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The Actuary The magazine of the Institute & Faculty of Actuaries

Watson Wyatt research points to new era for private equity

Successful private equity managers of the future will be those that can remain disciplined through this uncertain period by carefully getting transactions done, while avoiding strategy drift, according to Watson Wyatt. These managers will also succeed if there is an understanding that financial engineering has become a commodity and that multiple expansion is no longer a return driver that private equity managers can rely on to generate returns.

Jane Welsh, global head of private markets research, said: “In the recent past, cheap and readily available debt, combined with rising prices and an accommodating exit environment, created an ideal environment for private equity managers to generate strong returns without needing to exercise particularly high levels of investment judgment. That era is over and the new world will reward those long-term and selective managers with strong track records of creating value through accelerating the earnings growth of their portfolio companies.”

In a research paper, the firm makes a number of assertions about the private equity industry and its future shape:

Banks to remain cautious in underwriting new debt
Credit markets changed dramatically in the second half of 2007, with banks left holding huge amounts of unsyndicated debt. This precipitated a large fall in deal volumes, with US LBO transactions falling around 70% from the second quarter of 2007 to the corresponding period in 2008, according to some sources.

Decreased returns
Unwillingness from banks to provide debt to finance transactions means an increase in equity contribution from private equity sponsors. This could result in a decrease in the expected returns of a deal due to managers being required to finance deals with more of their own capital.

Exit routes blocked
Between 2005 and 2007, leveraged recapitalisations provided liquidity to private equity investors in exchange for an increased interest burden for the underlying businesses. This option no longer exists, and many portfolio companies find themselves hindered by this increased debt burden and, consequently, their medium-term prospects have become more challenging. It is expected that managers will continue to find near-term exits for these businesses particularly difficult.

Deployment dilemmas
Large and mega-cap managers, who raised unprecedented pools of capital through 2006 and 2007, are now facing capital deployment challenges. This is giving rise to style drift, meaning managers are pursuing strategies in which they have little or no track record of success. While imagination and innovation from private equity managers is welcome, there is a fine line between innovation and desperation and investors must be aware of this.

The full report can be found at www.watsonwyatt.com/research/whitepapers/wprender.asp?id=2008-EU-1008