Now it has been forced back to basics. Find good companies with potential and invest at the right price. The only difference between public and private equity investment is that you need to be more careful with the latter, because once committed it is harder to get out.
The environment for investment in private equity is extremely attractive despite the constant stream of bad publicity. The soap opera formerly known as EMI, is just the latest in a long line of PR disasters.
Of course the private equity industry needed to downsize as the pre-credit crunch excesses were unwound and there are bound to be more hubristic deals hitting the buffers. However, investors should not be distracted. Along with a contrarian frame of mind.
“One of the keys to successful investment is knowing when to stop agonising about the problems of the past and move on. Now is the time to consign the excesses of the pre credit crunch world to the archives.”
It was clear by mid-2009 that global economic growth was recovering after the crisis of confidence in 2008, but the banks were still extremely weak and highly dependent on government support. At that time it was likely those able to look to the future would have seen the best opportunities in private equity for a generation with the possibility of returns similar to those achieved in the years after the recession of the early 1990s.
In addition it was likely, because of the extreme nature of the downturn in 2008 and the weakness of the banking sector, that the window of opportunity present in 2009 would stay open for several years.
Moving forward to 2011, the global economy is forecast to grow at a rate +4.4% this year. However, the banking industry is still in the recovery ward and under close observation in case of a relapse.
Bank lending is critical in making the case for investment in private equity, but not
for the reason that might first spring to mind – a return to excessive leverage.
So far the banks have only used the insolvency process for their worst cases. Instead, loans have been re-priced and extended in the hope that better economic times are ahead. This approach worked reasonably well in 2009 and 2010, but there is increasing evidence lenders are now looking for a more permanent solution and this will require new capital. Private equity investors are ideally placed.
Despite the recently announced efforts of the UK Government to encourage bank lending, the net effect is unlikely to be significant. Long standing relationships between companies and banks have been damaged by what the companies see as over charging and the arbitrary withdrawal of support at a time of need. As a result there will be opportunities to invest at the right price across a broad range of companies - those that are in a growth phase and need capital to expand and good companies with weak balance sheets, but otherwise operationally sound. Exactly the same valuation techniques apply as when identifying attractive equities listed on the stock market.
Furthermore, it should not be forgotten that UK and Irish banks are the UK’s largest economic owners of hotels, commercial property, house builders and retailers. Banks have neither the skills nor structure to manage their way out of these positions. These reside elsewhere, which is why we are seeing the return of trade buyers. Although banks are supportive, external finance is needed and again this is an opportunity for private equity. Investors willing to provide risk capital should expect returns in the range of 15 – 20% per annum after fees and carried interest.
The liquidity crisis will be long and hard with the impact felt for many years to come. The UK economy and its banks are holding excessive levels of debt and equity risk and need to de-gear as quickly as possible. This will be achieved by a change of ownership in favour of those with fresh capital to commit.
One of the many advantages of managing global multi asset class portfolios, ranging from government bonds to venture capital, is that unexpected connections can be made. In 2007 - 2008 we learned that no one investment should be assessed in isolation. Private equity is no exception. One of the frustrations about investment in emerging markets is that many important companies are not listed on a public exchange. Specialist funds are, as a result, restricted to investing in companies that individuals, families or governments want to sell. Not always a good starting point. For example, although China has now overtaken Japan to become the second largest economy in the world, the total value of companies listed in Shanghai is still only 75% of the London market. As the emerging economies mature more of the corporate sector will move to public markets, but during this transition period better value and greater opportunity may well be found off-exchange via private equity.
In developed markets different issues are driving the balance between public and private. Companies are questioning the benefit of a public listing not only because of the pressure to report progress on a quarterly basis but also because of increasingly onerous regulations. In Europe there are 8,179 listed companies of which 5,162 have a market capitalisation
of less than Ð100 million. Undoubtedly some of the smaller companies will return to the private sector, but perhaps more importantly new companies will choose not to list. Facebook with an estimated value of $50 billion remains a private company.
Tactically, the next few years have the potential to be exceptional for private equity. Strategically investors will need to address how to invest in growth companies whether in developed or emerging economies that are unlikely ever to be listed.
