Private Equity: Dead or Just Resting?

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Byline: ANTHONY HILTON

ONE of the big questions brought on by the credit crunch is whether the private-equity industry is dead, or as Michael Palin famously argued about the Monty Python parrot, merely resting.

However, it is a debate that operates on all sorts of levels.

Clearly, for example, it is impossible for an industry to do deals financed by debt when there is no debt available so it is no surprise the value of transactions done in the last quarter was, according to the Nottingham Centre for Management Buyout Research, the lowest for 15 years.

Similarly, it is obvious that the performance of funds will be disappointing if they were major participants in the boom of 2005 to 2007 when acquired companies were loaded with unprecedented amounts of debt.

In many of these cases, there was a minimal cushion of equity and when equity accounts for only one fifth of the capital in a business, the shareholder is wiped out by a 25% fall in the value of the debt.

That sort of decline is commonplace.

Clearly, this is going to disappoint investors, and embarrass those who were relying on profits from these early investments to finance later privateequity commitments.

What is less often discussed is the effect this will have on the executive management actually running the business, who made the Faustian pact to do what had to be done to turn the business round in return for a massive, equity-based pay off in three or four years' time.

The problem is particularly acute, not in private equity-backed businesses which have run into trouble because in such cases the management would expect to be turfed out.

According to Andrew Spiers, a restructuring expert with financial advisory firm Hawkpoint, it actually occurs in companies where management has done everything expected of it in terms of boosting sales, increasing profits, cutting costs and improving all the businesses' ratios.

This performance still turns out not to be enough because changed conditions in the credit markets mean the business will never again be valued as highly as it was in 2006-7.

What the executives have to confront is that no amount of effort by them, even if they shoot the lights out for the next four years, is going to increase the worth of the business enough to compensate for the collapse in its debtfuelled value.

It is never going to command the price it fetched when it was bought with underpriced debt.

Thus as the equity is and will always be worthless, the entire basis of their incentivisation has collapsed. …