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Business as unusual: The state of the PE industry

by contributors Doug Warner and Michael Weisser, Weil | Published March 19, 2012 at 2:46 PM

2011 was an interesting time for the private equity industry. It was a year that started off with a bang but ended with a whimper. Overall for 2011, private equity deal volume was largely flat compared to 2010, but it was heavily front-loaded, with fourth-quarter leveraged buyout volume in 2011 declining 38% against the comparable quarter in 2010, according to Thomson Reuters.

The overarching theme of 2011 was uncertainty -- macroeconomic, political and regulatory. There was a steady drumbeat of bad news with the U.S. ratings downgrade, European sovereign credit risk, the political dysfunction in Washington, the political dysfunction in Europe, the looming presidential election in the U.S., the uncertainty over future bank capital rules and the implementation of Dodd-Frank, among other items. The impact of this on the industry was a weaker debt financing market in the second half of the year, a disappointing initial public offering market and a dearth of strategic buyers of businesses. Despite this, the industry had a solid year and had real success in a number of areas, including pushing out the refinancing wall of debt maturities that arose from 2006 and 2007 vintage LBOs.

Some of the trends that we saw in the industry in 2011 and some predictions as to what awaits the industry in 2012 are summarized below.

Some of the trends that we saw in the industry in 2011 included:

The good news is that the limited-partner community remains committed to the asset class. According to Buyouts, over $90 billion of buyout funds were raised in 2011 compared to just over $69 billion in 2010. A recent survey of LPs by Coller Capital Ltd. concluded that 83% of surveyed LPs plan to maintain or increase their target allocation to PE over the next year. Interestingly, Coller Capital's survey concluded that LPs viewed midmarket and small buyout funds to provide better opportunities than large buyout funds with approximately one-third of LPs planning to scale back their investment in large North American buyout funds.

Even though the LP community remains committed to the asset class, it is becoming more discriminating, and the structures and terms of new funds are evolving. Whereas some of the more successful midmarket buyout funds relatively easily raised capital exceeding their previous funds in 2011, other funds had significant difficulties in raising capital at anywhere near the size of their previous funds. LPs also continued their push to improve deal terms, and many notable sponsors reportedly made concessions on management fees, carried-interest percentages, transaction fee offsets, hurdle rates and other terms. One other new structure we saw in 2011 that could become a trend was large LPs making large commitments to a sponsor across multiple platforms and funds in exchange for concessions on fees and other terms. A notable example of this was the $3 billion commitment that Teacher Retirement System of Texas reportedly made to both Kohlberg Kravis Roberts & Co. LP and Apollo Global Management LLC.

One of the trends that we began to see in 2011 and expect to see more of in 2012 is for sponsors with 2006 and 2007 vintage funds with undeployed capital to approach their LPs regarding extending the commitment period. This will allow sponsors to avoid deploying capital prematurely in order to not lose the opportunity to use it and to potentially defer their need to raise additional funds. LPs may be amenable to extending the commitment period so as to disincentive sponsors from deploying capital imprudently prior to the expiration of the original commitment period.

As noted above, deal activity started strong in 2011 but then tailed off given the increasing macroeconomic and political uncertainty that heated up over the summer months, which dramatically dried up the debt financing markets. The debt financing markets recovered modestly in December, but that was largely due to a supply-demand imbalance given the relative small number of leveraged deals that were in the pipeline to be funded.

It was also a tough environment for deal exits in 2011. As noted above, the financing markets became difficult in the second half of the year, strategic buyers were few and far between, and the volatility in the equity markets did little to shorten the long queue of sponsor-backed companies lined up to go public. On the bright side, 2011 was a decent but not spectacular year for dividend recaps, particularly in the first half of the year.

One of the success stories of 2011 was the ability of sponsors to extend the maturities of the debt issued to finance their 2006 and 2007 vintage LBOs. The debt financing markets were strong in the first half of the year, which allowed many sponsors with 2012 to 2014 debt maturities to extend those maturities through amend and extends and exchange offers. This will take the pressure off sponsors to exit or permanently refinance many of their portfolio companies prematurely.

Some of our predictions for the industry in 2012 include:

The past year ended with many frustrated sponsors on the buy side -- frustrated at the valuations being sought by sellers, the lack of good product for sale and the less-than-optimal financing market -- as well as frustrated sponsors on the sell side -- frustrated at the valuations being offered by buyers, the dearth of strategic buyers, the lack of a great IPO market and the less-than-optimal financing market. We would expect that frustration to continue in the near term due to the continuing political and economic certainty and suboptimal growth prospects in the U.S. and Europe and the continuation of the global "risk off" trade worldwide (10-year Treasuries yielding less than 2% still have lots of eager buyers). Over the medium term, we are optimistic about the level of deal activity as corporate buyers are cash rich, the debt markets are relatively strong, and stock markets started 2012 on a positive tone.

In recent years, there has been significant diversification by some of the larger buyout funds. There are now several sponsors that have become or are becoming "alternative asset supermarkets" and offering a whole range of products under one roof, including large buyout funds, small buyout funds, regional buyout funds, distressed funds, credit opportunity funds, real estate funds, CLO funds and hedge funds.

As noted above, sponsors have been successful in pushing out a substantial amount of debt maturities from 2012 to 2014 to 2015 to 2017. This will give sponsors some breathing room, but if the economy and the deal markets do not pick up by the beginning of 2013 or so, sponsors may have debt maturity issues with a number of their portfolio companies.

Although the private equity industry faces a number of challenges going forward, we expect that the private equity model will continue to provide opportunities for entrepreneurs and deal professionals. As Coller Capital's recent survey underscored, the LP community is placing its bet on the future of the industry. In addition, a recent report by the Private Equity Growth Capital Council stated that private equity had returned about 800 basis points of annual performance in excess of the S&P 500 over the past 10 years. In a world of 10-year Treasuries yielding less than 2% and modest prospects for public equities, investors need private equity to exist and flourish.

Doug Warner and Michael Weisser are corporate partners in Weil, Gotshal & Manges LLP's private equity practice in New York.

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