Investors seek private equity amid weak markets

The biotechnology sector is expected to see further consolidation Keystone Archive

Management buyouts (MBOs) are expected to pull investment money this year amid better prospects for the economy.

After last year’s slump in MBOs – only 34 transactions compared with 44 in 2000 and 48 the year before – experts are expecting a good year, amid improved prospects for the economy as a whole.

“Now that the economic turmoil appears to have levelled off, 2002 looks like it will be a good year for MBOs,” says Rudolf Lyner, CEO of CapVis Equity Partners AG, a private equity house preparing to raise a new buyout fund this year.

In Lyner’s view, MBOs are likely to be driven by the continued lack of liquidity on the public capital markets. Investors are still holding back from investments in publicly traded companies with the result that there is a dearth of IPO opportunities.

Indeed, so-called “old shareholders” who expected to cash out in a 2001 or 2002 flotation, will look to sell their shares to private equity investors rather than the public market as a way of achieving liquidity.

“An MBO might be the most attractive alternative to an IPO,” Lyner says, adding that he expects to see “more secondary buyouts, such as the Soudronic transaction [the largest buyout in Switzerland in 2001]”.

No competition from banks

Another reason why MBOs are likely to do well this year is because “banks will continue to shrink from the MBO market, leaving the field open for specialised funds”, according to Philipp A Hofstetter of PriceWaterhouseCoopers in Zurich.

Hofstetter points to an expected increase in industrial spinoffs and corporate restructuring, where business units that are not part of a company’s core activities are sold off in order to generate fresh capital.

A related trend is the public to private transaction or stock market de-listing. “Low stock prices and poor stock market liquidity will drive public companies to go private – seeking private equity financing as an alternative to public money,” says Hofstetter, referring to the type of transaction that sees a public company de-list itself from the stock exchange in order to seek new shareholders via a private placement.

European industries most likely to see intense buyout activity this year include chemical/pharmaceutical, real estate, insurance, telecoms, and financial services. “For Switzerland, the field would also include logistics firms, electronics, and retailers,” says Hofstetter, adding, “Biotechnology will also increasingly see consolidation.”

Bulls vs bears

The jury is still out on what returns private equity investors, and buyout funds in particular, can expect from MBOs this year.

The bullish argue that a “vintage year” is in the offing, but Dr Roberto Paganoni, of LGT Capital Partners, warns it could go either way. “Arguments can be found for a bear perspective – price-earnings ratios for private companies remain high, for instance – but there are equally strong arguments for a bullish outlook.”

Returns on MBO funds dipped in the 1990s after two decades in which buyout fund managers achieved great gains because they were able to buy equity at low prices and sell high.

The boom ended in the 1990s when increased competition for deals from the public markets, as well as corporate acquisition sprees, pushed up the value of companies quickly, translating into higher prices for shares in private companies and lower returns for buyout funds.

Today there is still strong competition for deals which could keep valuations high. “Despite strategic corporate buyers retreating from the scene, there remains $300 to $400 billion of private equity acquisition power available still to be invested,” says Paganoni.

The bullish argue that returns in 2002 are likely to be boosted by a rise in the number of “distressed sellers”, who are unloading because of the tough economic climate.

They say companies are also more willing to seek capital from private equity sources following an intense round of corporate restructuring and growing debts among over-leveraged firms.

“History shows that funds raised in tough economic times have done remarkably well,” says Paganoni. “Buyout funds should over-perform if they have active management teams who are industry-oriented and able to manage turnarounds.”

Typical investors in private equity include institutional investors (such as pension fund managers) looking to beat inflation and the stockmarket, funds-of-funds, and asset allocator funds. “Pension funds are becoming interested in buyout funds,” says Lyner.

Private equity boom

MBOs are part of “alternative asset class private equities”, which are increasingly attracting institutional investors. European private equity fund commitments have almost doubled since 1999, reaching €26.7 billion in 2001, according Goldman Sachs and Frank Russell.

When an MBO takes place, a firm’s ownership is shared between private equity funds and the management team running the company. “Buyout managers also have to manage their portfolio firms, participating in board meetings and helping with strategic decisions, so experience counts,” says Lyner.

The increase in the appeal of private equity is due primarily to the impressive returns earned by some institutional funds and by a change in pension investment laws.

“The classic example of pension fund investment in private equity is CalPERS (California Public Employees Retirement fund),” says Paganoni.

The fund, one of the world’s biggest, had an enviable performance in the 1990s, achieving an average return of 19.6 per cent between 1990 and December 2000, proving that private equity can outperform other asset classes, such as the stock market. The Standard & Poor 500, an index of blue chip stocks, averaged 15.27 per cent a year through the 1990s.

High returns for the rich

Those who manage to invest in the upper quartile of a private equity fund can expect to make returns of upwards of 12 percent based on the measurement of an “internal rate of return”. “Only those fund managers that have a proven track record will be able to raise new capital from investors,” adds Paganoni.

But investors must also be aware that there is also a lower quartile. Paganoni points to statistics from the US private equity market. “In this group returns are often less than five percent. Therefore, it is critical that investors know who the top fund managers are.”

Furthermore, private equity is an illiquid class of investment for the long term. For this reason, many fund managers offer “funds of funds”, investment vehicles which give investors exposure to the private equity asset class but reduce the risk by spreading it over a diversified range of selected private equity funds.

by Valerie Thompson