2012 is poised to conclude as it commenced: marked by uncertainty and choppy economic waters. While political ambiguity may subside following November's U.S. presidential election, private equity will continue to face the same undercurrents that have made recent years among the most challenging in the industry's history.
The capital overhang of dry powder waiting to be deployed has hit record levels. Not surprisingly, with too much money chasing too few good deals, prices for attractive targets have increased. Exit time frames have extended considerably -- with the median hold period approaching five years -- as traditional paths have become more difficult.
With a growing number of funds quickly approaching the end of their 10-year contractual periods, many still hold sizable portfolios of companies they're under increasing pressure to sell -- even though many assets have yet to reach their intended potential. And amidst a highly polarized election year, firms are facing unprecedented political and regulatory scrutiny.
In the face of this seemingly unabated torrent, where does the private equity industry go from here?
Each economic cycle routinely produces lessons learned. This time is no different. Too often, however, the analysis is cast in terms of what went wrong, what should have been done differently. Now, though, even with formidable headwinds in place, there are plenty signs of optimism. While the Private Equity Growth Capital Council reported that deal volume, exits and equity contributions fell for the second quarter compared to the first three months of the year, fundraising is on the rise -- with firms pulling in 106% more over the same quarter last year. But raw numbers are just the beginning.
Over the past five years, most successful PE firms have undertaken a fundamental shift in their investment approach. With "buy-low, sell-high" strategies now only relevant in history books, firms have adopted strategies based on operational investing -- looking for opportunities where they can produce quality investment returns by improving the underlying value through operational improvements.
This strategy has positioned firms to perform almost regardless of market conditions, since the investment thesis is based on transforming the business to make it stronger and more valuable rather than relying on financial engineering and multiple arbitrage.
But the approach has come with somewhat of a catch. The strategy, by its very nature, dramatically increases execution risk as well as raises the diligence bar. This has led to a significant change in how firms conduct due diligence. An integrated approach has become paramount. Integrated due diligence provides for a multidimensional and more holistic view of the asset by combining traditional financial accounting and tax skill sets with operational, industry and functional expertise. This enables PE firms to approach the exercise with a united front that offers greater insight into potential upside opportunities and the information necessary to understand, manage and mitigate risk before investing. This is particularly critical in an environment in which there is a paucity of obviously attractive opportunities and the best returns are going to result from deals that are harder to pull off.
Competitive auctions, for example, have become more intense. Successful bidders must find an angle -- an opportunity that may not be obvious or may not be easily identified within an aggressive time frame, absent an integrated due diligence approach. The same can be said for carve-out situations as investors must embark on the arduous task of evaluating what the real underlying value of the business would be as a standalone asset. This is also the case when it comes to deals in industries experiencing major periods of transformation, such as healthcare, energy and financial services, which are hotbeds of investment activity.
Many private equity firms possess significant operating experience and consider that experience an important part of their value proposition. Now is a time when the application and integration of that experience, at a much earlier stage in the transaction cycle and in a range of disciplines across the enterprise, can differentiate between those who achieve successful outcomes and those who continue to be buffeted by economic storms. n
Nick Alvarez is national practice leader of Alvarez & Marsal's private equity services operations group. Paul Aversano is global practice leader of the firm's transaction advisory group. Ernesto Perez is national practice leader of the firm's transaction and international tax practices.