NEW YORK – Private equity (PE) firms will propel deal-making forward in 2012 as they race to put vast sums of aging "dry powder" to work before investment periods expire, says Bain & Company, one of the world’s leading advisers to the private equity industry. However, Bain & Co. says, PE firms will face strong headwinds.
According to the report, uncertainties in the economic outlook and volatile equity markets will make it difficult for buyers and sellers to agree on price. Bain finds that debt-market conditions were less favorable at the start of this year than in 2011. One major concern: whether the supply of debt will be able to keep pace with demand, even if deal-making picks up — though, say the report’s authors, it’s likely that credit markets will remain accommodating as long as the hunt for yield in a low interest rate environment continues to attract investors.
“Private equity firms (GPs) will feel pressure to unload assets in 2012,” said Hugh MacArthur, head of Bain & Co.’s Global Private Equity Practice and lead author of the report. “They have been slow to return capital to investors (LPs) since the downturn, and the exit overhang has grown to nearly $2 trillion globally.”
Adding to the pressure to do deals is the fact that a sizable portion of the dry powder earmarked for buyouts — 48 percent of the total — is held in funds raised during the big 2007 and 2008 vintage years.
“The clock is ticking loudly for these funds,” said MacArthur. Unless that capital is invested by the end of 2013, GPs may need to release LPs from their commitments and forego the management fees and potential carry it could generate, according to the report.
Burning off the aging dry powder will likely result in too much capital chasing too few deals throughout 2012, as GPs that manage the older vintages compete with one another and with GPs of more recent vintage funds to close deals. Indeed, if buyout activity remains at the modest levels of 2010 and 2011, the dry powder from the 2007 and 2008 vintages alone could fuel the deal market for 1.8 years. That pressure will be even greater in Western Europe, where funds are sitting on an even larger proportion of dry powder nearing its “use by” date.
But do not look for exit activity to perk up in 2012. According to the report, weakness persists across all exit channels, and many companies in PE fund portfolios are still not “ripe for sale,” held at valuations below what GPs need to earn carry.
Fast-growing emerging markets continue to attract both LPs and GPs, Bain & Co. says, but most will be challenged to meet their high expectations. LPs are captivated by robust emerging market growth and continue to pour money into these regions, but to-date, the long-awaited potential has failed to materialize to the extent investors had hoped, the report finds. The principal factor influencing an economy’s ability to absorb PE capital is the number of larger-scale companies available for acquisition. With many emerging markets falling short on this dimension, dry powder will continue to pile up.
From the perspective of PE investors specifically, Southeast Asia is attractive for many reasons. It is relatively well-endowed with scale companies, particularly in Singapore, Malaysia and, to a lesser extent, Indonesia. Unlike China and India, where PE funds have typically been able to take minority stakes in smaller companies or limit themselves to private investments in public equities, Southeast Asia has traditionally been a buyout market, offering GPs more opportunities to create value.
“Bigger, as in the relative size of GDP, is not always better,” said MacArthur.
Fund-raising is not poised for a recovery in 2012. The slower pace of exit activity is leaving liquidity-strapped LPs strained to meet capital calls for past commitments and volatile equity markets are pressing them against their PE allocation ceilings. Meanwhile, an oversupply of funds seeking capital could force GPs to scale back lofty expectations or face being disappointed. Despite a huge backlog of dry powder, they are already struggling to put to work, and deteriorating fund-raising conditions going in to 2012, GPs are looking to raise 2.8 times as much capital globally this year as they were able to raise in all of 2011.
From a sector investment perspective, a consensus is emerging that the U.S. real estate market has finally hit bottom, drawing GP attention to construction and building products. In this segment, timing and geography are critical. GPs are taking care to understand where in the building cycle the products made by the companies they are evaluating fit. For example, in commercial construction, where it can take 18 months to erect buildings, they want to be able to move quickly to acquire producers of building materials that are in demand early in the cycle. In Europe, GPs are also playing the business cycle, looking broadly within the industrial sector at everything from automotive to chemicals that they might be able to buy at low valuations relative to recent highs.
According to Bain’s report, the ingredients of “market beta” — strong GDP growth, expanding multiples and abundant leverage to power returns — are gone and they are not coming back any time soon. The focus of both GPs and LPs now needs to be on generating alpha to earn market-beating returns by boosting growth in their portfolio companies. For GPs, that means honing new disciplines for vetting deals, adding organizational capabilities to accelerate growth and building a repeatable model for value creation. For LPs, the challenge will be identifying GPs that can deliver alpha going forward. They will need to look beyond a GP’s performance track record in light of recent evidence that the persistence of superior performance could be fading.
“Selecting the right fund manager is key for LPs,” said MacArthur. “GPs that have managed a top-quartile fund have a better than six-in-ten probability that their successor fund will also be an above average-performer. Likewise, for a GP whose last fund ended up in the bottom quartile. Their next fund will be nearly 60 percent as likely to underperform the industry average.”
