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Private Equity Post-Op

11/3/2011 --

Firms at ZLI's annual private equity conference say a recovery is under way after the financial crisis, but a shakeout is on the horizon.

ANN ARBOR, Mich.—Three years removed from a major financial crisis, things in the private equity world are starting to look up.

Looking up, that is, for firms with proven track records who've managed their companies through the recession. There are a lot of private equity firms chasing a limited amount of money these days, and investors can afford to be choosy.

That's according to professionals at the annual Michigan Private Equity Conference, held Oct. 28. The conference — sponsored by the Samuel Zell and Robert H. Lurie Institute for Entrepreneurial Studies and the Center for Venture Capital & Private Equity Finance — draws together private equity professionals, investment bankers, and business leaders to get a pulse of the industry.

Private equity took off in the mid-2000s, with the growth of international markets and bigger deals. But some insiders got carried away, the financial crisis scrambled things, and the industry is now in "the reflective phase after a heart attack," said Stewart Kohl, co-CEO of the Riverside Co. in New York.

That reflection is going to come with some thinning of the herd. There are a lot of firms chasing capital, and not all of them will be able to raise their next fund.

"We're in a shakeout for sure," Kohl said during his keynote address. "Perhaps one-third of the private equity firms won't make it. Private equity is going to go through natural selection and we need to be a part of it. There are zombie private equity groups among us, the walking dead who won't be able to raise their next fund. It was too easy to raise a fund before, and now it's too hard. In this new era, the capital is going to gravitate to those who have done an outstanding job."

The shakeout will occur slowly over the next few years, he said.

John Higgins, BBA/MAcc '95, a partner at Huron Capital Partners in Detroit, noted there are about 1,600 funds in the market looking to raise $600 billion in capital.

"It'll be interesting to see how many get raised," he said.

But Higgins noted that exits and merger activity in general have picked up lately. Private equity firms are seeing successful exits — sales of portfolio companies — after a long freeze.

"We're certainly not back to where we want to be, but the trends are in the right direction," Higgins said.

So what kinds of funds will be the winners? A panel featuring limited partners — those who invest in private equity funds — provided some answers. Firms that actively worked with their portfolio companies during the financial crisis and drove higher margins during the recovery are in the driver's seat.

Charlie Huebner, MBA '85, managing principal and co-founder of RCP Advisors in Chicago, said that all funds talk about their distinguishing features. But sometimes what you thought was great exit due to a firm's strategy was nothing more than good market timing. The financial crisis changed that.

"In the bad environment, we saw who was going to work to cure the company, maintain value, and work through it," Huebner said. "The separation became very obvious."

Since overall economic growth is expected to be small for some time, many companies in a private equity fund's portfolio won't have a tail wind. So the funds who manage their companies well have an advantage.

"Some sectors are doing well, but by and large it's anemic," said Clayton Miller, partner at private equity firm Stone Arch Capital LLC in Minneapolis. "So which companies can you effectively muscle EBITDA (earnings before interest, taxes, depreciation, and amortization) out of? In an economy that grows at 1 percent, there's no tail wind. You have to find a way to force the growth. You have to drive it."

Where does that put new funds with little track record? Quan H. Mac, director of the investment management group for family office RDV Corp., said she spends a lot of time studying the private equity firms coming to market for funding.

"Our trick is do we stay with the funds we know, or do we want to look at the next great funds in the space," she said. "We put out about the same amount every year. Who do we want to deal with for the next seven to ten years? I'm trying to get to know a lot of different funds...We don't do many first-time funds, but we follow opportunities."

She also said she looks for funds who want their investors to be partners and not just a source of money.

Another issue facing private equity firms is a new restriction on bank investing in the Dodd-Frank Wall Street Reform and Consumer Protection Act. That law prevents banks from investing more than three percent of their capital into private equity funds. Also, a bank can't be more than three percent of the total in a particular fund.

There was grumbling about this rule, with some noting that private equity funds were not the cause of the 2008 financial collapse.

"I don't see how our funds are a systemic risk to the economy, but somebody in Washington thinks so," Miller said.

But there is a way around it. Banks can disregard the restriction when investing in funds registered as small business investment companies, or SBICs. This involves licensing by the U.S. Small Business Administration.

Matthew Hook, a partner at Centerfield Capital Partners in Indianapolis, said his firm is setting up an SBIC just for that reason. The good news is that the U.S. SBA is more sophisticated and easier to deal with than in the past, said Melford Carter, principal at Credit Suisse Customized Fund Investment Group.

Riverside's Kohl said there are some things private equity can do as an industry to improve its lot. First, it needs to overhaul its public image.

"How we're perceived by the press, the public, and business owners isn't good," he said. "We can change that by speaking out."

He noted that private equity funds provide the capital businesses need in good times and bad, create jobs, and generate returns for investors. The wave of failures that was predicted hasn't happened, and that's due in part to private equity's ability to marry financial capability and intellectual capital.

He also suggested that private equity funds become more specialized.

"It's better to be expert at one thing than average at a number of things," he said. "The good news is that there are many more industries in play for private equity."

Private equity in the past played mostly in the manufacturing and distribution sectors, he said. Now technology, banking, services, and infrastructure are all open to private equity ownership.

Kohl said public markets are less effective at meeting the needs of middle-market companies. Private equity gives family run or founder-run businesses that have reached some size the ability to grow and profit from their work.

"As an industry now, we need to make the right choices if we're going to be viable and grow," he said. "It's all about hard work and adaptation. Charlie Darwin really did have it right."

Terry Kosdrosky



For more information, contact:
Terry Kosdrosky, (734) 936-2502, terrykos@umich.edu