A Shakeout of Private-Equity Firms Is Inevitable

The private-equity model is here to stay, but the shakeout will significantly change the shape of the industry that will create opportunity for entrepreneurs! I believe that the industry is in at the maturity phase of “product life-cycle” with approaching a point of infection. In fact, Private Equity industry is in the middle of the perfect storm that will create significant opportunity for the emerging entrepreneurs or new type of PE firm who actually know how to build and grow a business (i.e. sector focused executives)!

Private-equity firms have enjoyed extraordinary growth and returns over the last five years, but the collapse of the world’s debt markets and the deepening economic crisis have brought this boom to an abrupt end, with potentially severe consequences for private-equity firms, the companies they own (so-called portfolio companies), and the real economy. Nearly all private-equity firms were able to grow exponentially thanks to an unusually favorable financial and economic climate and, in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all industries, escalating asset prices, and the allocation of significant assets from institutional investors to private-equity funds. The recent financial and economic crisis has sent all these drivers racing rapidly in the opposite direction. The debt bubble has burst and a business owner must go back to the basic (i.e. running and building a good business)!

The biggest impact of the perfect storm will be on the private-equity firms themselves and according to BCG around 20 to 40 percent of these firms will disappear; on the other hand, at least 30 percent will survive. The fate of the remaining firms will hang in the balance. The TRUE operation focused PE firms will emerge gain grounds on the next phase of the “life-cycle” because the key players of the firm must understand how to fix and grow a company. Traditional PE firms leaders lack this vital requirements (although, they have been trying hard to fill the gap by hiring “industry operators” that may not be enough!)

Some obvious things are happening such as company earnings have dropped, multiples have collapsed, easy credits are gone, publics are demanding higher accountability from employers, and government /regulatory authorities are scrutinizing more on the issue of “fare play or not—high concentration of wealth at expense of many”! Most private-equity firms’ portfolio companies are expected to default and the overhang of LBO debt on banks’ balance sheets might be as small as $50 billion to $80 billion because banks have already offloaded or written off most of their LBO debts. Some calculate that the potential book loss from the defaults is about $300 billion—on the basis of an estimated LBO debt of around $1 trillion for the entire market and assuming a current value of this debt will remain true (i.e. value will not decline further). This may give another shock in the financial system! Another potentially hidden time bomb is collateralized debt obligation (CDO) and it’s nearly impossible to estimate the level of exposure since CLO debt is not transparent (what a surprise!!). We believe, many PE owned portfolio companies are expected to default on their debt obligations (covenants) within the next 2-4 years that will potentially create opportunity for new comers with entrepreneurial spirit and TRUE operating experience. Fund investors/LP are likely to favor firms that have produced top-quartile, long-term performance, or a new type of PE-firms with first-hand operating experience. Knowledge of shuffling money around may not be enough to create long-term value! Just ask, “What will the owners of the equity and debt do when there are defaults?”