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Private Equity Copes with Credit Crunch, Other Challenges

7/29/2008 --

Mega-deals on the decline, global deals on the rise, says Ross professor.

ANN ARBOR — The private equity business has felt an acute sting from the credit crunch as the frothy loan market that helped fuel mega-deals has fizzled out. But private equity isn't going away. It's just changing, says David Brophy (pictured at right), associate professor of finance at the Ross School and director of the Office for the Study of Private Equity Finance. Those changes and more will be up for discussion at Ross on Oct. 3, 2008, at the Global Private Equity Conference.In the following Q&A, Brophy shares his thoughts on the state of the private equity industry.

How has the credit market turmoil affected private equity funds, which mostly do leveraged buyout-type deals? Credit seems much tighter since banks are having a harder time selling loans in the marketplace.

Brophy: The debt crisis has affected private equity and it has hit the megadeal part of the market first and hardest because they're more public. They're also more touchy and sensitive to market conditions. And so that's caused some of the big funds to sort of come down market, into the middle market. The middle market, by and large, has stayed pretty strong. By middle market, we mean companies with $500 million to $1 billion in enterprise value.

So as the bigger private equity funds go to the middle market, what happens to the funds that specialize in that?

Brophy: If you look at the balance sheet of a private equity shop, you're likely to find that they put more dollars per deal into acquisitions than the venture capital people do. They will do fewer deals with the same amount of money than the venture funds. Then a big private equity shop will begin to look like an investment banking firm or a big commercial bank. They're not, but their size approaches that. They're built for scale and have a lot of employees. So how do you handle the smaller deal? When you look at the funds that do middle market deals, they're smaller, they have smaller staffs, they tend to be local or regional rather than national and not exactly welcoming visitation by their larger brethren into their space.

So that's still shaking out. What other direction are funds moving into?

Brophy: The other thing the big funds are doing instead of coming down the ladder is that they tend to go abroad. You can get different pricing overseas. But in the other markets, those guys aren't dumb. They know what's going on. You can no longer think that you can go into X, Y, or Z country and have your way over there. You can get screwed by the judiciary, the legal system, or even a parliament.

So is it more difficult to get a deal done?

Brophy: I would be careful about that assumption, because sellers are getting hammered as well in this market, and there are still companies that might take it in their mind that they don’t want to be public anymore and may be ready to come to the market. That's a strong motivation for a lot of companies and the jury is still out with respect to who wants to be public and who wants to be private, both in the U.S. and other countries.

So how are private equity funds putting their money to work?

Brophy: Well, they are doing it in ways they don't particularly like. They are having to put a little bit more equity in a deal. They are standing up to more difficulty in negotiations with lenders. Some would say they're finally having to earn their livings, although private equity was never easy. But before, it was a somewhat straightforward process. As long as the drive was to the northeast in terms of upside potential and as long as you could get fixed, rated debt and pay fees, you had very willing lenders. The lenders in those days would kind of bow down and touch their foot to the floor, hoping they could get to do the loan and do the deal. Now, as the worm has turned, the power has shifted in that sense back to the lenders, and it's tough to be a big private equity guy now.

But it's not impossible and these people are sharp and smart and react quickly. For instance, they're going out and buying back some of the debt from these deals. If lenders, in their view, are overburdened and want to get rid of the loan, they'll ask, 'How bad do you want to get rid of it?' If you've got debt out there on a company that the lenders are getting nervous about and they would like to get out of that and are willing to discount the loan, then you might do that. It helps you in two ways. You get a baked-in profit on the loan you bought and it takes that bank off the hook so when they get their act together, they will be a good lender again.

Will private equity funds change their behavior after this credit crisis, when things return to normal?

Brophy: I think people learn and change, always. Things rarely go back to exactly the way they were. So, as a byproduct, you have other types of avenues for financing that have shown up – the Private Investment in Public Entities market and the Special Purpose Acquisition Company. You have search funds. These are just different takes on the private equity process that are different in some respects from the orthodox private equity business.

We've seen a broadening of the scope of industries in which funds are willing to do deals. I remember years ago venture capital funds wouldn't touch retail. They wouldn't touch services deals. They sure as hell wouldn’t back a kid with a video game. You look around today, the deals that are tough to find are the plain old manufacturing deals.

So you see a broadening span of industries and you'll see a broadening or deepening of global interest. And those two will demand different skill sets. Private equity funds are going to have to expand their knowledge base. I know one fund that makes it their stock in trade to build a bank of executive talent. The beautiful thing about private equity is that it has greater flexibility, greater freedom of movement than a public corporation.

Is there still interest in the private equity courses among students?

Brophy: Oh, yes. It's there because the transactions are as old as dirt and it's not going away. This is not an overnight discovery on the part of the school. You think of Harvard and Stanford as the big private equity schools. Their location is great for that—Silicon Valley and Route 128 in Boston. But we've been doing it for a long time, since 1982. We are a general management school and our region was heavy in traditional kinds of companies. Nonetheless, there was sort of a guerilla movement with myself and others who were involved in getting a toehold in this field for the University and our school. So we built that over the years. It started out as Venture Capital, which was the generic term of the day, and it was a 14-week course that took you through venture capital and took you into private equity in the latter stage with buyouts and IPOs. Then the school began to break the course in two. We have another course called Global Private Equity.

Student interest is sort of pro-cyclical.When venture capital is hot, the venture capital class is jammed. When private equity is hot, the private equity class is jammed, and those two don't always coincide. But interest is still high because private equity has really been around for a long, long time. It hasn't always been the same and it hasn't always been on the front pages.

Hear more from Professor Brophy at the Global Private Equity Conference: Oct. 3, 2008, in Ann Arbor. Private equity, investment banking, and business leaders from across the country will gather to learn about the latest developments in private equity finance. Topics include how the green economy is impacting limited partners’ mix of portfolio investments; alternative investment vehicles; and private equity investing abroad. Keith Alessi, MBA ’79, of Westmoreland Coal Company and former CEO of Jackson Hewitt, will present the luncheon keynote.

More information.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu