Bouncing back
Written by Matt Ritchie
January/February 2012
Activity in the private equity space dropped off sharply in the second half of last year. Matt Ritchie looks at the current landscape and the road ahead
The fiscal woes of a number of European nations cast a long shadow over the financial sector, and private equity has not been immune from the macro pressures that hit other asset classes in 2011.
The fiscal crises that rocked Europe over the last year resulted in banks reducing lending activity and looking to shrink their balance sheets. High-yield bond issuances also dried up toward the end of the year. Low availability of debt and shaky confidence saw a number of private equity deals get snagged.
A report on the private equity market from intelligence provider Preqin shows that the aggregate value of deals completed in Europe in the fourth quarter was USD $15.6 billion, a 37 per cent fall on the value recorded in the previous quarter. The numbers look worse when compared to activity in the second quarter, when the value of deals reached USD $33 billion.
Despite the poor finish, last year was still much busier than 2010 for the asset class. Preqin’s report shows overall deal value in Europe of USD $95.4 billion, up 34 per cent from 2010.
A lot has also been made of regulatory developments regarding alternative investments, and the potential for new legislation to act as a brake on pension funds investing in private equity. The Alternative Investment Fund Managers Directive (AIFMD), voted into law in November 2010, was a particular topic of debate.
However, although a lot of the commentary around the directive during the drafting process was uncomplimentary, European Private Equity and Venture Capital Association (EVCA) external affairs adviser James Burnham says that the end product has had some positive effects for the industry.
“Ultimately the industry and investors did such a good job of educating policy makers that the regulation now, while it may cost you a little bit more, is workable and it gives investors the knowledge that PE is grown up - it’s regulated, it’s not a cottage industry.”
However, there is still work to be done on the implementation. As a new piece of legislation, the AIFMD borrowed some elements from existing directives, which may not have been a perfect fit with the objectives of the new legislation.
Burnham raises the example of the definition of a ‘professional investor’, which he says the AIFMD borrows from MiFID regulations. The definition is based on frequency of investments, which does not fit with the targeted, long-term nature of private equity. The industry is now trying to persuade regulators to resolve this issue on a technical level, and Burnham says pension funds have a role to play.
“Regulation that affects the asset classes in which pension funds invest also has a feedback onto them, so being involved in negotiations and the lobbying process can be very helpful in terms of protecting investment opportunities.”
Most elements of occupational pension provision could be touched by the ongoing review of the IORP directive, and funds’ ability to invest in private equity is no exception.
Should new solvency capital requirements for pensions follow too closely in line with the Solvency II regime for insurance providers, this could make it a less appealing option for funds due to the risk weighting given to the asset class under Solvency II. This could combine with a general move from any equity investments into fixed income to prevent the solvency capital ratio moving around with market movements.
Opportunities
Whilst the environment remains challenging, some feel that the nature of private equity is such that if obstacles can be overcome and deals put in place then now could be a good time to put capital to work.
Aberdeen Asset Management’s head of alternative assets Alex Barr says the long-term nature of private equity investment means it “looks through” economic difficulties and investors can invest now to take advantage of improved conditions in future.
Potential targets for private equity investment can emerge in difficult times. The changes necessary to get businesses back on track can be made in a depressed environment with the benefits accruing once markets pick back up.
“It can often take two to three years for the fruits of operational change to become evident, so by the time that we are getting to the end of a recession there’s actually a huge amount of value being created within a private equity business,” Barr says.
“The textbook theoretical case is that you come out of that period a fully re-invigorated corporate that catches that wave of accelerating or improving GDP, so there’s a double whammy there.”
The EVCA’s Burnham adds that as private equity investments are held for a longer period, they tend to “iron out” market fluctuations over time.
“Over the last 10 years, private equity and fixed income are the only investment strategies to have generated positive returns for public pension funds across one, three, five and 10 year periods. All other asset classes have fallen into the red at least at one point during one of those periods.”
For those looking to gain or increase exposure to private equity, diversification across geographies and investment periods is an important consideration.
Capital Dynamics managing director and head of investment management Europe John Gripton says it is vital to avoid confusing where a business is headquartered with where its revenue streams come from.
Although a company may be based in a country with a grim GDP outlook, this means little if it is deriving its earnings from a healthy market.
“That’s very important from our perspective, that the companies are much more global and therefore their revenues may be coming from growth areas, although they’re domiciled in an area where we don’t anticipate much growth,” Gripton says.
SL Capital has around 70 per cent of its capital invested in German speaking countries, the Nordics, and the UK, and chief investment officer Peter McKellar expects these areas to remain the focus throughout 2012. In terms of sectors, the fund of funds provider will continue to favour defensive and industrials, whilst limiting exposure to consumer and leisure.
“There are definitely opportunities out there, it’s just that people need to have the confidence in the funding structures and the earnings positions of the businesses before they actually start to transact.”
Greater opportunities also exist in the secondary markets. Barr says there has been a marked increase in pass-the-parcel deals, where one private equity house sells a primary investment to another. These deals can both help funds with undrawn capital put their money to work, and ensure investment businesses are owned by the most appropriate investors.
“Quite often there’s a compelling logic behind these deals,” Barr says. “The second private equity buyer might have a completely different skillset to the first buyer, and be able to effect a level of operational change in a way that the first buyer couldn’t.”
The EVCA has also noted an increase in activity in the secondary space for limited partner investments. In these cases an investor buys out all or part of another’s stake in a private equity fund. Although something of an opaque market, Burnham says these transactions do address some of the liquidity concerns traditionally associated with private equity.
While the level of activity in the private equity space will be largely determined by the health of the eurozone, McKellar says there is cause for optimism.
“I think you will see a quiet first half of the year but I would expect there to be an uptick in activity and greater visibility as we move into the second half. If you look at it from a broader macro perspective there’re some very positive numbers coming from the US, there are also some good numbers coming out of specific areas within the broader eurozone,” he says.
