What the market is doing to private equity

Volatility can scare away even some of the most steadfast of investors, and it also tends to cause problems for those looking to cash out investments. That’s particularly true for private equity, according to a Wall Street Journal story:

It all was going so well. For the first 5½ months of the year, private-equity firms took advantage of soaring markets and eager investors to raise about $35 billion by selling stakes in their companies, not to mention billions of dollars more through initial public offerings.

The rush for cash prompted some buyout executives and bankers to view 2013 as the year of the exit, a moment to reap what they sowed, including on some highly indebted, controversial deals just before the eruption of the financial crisis. Leon Black, Apollo Global Management LLC co-founder, in April called the market’s receptiveness to such sell-downs “biblical.”

Then the markets turned. Stock and bond prices fell amid fears of an end to the Federal Reserve’s stimulus, and the resulting market turbulence this month threatens to disrupt the sales planned by private-equity firms and possibly put the brakes on a blistering pace of big paydays for their top executives and investors.

The public offering of HD Supply Holdings Inc., a construction-materials supplier, priced Wednesday at $18 a share, far below the range of $22 to $25 the company previously expected. Private-equity-owned information-technology company CDW Corp. on Wednesday priced its IPO at $17, also well below the company’s previously expected range of $20 to $23. The private-equity owners have decided not to sell their stakes in either deal.

According to the Financial Times, the biggest drop came from more developed countries:

The decline was sharpest in the US and Asia, where volumes contracted 67 per cent and 66 per cent respectively. Europe recorded an increase of 56 per cent in volumes to $27bn from the first quarter, helped by the acquisition of Ista, a German metering company, by CVC Capital Partners for €3.1bn. It is also a 25 per cent jump from the same period the previous year.

While private equity groups have found it harder to deploy capital, they have exploited renewed appetite from trade buyers to sell investments.

Private equity-backed exits rebounded 78 per cent in the second quarter to $61.6bn, compared with the first quarter. There were 310 in total, including the $8.7bn disposal of Warburg Pincus’ eyecare company Bausch & Lomb to Valeant Pharmaceuticals. However, exits were down 39 per cent from the second quarter of last year.

So-called secondary buyout exits, where private equity assets end up in the hands of another private equity buyer, more than tripled to $25bn in the second quarter from a three-and-a-half year low in the first quarter. The second-largest exit was such a deal: the acquisition of Springer Science by BC Partners for $4.4bn. It was also the fourth-largest buyout in the first half.

Given the growing backlog of private equity exits, bankers are hopeful that the rest of the year will remain active. However, recent market turmoil after Ben Bernanke, the US Federal Reserve chairman, signalled the end of his stimulus programme adds an air of uncertainty.

Firms are also having trouble adding to their portfolios right now since valuations are all over the place, according to the New York Times:

Buying new companies is a different story. Some $62 billion worth of deals greater than $1 billion have been announced this year, according to Thomson Reuters. That’s slightly more than all of last year. Yet the two biggest – a $27 billion purchase of the H.J. Heinz Company and $18 billion purchase of Dell Inc. – are atypical. The former was more Warren E. Buffett than private equity, and the latter is largely a mogul buying back his company.

Ignore these two, and there have been only five transactions amounting to $16 billion. The industry has $187 billion of dry powder to do deals, according to Preqin. At typical leverage ratios, that could amount to more than $700 billion of deals. At this year’s rate, it would take decades to put that money to work.

Part of the explanation lies in a mistrust of current valuations. But a hardening of boardroom attitudes since the leveraged buyout boom figures, too. The industry is seen by some as being too sharp-elbowed to be a desirable buyer. These may be halcyon days to sell, but the industry may need to buff its reputation if it wants to replenish its inventory.

So what does this all mean? While not much for retail investors, buyouts are huge business for investment managers, pension funds and banks. Investment banks will earn less money on advisory fees as well as helping private equity firms exit their holdings.

Pension funds and other investment managers may have difficulty reaching their return targets. It’s also important for private equity firms to show solid returns as well. The Journal again:

Such investment exits are crucial for private-equity firms because they create deal profits for the firms’ executives and the pension funds, universities and wealthy individuals that give them money to invest. When buyout firms successfully cash-in on deals years later, it helps them raise a new round of money from investors—a virtuous cycle that can be damaged if selling down an investment doesn’t deliver the desired profits.

While it might seem like an inside Wall Street story, private equity touches nearly everyone on a daily basis from the clothes we buy to the returns in pension accounts. A slight bump might not be so bad, but if the markets continue to be uncertain, pensions and universities may need to looks elsewhere for returns.