I've spent a couple of days this week in Munich, hanging out with the private-equity crowd at their annual SuperReturns conference. It's been a slightly unreal experience, which has brought back memories of going to a First Tuesday dotcom networking party in the summer of 2000, some months after the tech bubble had burst.
The conference was full of people discussing deals that will never get done, investments that will never be made and funds that will never be raised. Everyone accepts this year will be a stinker for private equity, but no one can quite believe the good times are gone for ever.
The bad news for most of those in Munich certainly those at the mega-buyout end of the business is that they almost certainly have. Carlyle founder David Rubenstein tried to cheer up his audience with a chart that he said showed that the debt markets soon recovered from previous cyclical downturns, which, if repeated this time, would allow private-equity firms to start snapping up bargains again in depressed markets. But what his chart actually showed was a giant hockey stick that clearly indicated that for the last three years the debt markets were in the grip of a remarkable bubble.
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It was left to other speakers to point out that the banks were still sitting on more than $200bn of unsold loans that prevented them making new ones; that the hedge funds and collateralised loan obligations that used to be the main buyers for loans had disappeared from the market; and that the entire structured credit industry, including the ratings agencies, had fallen into such disrepute, it is almost impossible to see how this market can come back anytime soon. Without access to cheap bank debt, buyout firms cannot do deals and existing deals are hard to refinance, making them more likely to default.
Besides, even if the debt markets do recover in the year or so, private equity faces other challenges. The heat may currently have gone from the political backlash against the industry but no one believes it has gone for good. The UK and Germany have already increased taxes on private equity. The US is likely to do the same once the election is out of the way. Many private-equity firms also privately acknowledge they are coming under increasing pressure from their own investors to pay more attention to the social and environmental impact of their investments, rather than targeting purely financial returns.
That political pressure is only going to get worse if investments start to go badly wrong this year, as many expect. Many stockmarkets have fallen more than 15% from their peaks last year, which means that highly-geared investments may have fallen in value by 30%-40% or even more enough to wipe out the value of the equity in the deal. Many private-equity bonds are trading at distressed prices, which may simply reflect the lack of buyers, or could signal a risk of defaults. The loosening of bank covenants at the height of the boom should give buyout groups some flexibility to deal with an economic downturn. On the other hand, it may simply delay the inevitable reckoning.
Some private-equity firms have tried to put a brave face on their industry's predicament by suggesting the industry could adapt to new conditions. But none of the ideas I've heard sound entirely convincing. There's talk of focusing more on smaller and mid-size deals that don't need so much debt, or buying firms in emerging markets. But that's not going to help a mega-fund with $10bn to invest. They would need to make hundreds of small investments before they had used all their firepower.
Other firms have talked about side-stepping the banking market and going direct to sovereign wealth funds and other investors to fund big deals. But very few firms are equipped to do this or likely to be able to do so in the near future. Others have talked about focusing more on improving the operational performance of their portfolio companies, which is easier said than done. And all now acknowledge the need to show they are good corporate citizens as a way of heading off the current backlash.
But it is hard to believe any of this will alter the bleak outlook for private equity. Buyout firms can insist that stocks look cheap and that now is a good time to buy assets at distressed prices, but that's not much use if you can't borrow the money to buy them. Meanwhile, the credit crunch will make it harder for firms to exit existing investments, which means returns will suffer and it will become harder to raise new funds.
Inevitably, a lot of the private-equity firms that proliferated during the boom, many offering nothing much more than fancy financial engineering, will disappear like the dotcoms taking with them all the hangers-on who climbed aboard the bandwagon during the bubble. Somehow, I doubt there will be quite so many people in Munich next year.
Simon Nixon is executive editor of Breakingviews.com
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