Restructuring in a Down Economy
Helen Mallovy Hicks
Peter Dale, national leader of PwC's Private Equity practice, offers an overview of how the face of private equity has changed recently, and what key challenges will be for the future.
Dean: Welcome to Strategy Talks with Dean and Helen, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, co-head of our Restructuring and Distress Strategy Group, and a member of our Credit Crisis Task Force.
Helen: And I'm Helen Mallovy Hicks, a Partner in the Advisory Practice of PricewaterhouseCoopers in the Dispute Analysis & Valuations group.
Dean: The current state of the economy is understandably of great concern for most Canadian businesses. This series of audio podcast discussions with a variety of subject matter and industry guests are designed to help your business weather the storm by exploring some of today's hottest issues related to the economic crisis.
In today's episode, Private Equity in a Troubled Economy, we welcome Peter Dale, National Leader of PwC's Private Equity Practice. He'll offer us an overview of how the face of private equity has changed recently, and what some of the key challenges will be for the future.
Helen: Peter, how has the private equity landscape changed over the past two years?
Peter: First of all I think we should just step back and look at what's happened in private equity and how really successful it's been over the last number of years. If you think about it, we've had an unprecedented boom in the industry, but, to some extent it could be argued it's been fueled by cheap and plentiful credit, and increasing valuation multiples that have resulted in spectacular returns. Now with these returns, that sort of fueled more and more funds going towards this industry as anybody else, if you're getting great returns, why wouldn't you apply more funds to that and some of the larger LP investors have in fact done that.
So there's been a drive, and more and more funds have come into the industry. With the more and more funds, the industry has expanded. It's gone into different areas, increased it's breadth towards infrastructure, distress and it's horizon of where it looks to investments. You've seen it going towards merging economies which is more and more of a recent development. So, it's been extremely successful, it's grown, and I think when you get to it at the height of the boom, you could say that up to twenty percent of the M&A total transactions was PE driven. In Canada, one thing too, it's a little bit different our industry, it's more. It is historical the middle market type of industry, but we have seen our larger LP investors been pension funds for the most part that have taken a more direct and active part recently.
They set up their own PE teams, and have allocated more of their resources towards the private equity sphere, so we're seeing a little bit more like that. I guess with spectacular and quick success, sometimes you get the counter where when things fall off, as they have done, you get the quicker fall than some other industries, and I think that's true the PE.
The faster and higher you go, sometimes the harder you fall, and we're kind of seeing that right now with the restriction and the credit, valuation multiples going the other way, PE has been very adversely affected. But, that being said, PE, it's here to stay. It's a very viable alternative, it's offered better returns historically than other equities being, you know, in the public markets. So we'll continue to see that. I think our expectation at least here at PwC is it will probably go back more to its middle market routes where it was more successful working with entrepreneurs, doing add-on types of acquisition, using their financial expertise rather than the huge mega deals that have happened in the last few years that to some extent may have been fueled by those conditions.
Helen: Are you seeing any activity right now in the private equity sector, or are you seeing different things that we saw six or eight months ago? Or are you seeing them all stand on the sidelines waiting for the credit markets to open up again?
Peter: Well I'm not sure it's just the credit markets that slowed it down. First of all we're definitely seeing a slow down. Private equity has been to the sidelines. There are deals happening. They're the smaller type of deals and they're happening on different parameters. We have seen a couple of deals where by the private equity firm has decided, you know what, the bank credit is just not on favorable terms right now but we like the deal and we're going to do the deal but we're actually going to act as the banker for the deal, and when credit markets improve, we'll refinance on proper, more traditional terms.
So that's the type of thing that we are seeing, but of course when you're in that type of situation, there's a lot less credit out there, or a lot less funds to make acquisitions, so for one of those reasons it's slowing down, and specifically right now, the things are deteriorating so quickly with the economy at large, it's hard to get a valuation on what the various enterprises are worth, because the historical numbers don't necessarily apply anymore, and I think we're also getting into a situation where the vendors have not quite accepted the new valuations and they're stepping back, and until that period of adjustment happens where there's a recognition that, you know what, what happened six months ago, that no longer applies, and you're right, you could have sold six months ago, and received a lot more, or a year ago. But you didn't. So that's money, it's gone; let's just deal with the new realities.
Dean: That's an interesting point, Peter. I was at a conference last week and that very point was discussed amongst a bunch of private equity funds, and all the deals that they're seeing today, the valuation expectations of the vendor or the seller are much higher than what the current market dynamic would support. You talk about PE staying around for the long term, and I would tend to agree with that, but I guess the real thing is that valuations and the leverage model that was there historically will go back there which is significantly different that what we saw in the last two to three years. Then I guess people's expectations just need to change.
Peter: Absolutely, and like everything else, it takes time for human beings to adjust to the new realities and I think we're just going through that time right now.
Dean: Now what are you seeing as key challenges that private equity firms are facing today?
Peter: First and foremost I think is that with their existing portfolios and with the economy at large, they, like everybody else, they have to deal with their portfolios and manage through this economic crisis, and I think to some extent, some of them are even more exposed than the economy at large because if they were appealed by higher debt levels than would normally be the case, well there's going to be more pressure on them than would otherwise be the case. First and foremost it's just dealing with the economic crisis we find ourselves in right now.
One thing with the private equity firms too, with respect to their existing portfolios, I think that they're going to have to have a really hard look at the portfolio companies themselves and determine which ones have the most potential, and which ones should be devoted additional capital on a go forward basis. Capital's very scarce right now, and opportunities are ultimately going to be bountiful in the new economy, so they have to look hard and fast at their portfolios and are they the ones that are deserving of these scarce capital dollars or should they be looking elsewhere? And that's a difficult decision when you're a private equity firm and you've made this investment, but you do have to stand back and if the circumstances that led you to think this was going to be a great investment have changed, well, maybe you have to change and even look at releasing that investment.
Dean: So you're saying walking away from the current investment you have.
Peter: I think so. The dollars are scarce, and that's one thing that they'll all have to look at very closely.
Helen: Have you seen any private equity firms doing that?
Peter: Well I've seen them looking at it and talking about it, but to actually made decision to let one go, no. That decision may be taken out of their hands by their banking covenants, and that's probably would happen first and foremost, but I think they have to look at that, because there's pressure to put more equity into their investments from the banks and elsewhere, so they have to look very closely at do we want to make that investment, because that investment into a historical portfolio is taking an investment opportunity away from something else, where better opportunities may lie.
Dean: You make a very good point there, because what I've seen in the past is usually there is a round of ask for capital from equity and generally the first time they put their hand up and they put it in, but I think the number of times they'll be asked that from this time around will be pretty high, so I think that's some pretty solid advice you're giving there.
Peter: The big problem they do face right now is this access to capital, and that's for a number of reasons that we're seeing right now. The well publicized one is the debt market. It's the debt markets of essentially, if not shut down, have become far more restricted. Maybe in Canada, they're a little bit less shut down than some other countries where we're seeing there is a complete shut down and there's absolutely no credit whatsoever available. But that's one issue. Valuation issue, it's a little bit of a funny accounting issue in a way in that there's been some of the larger LP's have allocated a percentage of their capital towards private equity, but what's happened is that public equities that they've held have taken such a large hit in their valuation that just by the denominator effect, the private equity to the extent it hasn't taken quite the same type of valuation hit has become a larger portion of their portfolio and they're already bumping up against the allocation that they wanted to devote to private equity.
And that again, if you're already there, that means less dollars to push towards that. When I say limited partnerships, or LPs, what I mean is the limited partners of the, usually a private equity investment is formed as a partnership, and the limited partnerships are the investors in the partnership itself that makes the portfolio acquisitions. So they are like the investors while the private equity firm itself is the general manager in a similar manner that your mutual fund administrator is paid. Actually in a way it's no different than investing into a mutual fund. When you invest in a mutual fund, the only difference is that's a group of public fund trade securities as opposed to a private equity firm where it's privately held securities. What was happening is that commitments are still high to a lot of the funds, but a lot of times the commitments funded by the private equity firms were making their dispositions, making nice profits and sending the funds back to the LPs, and they would become reinvested as part of the next series of financing. Well right now, there's very little, well there's absolutely no IPOs going on in Canada. There's very little M&A activity at the private equity portfolio level. So, there's no cash going back to the LP unit holders, meaning there's any new investments and including their commitments have to come from new cash and as we know, a lot of the LPs have their own cash issues, so that again, the commitments for cash may be out there, but the private equity firms right now they're not asking for the cash because they recognize that there's issues out there with respect to what their LPs can actually provide.
Dean: So they're afraid of asking and getting the wrong answer.
Peter: Absolutely. Right now the secondary market for private equity investments, it's out there, it's developing, but it's not as robust as it might otherwise be. And again, people haven't accepted maybe what the private equity investments are worth because right now the secondary market is trading at far lower figures than the book values of private equity investments.
Helen: Right, yeah. There's a lag in changing the view in valuation.
Dean: There are some funds, I guess, you mentioned the point about recycling of cash. Some private equity funds have the ability once they've cashed a transaction to keep the cash and recycle it into a new investment, and some are restricted from doing that. If you're a company and you're looking to raise capital, I guess in this market it's important to understand the dynamics between the different funds and who has access to that capital, etc., because often times it may not be just one ask of capital, particularly if it's a growing industry or a growing business.
Peter: Oh, absolutely, and that's you know, you have to carefully look at the LP agreement to see exactly what it does say, and what can be done. But that being said, the agreements right now are quite fluid. The private equity fund, and along with its LP unit holders, they're wanting to work together and make things as smooth as possible under this new scenario we find ourselves in. And that goes right down to the remuneration of the private equity firm, I mean there have been issues raised whether some of the older deals have been very successful, and then there's a carried interest which gets paid out, well, what about the existing portfolios? Is there going to be a loss? Well, should have that loss have been applied against the former carried interest? It's these type of complications that are being dealt with, and I think that from an overall perspective to the extent that, and very importantly, that the private equity operators deal very openly and candidly with their LP unit holders, with their banks, and with their management team, to put everybody on the same page. That's especially key during this environment.
Helen: Yeah, that's interesting. So lots of issues and challenges facing private equity firms right now. Where do you see them going forward? How do you see the industry changing on a go-forward basis?
Peter: Well, I think that the fortunate returns, with the environment that we found ourselves in, are likely over. Private equity's going to have to look at the businesses in a more all-encompassing light. Financial management and doing good things on that side, that's not going to be enough. They have to look very closely at the operations, and find new ways to increase the real business operations on a go-forward basis. That's going to be a key thing. And then in light of that, they're probably going to have to hold out some of these portfolio entities for a longer period of time. We expect that there's going to be more, let's say, fold-on type of acquisition activity, whereby if you have a strong portfolio, it may be trying to grow through acquisitions. Smaller acquisitions. Back to the traditional private equity. Some of the things that we think they're going to find is carve-out acquisitions. The public entities themselves, they have their own issues, and they maybe want to sell off some off their business lines, and this is where an opportunity lies for some of the private equity portfolio entities to acquire carve-outs and add them on to their portfolio, or start fresh with a new portfolio. So we see that as an area that is going to grow, let's say. We would think there's opportunity there. We do see however, is that we think that, over time, that the LP investors are going to become a little bit more pickier on to which private equity firms that they use for their investments. They're probably going to go towards the ones with the stronger brand recognition and the ones that seem to be seizing the opportunities and delivering the returns in a very transparent manner whereby everybody understands what's going on. So, to some extent what you likely will see is, let's call it a flight to quality, whereby the LPs will be going towards perhaps fewer and fewer private equity firms. So there could be a consolidation itself in that industry.
Dean: Peter, everything you're saying about the future of private equity sounds like a heck of a lot of hard work for these guys. A few years ago, being in private equity was quite sexy. You know, you could see it in fiction novels, things coming out, everybody graduating out of MBA School wanted to go into private equity. But it's obviously a very different place today. Because of that, do you see some attrition, some fallout, some real changes of the face of private equity going forward?
Peter: Absolutely. I think that, again, it goes back to those firms that are able to thrive through operational effectiveness are the ones that are going to succeed. Those that were fortuitous and dealt just purely in the financial sphere and knew how to raise money, knew how to take things public, that type of process, that's still an extremely important part, but it's not the only part. That's what the expectation is, that operational effectiveness and the hiring of either outside professional help to assist in that, or internally, these private equity firms are going to have to bring on operational people to assist them in increasing their ultimate returns.
Helen: Peter, do you find that private equity managers are being proactive in managing their portfolio of assets, or are they waiting until there's a big issue to call us in?
Peter: Both. But if they're not proactive, they're not going to survive through these times. I think nobody knows how deep this recession is going to be. Transparency with all their stakeholders, whether the banks, the limited partnerships, and/or their management is absolutely key right now, and they have to deal with that. Most of them are not set up to internally do all of that, they things that have to be done. So yes, proactively they have to first keep their stakeholders informed and secondly, they have to actually make the changes that are necessary and with that, they don't have it in house for the most part, that skill set, so they have to go outside and they should be doing it if they're not doing it.
Helen: I think that's right and that's a message we're hearing from other Partners we're speaking to on Strategy Talks, is that the critical matter of being proactive and how it can make a difference in the long term. I think we're running out of time, so with that, can you give us some key take away messages that you'd like our audience to be left with?
Peter: Just reiterating the fact they have to work closely with the various stakeholders that they have right now, and that includes the lenders who would love to change the terms that we were speaking about, the limited partners who have their own cash flow issues, so they have to be cognoscente of that although they may have the commitments for additional funding, they have to be cognoscente that the cash is very tight right now and to ask at the right time for the right investment. And also with their management. The management, we have situations now where management, their options and their incentive plans may be well under water, under the new environment, but they have to keep their management incentivized to assist through this process, and also make sure they know who exactly are the management that they want to keep, because ultimately in this environment, headcount and other cost reduction type techniques are going to be key. So deal with your stakeholders and keep them well-informed. It's a little bit of doom and gloom right now, but whenever there's a big change, there's great opportunity, and those private equity firms that are able to seize this opportunity right now, once we see the lower valuation models come through, the distressed opportunities, once they're able to exercise they're going to be set up for spectacular returns in the next few years it's just a matter of dealing with the issues right now, and especially with their existing portfolios.
Dean: Peter, one last question, as to why people would like to hire you and your practice area.
Peter: Well, what I'd say to that Dean, is the one thing we have here at PwC, we have a number of highly educated professionals who specialize in the private equity field. They know the issues associated with private equity, they know the things that they deal with again and again. Now we recognize that private equity and their investments is very broad, so they cannot have a one size that fits all type of solution set, but, we do know what they deal with. We have the broad scope in Canada. We were extremely well integrated with our other offices throughout the world, so if there is an opportunity that rises in a different country, we can make a seamless service happen in that respect too.
Dean: Peter, thank you for your simple, honest and practical advice. Thanks for being a guest here on PwC's Strategy Talks.
Peter: Great. Thanks Dean. Thanks Helen.
Helen: And thank you, Peter. Go to pwc.com/ca to download our Global private equity report 2008 seeking differentiation at a time of change.
Voice over: In the next episode of Strategy Talks, Innovation in a Downturn, Helen and Dean talk to Chris Dulny, a Partner in the Assurance and Advisory Services group at PwC. He discusses why it is so important to continue to innovate in technology companies, even during a recession. Here's a sneak preview of what Chris has to say.
Chris: Technology companies who look for ways to innovate in this economy will be the ones who are not only standing after the downturn, but will be well-positioned to take advantage of growth opportunities as the upturn comes back.
Dean: This concludes this episode of Strategy Talks, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, thank you for listening.
Helen: And I'm Helen Mallovy Hicks. We hope you'll join us again soon for another episode. To download or to subscribe to this podcast series or to find more information on this topic, please visit our Managing in a Downturn website at pwc.com/ca/managinginadownturn.
The information in this podcast is provided with the understanding that the authors and publishes are not herein engaged in rendering legal accounting, tax or other professional advice or services. The audience should discuss with professional advisors how the information may apply to their specific situation. Copyright 2009, PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership, or as the context requires, the PricewaterhouseCoopers global network or other member firms of the network. Each of which is a separate and independent legal entity.