The dramatic decline in M&A activity over the past 12 months has seen an equally precipitous drop in Private Equity’s (PE’s) share in the M&A market. As the chart below highlights, M&A transaction volume peaked in 2007 with over 12,000 transactions and $1.7 trillion in value.
The peak for PE firms also was reached in 2007 when their activity totaled 11.3% of deal volume and 32.5% of the value of all transactions. In Q1 09, PE’s share of deal volume was reduced to 9.4%, representing an anemic 1.5% of transaction value. This slowdown in activity is keeping PE firms’ buying power extremely high.
From 2007 through 2008, PE firms grew not only in numbers but raised nearly $600 billion in capital. Current estimates indicate PE firms have over $400 billion of unallocated equity which, when combined with potentially available debt of three times equity, equates to $1.6 trillion in potential investments.
Private Equity Capital Raised
PE firms are well capitalized but they face many challenges. Existing portfolio companies are struggling through the recession like all other businesses, leading PE firms to spend a significant amount of their time managing these assets. Additionally, many PE portfolio companies are burdened with heavy debt loads and face impending maturity dates in a precarious financing market.
New acquisitions present their own set of challenges for PE firms. In an unhealthy economy it is hard to find a quality company that wants to sell. Even if you can find a company that wants to sell and bridge the gap between seller expectations and a buyer’s willingness to invest, you will need a healthy debt financing market. Currently PE is virtually cut off from cash flow debt financing. PE firms can remain competitive on asset-based deals, where lending is still available albeit not at the levels seen in the past. However, PEGs cannot compete with strategic buyers on cash flow deals unless they are willing to over equitize, which dramatically affects potential IRRs, and thereby reduces the price that a PE firm can pay for a company.
So what does this all mean for the future of PE? The net effect will likely be the elimination of some PE firms. This will be especially true for those firms that invested heavily in the 2005 – 2007 time period when multiples where high and leverage was readily available and aggressively applied. This inevitably led to realization events that do not produce high enough IRRs to attract investors for new funds.
However, while I do foresee a moderate retraction in the quantity of PE firms, I do not believe PE is going away in a material way. As an asset class, PE has consistently delivered investors rates of returns that have far outpaced the S&P, with yields averaging in the high teens to low twenties. Additionally, asset class diversification is now a tent pole of the investing community, making the continuation of PE funding a foregone conclusion. This is evidenced by the recent announcement by CalPERS, a $231 billion fund, to raise its fund allocation from 10 to 14 percent in private equity. This strategy reflects the fund’s preference for moderate risk while responding to the current market environment.
Quality PE firms will survive and thrive. At PCE we have a favorite expression, “All money is not created equal.” Those PE groups that are able to navigate the current waters will prove this expression to be true as well as PE firms are not simply “financial engineers.”
The massive reduction in current asset values has created an unprecedented buying opportunity not seen in America since the Great Depression. Enormous wealth will be created in the next decade and PE firms are poised to be significant players.