James W. Angelica
Senior Research Analyst
“With purchase price multiples declining and significant amounts of dry powder for investment, there are private equity sponsors well positioned to take advantage of market dislocations.”
PRIVATE EQUITY: Buyout
Many private equity sponsors are feeling the impact of the “denominator effect” as well as overall market uncertainty in the form of tougher fundraising cycles. As a result, they have postponed the final closing dates of their current funds. Preliminary September 30, 2008 data show commitments to global buyout funds declined for the third straight quarter. In the third quarter, commitments fell by 8%, or $5 billion compared to the prior quarter, and over 20%, or $14 billion compared to the first quarter.1
This unprecedented economic environment is having a dramatic impact on the global buyout sector. The frozen credit markets have essentially closed down large/mega leveraged buyout (LBO) activity. As the table titled below details, global LBO deals fell significantly off their 2007 all-time highs. The volume of deals between $1-10 billion dropped by over 70%, while the era of mega deals, those over $10 billion, officially ended for this cycle. When comparing the number of deals announced during the first half of 2008 with the same timeframe in 2007, the difference is significant. In the first half of 2008, there were only 9 deals announced worth more than $1 billion (none were greater than $10 billion). In the same timeframe in 2007, there were 46 deals announced, including 4 deals that were worth more than $10 billion.2
The upper end of the middle market was also impacted by the credit crisis, as the availability of capital continued to become more scarce. The uncertainty of the current economic environment, coupled with the lack of liquidity among traditional lenders to private equity sponsors in the upper middle market, led to a 51.6% decrease in the volume of deals between $500 million-1 billion. The number of deals also fell considerably from 89 in the first half of 2007 to 56 in the first half of 2008.3 The small and lower middle markets, however, faired far better during these trying economic times due to the lower levels of leverage required to finance deals.
As a result of the current credit crises, investor uncertainty, and overall economic weakness, private equity deals are expected to be smaller and require increased equity stakes by sponsors. There is evidence that this has already begun to take place. As discussed earlier, the number of announced deals at the large/mega end declined significantly during the first half of 2008. At the same time, the chart below illustrates that during the first half of 2008 the percentage of equity contributed to deals by sponsors increased from an average of 31% in 2007 to 44% in the first half of 2008. Smaller deals sizes and increased equity stakes by private equity sponsors will have an impact on purchase price multiples. There are already indications that purchase price multiples are starting to decline, and they are expected to continue.
The current economic environment will have a greater impact on buyout funds with 2004, 2005 and 2006 vintage years as opposed to funds with late 2007 and 2008 vintage years. From 2004-2006 sponsors paid significant purchase price multiples and are now faced with an unfavorable exit environment. Funds raised in late 2007 and early 2008, on the other hand, have called little if any capital and in most cases made few to no investments. In the short-term, buyout sponsors are expecting values for their portfolio companies will get worse before they get better. Many investors believe the favorable credit markets of 2006-2007, which introduced covenant-lite loans and Payment-In-Kind (PIK) toggles, simply postponed the inevitable defaults among buyout backed companies. These defaults are expected to rise in 2009. Coupled with the implementation of FAS 157, limited partners could see meaningful unrealized losses due to write-downs of underlying portfolio companies in the coming quarterly financials.
Although things look rather bleak in the short-term for many existing private equity investments, the current capital environment poses great opportunities for skilled, experienced managers to buy new assets. The market environment is clearly shifting from a seller’s market to a buyer’s market in terms of valuations. With purchase price multiples declining and significant amounts of dry powder for investment, there are private equity sponsors well positioned to take advantage of market dislocations. Now is not the time to stop making commitments to the buyout sector. Below is a chart that we included in our last edition of the Private Capital Research Review. We included the chart again to emphasize that during these times of market chaos and uncertainty, significant opportunities are created, particularly in the small and lower middle market buyout segments that pursue growth strategies. As the chart below demonstrates, the three years following a recessionary period were strong vintage years in the buyout markets. The next 2-3 years may present significant opportunities for limited partners.
1 Information available from http://www.venturexpert.com. VentureXpert. Accessed on 14 October 2008.
2-3 “Insight: Industry Data.” Dow Jones Private Equity Analyst. (August 2008).
