Count private equity among the many casualties of the credit crunch. As liquidity has dried up, so too have the deals. And even though the frothy mood of the past two years probably won’t return anytime soon, the virtues of private equity are expected to help it preserve its place in the capital markets.

Until the credit crunch hit in mid-August, the size and volume of private-equity buyouts were growing rapidly and attracting plenty of attention. The total value of investments in Canadian companies by buyout funds more than doubled to US$10.9 billion in 2006 from US$4.5 billion in 2005, according to Canada’s Venture Capital and Private Equity Association. The trend continued through the first half of this year, with a rash of leveraged buyouts — including the biggest Canadian deal ever, the $52-billion takeout of BCE Inc.

The surging popularity of private equity seemed to herald a shift away from public markets. And the growing size and prominence of LBOs had some recalling the junk bond kings of the late-1980s, sparking fears of predatory asset stripping and outrage over fund managers’ compensation.

Defenders of the private-equity phenomenon argued that it does plenty of good for the market and the economy. By taking over inept companies and flushing entrenched, underperforming managers, private-
equity firms can ramp up corporate efficiency, improve resource allocation and enhance productivity. Moreover, going private allows companies to escape increasingly onerous and costly public market regulation. Taking firms private also allows managers to escape the tyranny of quarterly earnings expectations, letting them focus on the long term.

Whether these arguments are valid, it seems that none of them are powerful enough to overcome the financial realities underpinning the buyout boom. As credit markets have been disrupted, and liquidity has disappeared, so too have the private-equity buyouts (many of which rely on substantial leverage).

LBO deals virtually disappeared from the Canadian mergers-and-acquisitions market in the third quarter, according to Toronto-based investment bank Crosbie & Co. Inc. The bank notes that financial buyers, such as private-equity firms, accounted for just 9% of the value of transactions worth more than $100 million announced in the quarter. This is down sharply from 42% in the prior quarter. It also noted that there wasn’t a single financial deal of that size announced in October.

The reason for the sudden drop in LBO activity is the tightening of credit conditions worldwide, which has removed a central source of fuel for the private-equity flame. When money was cheap and plentiful, buyout funds could afford to make heavily leveraged deals with reasonable certainty that the companies being taken out could be cleaned up and run profitably enough to easily service the low-cost debt. This willingness to leverage much more heavily than a strategic buyer meant that buyout firms could handily outbid strategic acquirers.

But now that lenders are backing away from large financings, the money to make these sorts of deals is no longer there. Whatever high-minded theories may favour private over public equity, the arguments are moot without the cash to fund these sorts of deals.

As a result, analysts are questioning the resilience of the buyout boom. The current dearth of deals is hardly sufficient evidence to declare LBOs definitively dead. The effects of the credit crunch are still being worked out and the full measure of the fallout has yet to be revealed. However, the evolving credit conditions dim the prospects for big buyouts in the months ahead.

A UBS Wealth Management Research report suggests that the spread between the free cash flow firms can generate and their debt financing costs “will go a long way toward determining the future course of private-equity activity.” UBS predicts that this spread will narrow in the year ahead and that the importance of private-equity buyouts will shrink as a result.

UBS also points to a couple of other factors likely to affect private equity’s prospects: the tightening of lending conditions, investor attitudes to LBOs and the prospect for government intervention in the U.S. and Britain to tax buyout fund managers’ compensation more heavily.

These things are particularly relevant to the Canadian buyout market, which is largely composed of foreign investors. Only about 27% of 2006’s record buyout investments came from Canadian-based funds, according to CVCA data. The bulk of these investments came from foreign players: almost 38% from U.S.-based funds, and just under 36% from funds based throughout the rest of the world.

@page_break@Overall, UBS concludes that the conditions for private-equity deals have deteriorated: “Private-equity companies will continue to work to generate earnings from their portfolios of acquired companies, but new acquisitions will prove more difficult and perhaps even less financially advantageous.”

This could cause private-equity companies to revise their strategies to adapt to the new environment. UBS predicts that this may mean less reliance on leverage, pursuing smaller targets, taking more minority positions and a greater focus on emerging-market companies.

Despite the fact that this sort of shift in focus may indeed be required by private equity funds, the industry is far from dead. There is still a role for private equity and a demand from investors for the sorts of returns it can provide — just not at the boom-like levels of the past couple of years. Deutsche Bank Securities Inc. predicts that despite the tougher credit conditions and the possibility of negative developments (such as unfavourable tax reform), alternative asset managers (including private-equity firms) should enjoy 20% annual growth over the next 10 years.

DBS notes that the private equity business tends to be one of booms and busts. It adds that the industry likely faces a slowdown in the short run, but that it should be able to sustain long-term growth due to the value buyout funds can create by improving operating performance at companies, their ability to raise capital and a greater willingness among corporate managers to work with buyout firms. The latest boom may be over, but DBS sees the industry revisiting these levels in the next two to four years.

The McKinsey Global Institute also argues in favour of continued growth in private equity over the next few years. In new research examining what it believes will emerge as increasingly powerful forces in the capital markets in the next several years, MGI’s base case scenario projects a doubling in worldwide LBO assets under management to US$1.4 trillion by 2012 from about US$700 billion today.

That forecast assumes a notable slowing from recent trends. If current growth rates are maintained, assets would rise to US$2.6 trillion, MGI reports. Under a gloomier scenario of increased regulatory intervention and defaults by some of the companies that have recently been taken private, it suggests that growth could slow significantly, leaving AUM to inch up to just $770 billion over the next five years.

But MGI suggests that private equity’s influence extends well beyond its asset size. The prominence of buyout funds as players in the M&A area means that their practices spill over to other firms that want to avoid becoming takeover targets. MGI maintains that this has sparked changes in corporate governance and caused public companies to give more thought to efficient capital management (how they use debt and equity to fund growth). By taking out underperforming companies and turning them around before refloating them, and by prodding other firms to pull up their socks to avert a possible takeover, MGI argues that private equity firms may be bolstering public market returns in the years ahead.

Whether private-equity assets continue to grow, and by how much, will also depend on their performance. MGI reports the evidence is mixed. Its research finds that buyout funds have underperformed U.S. public-equity markets over the last 10 years. As a result, it foresees these funds consolidating as the industry evolves in the coming years.

One possible big customer for buyout funds in the near future are so-called sovereign wealth funds (government-controlled investment funds), which are expected to see rapid asset growth and increasing diversification into riskier holdings. UBS suggests that greater investment in private-equity funds from SWFs could prop up their position in the M&A market.

A rival view is that the existing SWFs’ asset allocation has served as a support for private equity. Recent research from Merrill Lynch & Co. Inc. proposes that SWFs’ marked preference for fixed-income over equity has caused an overvaluation of debt vs equity, and so, “the private-equity industry boom in recent years could be viewed as an attempt by the market to arbitrage away the overvaluation.”

Merrill Lynch is predicting that SWFs will move into riskier assets in the years ahead; and so, it says, such a shift, “would remove one of the pillars of the private-equity industry.”

Forecasting the future of private equity — particularly amid a decidedly uncertain credit and economic environment — is an exercise in speculation. For now, it appears the boom is over. That should spell the end of the very pricey LBOs, but it doesn’t mean bloated, underperforming public companies can breathe easy just yet. IE