It is only a year ago that The Economist declared Private Equity (PE) the new "Kings of Capitalism". Now, doom mongers are predicting its rapid demise. As so often in life, the truth lies somewhere in-between.
PE funds buy underperforming companies from their existing shareholders - often by taking them private from the public markets, turn them around and sell them on - ideally at a hefty profit. PE transactions are typified by the fact that the target's management team is incentivised by being given a slice of the equity in the business. The typical PE deal is therefore a management buy out (MBO), where existing management buys the company with the help of the PE house. Also typical is PE investors' desire to leverage the deal, meaning that they will use third party funding to pay for as large a proportion of the purchase price as possible.
The PE boom of the last four years had its roots in a variety of factors. Historically cheap and abundant finance made it easy to load up targets' balance sheets with debt.
Low share prices following sell-offs after the collapse of the dot.com bubble earlier in the decade gave PE funds a helping hand. Finally, plenty of capital became available to PE funds due to institutional investors', such as pension funds, hunger for alternative investments.
These conditions have spawned three trends. First, the mega deal. PE transactions have reached sizes that even industry insiders could only dream of a few years ago. Deal sizes have reached double digits in the billions. This proliferation of the large deal has also for the first time led to the purchase of household names by PE investors - KKR bought Alliance Boots, the first FTSE 100 company to fall prey to PE.
Secondly, deal consortia. In order to be able to do the mega deals, spread risk and, whisper it softly, avoid price-raising competition, PE funds started to club together and co-operate on transactions.
Thirdly, not only cheap, but easy credit. By the end of the boom, banks were falling over themselves to provide debt finance on so called "covenant light" terms, meaning that the terms on which the debt was made available to borrowers were a lot less stringent than would historically have been the case.
It is the loss of that last factor in particular that has slowed the industry down. The US mortgage crash-induced credit crunch can only hurt a debt-reliant industry such as PE.
On a positive note, there is still plenty of money sitting in the funds waiting to be spent. That money is still looking for viable investments. The mega deals may for the time being have disappeared but the mid-market remains surprisingly healthy. And the industry may be about to benefit from one of capitalism's golden rules: if a gap is left by one investor class, someone else smells a profit and is bound to move in. While banks have hastily retreated from the credit markets, sovereign wealth funds appear to be willing to take up the slack and become the PE industry's new providers of choice for debt funding. There may be life in the old PE dog after all.
This article was first published in Money Market.
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