrence,Excelsior Capital Asia; Eugene Pohren,PCG International; and Andrew Rice,The Jordan Company. According toCrocker, private equity investments inChina in 2007 totaled $12.8 billion,roughly matching 2006 levels; the num-ber of deals increased in 2007 by 37%, to177. China’s legal and regulatory environ-ment is developing to foster increasedprivate equity investment in the years tocome. However, significant barriers ex-ist that discourage traditional foreigninvestment. These hindrances includecultural issues, banking sector problems,discrepancies in the legal system, andgovernment restrictions. Lawrence de-scribed how government policy is shiftingtoward greater energy efficiency and en- vironmental protection, more investmento reduce income disparities, and devel-opment of the financial sector. According to Pohren, in 2007 early stage/growth capital strategies represented 38%of private equity investment in China, with buyouts representing only 13%. Riceexplained how Chinese companies havebeen looking to foreign partners not only for capital but also for guidance regardingcontrols and procedures to help them be-come world-class global suppliers. Finally,Davis profiled the relatively small venturecapital segment of the market that is cre-ated by government entities, which differsmarkedly from venture capital in theU.S. and other developed economies.
Management of conflicts of interestand spinoffs
Private equity investing coupled with otherbusiness activities, especially within bank-ing organizations, inherently generatesmany potential conflicts of interest. Man-aging these conflicts is an essential ele-ment in reducing legal and reputationalrisks. Kenneth Wilcox, SVB FinancialGroup, discussed how his firm (a bankholding company headquartered inSilicon Valley) addresses these issues. Wilcox detailed a wide range of potentialconflicts of interests that can arise in hisorganization. For example, the pursuit of LP interests could be contrary to cor-porate shareholder interest (and vice versa), or the pursuit of personal interestsby employees could hurt shareholdersor LPs. Key defenses against conflictsare clearly defined responsibilities andseparation of duties, clear prohibitions,clear incentives, an appropriate “toneat the top,” a strong culture of ethics,and severe and immediate consequencesfor policy violations.For strategic reasons or as a result of merg-er consolidations, management teamsresponsible for private equity activitiesare often “spun off” from banks and otherfinancial institutions. A panel, moderated

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