Some of the problems are externally generated; but many are self-inflicted. The difficulties of 3i, its shares at a 75 per cent discount to book and below their issue price, is a demonstration of the underlying crisis.
Many limited partner (LP) investors are finding it difficult to meet their capital calls, thanks to a lack of liquidity. Permira has already announced that it will not draw down 40 per cent of its last fund. Institutions over-committed to the asset class, assuming that cash returns would continue as normal. But exits have stopped, so LPs are getting no money back. Meanwhile their other allocations to assets including property and equities have plunged in value. SVG, the quoted fund of funds, has launched a rescue rights issue to prevent it defaulting.
Most major buy-out houses have carried out over-priced, over-leveraged deals that are underwater. Examples abound: EMI, Boots, Countrywide, Harrahs, Hilton, McCarthy & Stone, GMAC, Chrysler, Freescale, Gala Coral, Pilgrim's Pride and so on. In some, the bond prices indicate the equity is worthless; for others, the LPs have revealed huge writedowns. No doubt at year-end many auditors will insist on painful impairment provisions. The total paper losses will be at least $50bn – and quite possibly more.
Inevitably, gearing has amplified these. An astute observer of the scene in New York suggested participants should assume a 40 per cent markdown in values from June to December this year.
There are various reasons for the wipeouts. Companies were bought on multiples that were too high; many are not meeting budgets and have seen revenues and profits fall. There will be plenty of covenant breaches
in 2009. Most over-borrowed companies in trouble will see their debts restructured by the banks – and the buy-out owners will be diluted out of sight.
I pray that not too many investee companies go bust, so leading to huge job losses. The complete liquidation of companies such as Linen 'n' Things and Mervyns in the US – both healthy retailers when they were bought
– is fuelling accusations that private equity players are asset-strippers of the worst sort.
The true secret of private equity performance in the past five years was that bumper exit prices delivered a big chunk of their amazing returns. A rising market led to multiple arbitrage, which almost guaranteed that even dull investments did well. But that merry-go-round has stopped. If anything a reverse spiral of falling prices applies. Now
there has to be real value added
– which is much harder work.
Too high a proportion of profits in the 21st century have been generated from financial engineering rather than through sales growth and improved productivity. A classic example of an industry that has been financially engineered to near death is the UK pub trade.
Over the past 10 years freehold licensed houses have become
a magical vehicle for complex funding structures and lucrative City fees. I admit I am not blameless in this sorry saga, since I was a founding shareholder in Punch Taverns. But the impact of the economic downturn, cheap supermarket booze and the smoking ban, combined with too much debt and desperately underinvested estates, mean large portions of the industry are to all intents and purposes insolvent. Tenants cannot pay rents, there is too much securitisation and customers have gone. The future for the local pub appears bleak.
All the most profitable tricks
– recapitalisations and endless pass-the-parcel secondary buy-outs – are history. The debt and bond markets are almost shut, so funding new transactions is
a massive challenge. In any case, firms are fully preoccupied salvaging underperforming portfolio companies. Meanwhile, the public is looking for fat cats to blame for the recession, and LPs are questioning the old 2 and 20 golden formula (2 per cent of assets and 20 per cent carried interest on gains) that has worked so nicely – for general partners.
It looks like private equity is faced with having to work harder for somewhat less – just like everyone else . . .
