Now that the credit crunch has added to private equity's usual challenges of political sniping, difficulties around valuations, illiquidity and manager selection, Joseph Mariathasan assesses the outlook for the mega-deal and mid-market players

Everyone wants to be loved, even the masters of the private equity universe. Unfortunately for the private equity community, their public image has been tarnished in recent years, despite or perhaps because of record returns. "People make snide remarks because a few guys made a lot of money and paid little tax," laments Christopher Bödtker, CEO of LODH Private Equity(pictured right).

And private equity professionals worry that they may become less welcome than German tax inspectors at the après-ski parties on the more exclusive slopes of Europe. Their image may be even worse among the public due to tabloid headlines describing events such as the airline caterer Gate Gourmet, owned by Texas Pacific Group, which sacked some of its workforce by megaphone. The nadir came in 2005 when German Social Democrat chairman Franz Müntefering compared foreign private equity investors with an invasion of locusts stripping companies bare.

The private equity industry has since spent a lot of time in contemplation and angst as it struggles to combat a negative public image while experiencing what for many firms, have been outstanding returns.

Politicians like to attack private equity for other reasons than private equity professionals earn too much and pay too little tax. "The mega funds in particular are under attack by politicians because they are scared of the financial power wielded by these funds," says Bödker. "It also gets coupled with negative rumblings from trade unions in the UK and Germany. They paint them as the bad guys as they restructure companies with changes that are long overdue."

The private equity industry has been striving to respond to criticisms. The British Venture Capital Association and a group of leading private equity firms, for example, issued a report commissioned from a working group headed by Sir David Walker in November 2007 on guidelines for disclosure and transparency in private equity.

The mega funds have dominated the headlines and have attracted most of the criticisms over the past few years but in the post-credit crunch world, in the short term at least, it will be a much more difficult environment for them to thrive. As a result, as Hanspeter Bader, (pictured left) head of private equity at Unigestion in Geneva, notes: "Now mega funds are in a defensive position the politicians will calm down again pretty quickly. The political arguments always lag the facts. Politicians became very nervous on the compensation, taxation and transparency issues when the mega buyout market was at its peak. The fact that some of the mega funds do less well in certain periods can take the air out of the discussions."

Moreover, Bödtker points out that most of the mud slinging in Germany has taken place at the federal level: "At the state and municipal level, politicians are much more pragmatic as they see the benefits and are keen to see local companies restructured to become more competitive." Indeed, Marcus Shadbolt, the co-founder of Beamreach Growth Capital in London, argues: "In Germany, for years everyone has been talking about the Mittelstand opportunity but it has hardly materialised. Private equity had a bad name in Germany with the locusts debate and so on. This is changing now with more deals being done."

Given the potential for political criticism, as well as the difficulties arising from valuations, illiquidity and manager selection, it is not surprising that institutional investors are often wary of devoting too many resources to private equity. For Mike Powell, responsible for private equity investment at the UK's Universities Superannuation Scheme (USS), private equity occupies the high-return category in the fund's alternatives portfolio. "We expect our private equity programme to deliver a sufficient premium to public equities to compensate for the additional risk. We estimate this premium to be in the region 2-4% on an annualised basis."

A key disadvantage of private equity is its illiquidity, and even with the growth of the secondaries marketplace it can be an expensive and difficult procedure to liquidate investments before the end of a fund's lifetime. But as Powell points out: "USS has a long-term investment philosophy, which we consider a competitive advantage."

While some Ivy League US university endowments are famed for their aggressive approach to investing in private equity using their own in-house managers, few institutions in Europe have large enough private equity portfolios to warrant the resources required to manage it in-house. However, USS has taken the view that given its size it has sufficient scale to build a dedicated in-house resource to select managers, according to Powell. "The economics vis-à-vis the fund of funds route are compelling even with a significant in-house team," he says.

But for most institutional investors approaching private equity, there is no real alternative to the fund of funds route for gaining exposure. Institutions approaching the asset class with a blank sheet of paper will also need to be prepared to invest over a number of years to gain diversification across vintage years as well as across sectors and geographies. Gaining exposure to a secondaries fund can be useful in this respect by providing an element of exposure to previous vintage years.

The credit crunch has clearly transformed the environment for private equity. But as well as pitfalls it creates new opportunities, and these will change depending on the timescale being considered. Bödtker sees the current scenario as a "valuation reset". He says: "Equity values are being reset by first and foremost credit availability and credit terms and secondly concern about the outlook. On a structural level, there is also less leverage and all these factors are driving private equity valuations back towards more normal levels." As he sees it, the danger is that the process will take some time and liquidity is an issue in the meantime.

"Lenders are much less aggressive, with new debt packages in some segments reducing by as much as 50%," says Shadbolt. "A year ago a solid business at the bottom of the middle market might support a debt package of four or five times EBITDA, now it's two and half times EBITDA and banks are generally being more selective."

Richard Green, CEO of August Equity, adds that this will result in generally reduced price expectations. "As a result, you will see more trade sales as companies feel they can more easily compete with the private equity firms," he says.

While manager selection is the most critical aspect of private equity investing, the more astute investors would acknowledge that at certain points in the economic cycle, superior returns can be generated by ‘tilting' the portfolio to certain strategies, Powell says. "In the early part of 2007, USS made a number of commitments in the distressed debt space as we believed that we were nearing a turning point in the credit cycle and were increasingly concerned about the amount of leverage being deployed in some LBO transactions," he says.

Distressed and turnaround funds have also been in vogue and for Powell the use of complementary strategies such as distressed and mezzanine debt are a key part of the portfolio construction process in order to generate superior returns irrespective of market cycles.

They can be a victim of their own success: "So much money has been raised that deals are being piled up so distressed securities might never fall enough to make them really attractive before someone buys them," says Bader.

Bödtker finds that his own investors can be divided into two types. "Those who are a little scared and experienced investors who all have one question: ‘how can we take advantage of this?'"

Unigestion was also very surprised about investor behaviour, says Bader. "Many investors are saying that they know the party we have had for a couple of years can't continue. They are pleased that some of the air is going out and that people can buy good businesses with lower leverage and lower risk levels, so are happy."

Mega funds with their highly leveraged deals have been the worst affected by the credit crunch. The syndication market is largely closed and there are hundreds of billions in write-offs to work through the system. Bader says that deal activity slowed, especially in mega deals, in late 2007.

Not surprisingly, the general consensus is that mega funds will be defensive over the next 12-18 months, Bader says. "They will have to deal with the issues in their portfolio companies or announce that they are pulling IPOs or delaying them. The mega funds will be in the headlines for the IPOs not being done. So short term, the best opportunities are not with them. But in 24 months' time, these firms will come back as strong as before and will have good acquisition targets."

The private equity mid-market arena encompasses an enormous diversity of firms separated by geographic reach, sector expertise and size. Even strong in-house teams such as that of USS are finding that they need to explore using external advisory services or non-discretionary funds of funds in areas such as the US mid-market where, as Powell argues, the geography and sheer number of managers makes a strong argument for having specialist local expertise.

Given the large size of its programme, USS' initial focus was on managers in the upper mid-market and large buyout space in Europe and the US. "As the programme matures, there will be an increasing exposure to the lower mid-market and more specialist sector and country funds," Powell explains.

"Lots of people thought the credit crunch was only an issue for mega funds," says Bader. "But today, the debt on the balance sheet of lenders has had an impact on the mid-market."

But for some mid-market players like Beamreach, the credit crunch has proved to be generally good news. "Some deals at the bottom end of the market were being financed without private equity by using vendor loan notes and aggressive debt packages," says Shadbolt. "This is no longer happening, so they need private equity capital. There are also signs that price expectations are being realigned, though we believe there is some way to go there."

Green finds that while the credit crunch affects all parts of the market, the lower mid-market is less affected as, usually with a 50:50 debt/equity ratio, it was never reliant on large amounts of debt. Bader agrees: "The mid-market is certainly the better placed to benefit from the current situation in Europe and the US. They can claim that they are less leveraged, and focused on adding value rather than financial engineering. There is a strong position for the business case and they will have attractive prospects for the next 12-18 months."

While private equity firms have moved to larger transactions that have continually raised the thresholds for defining mega funds, it has left the bottom end looking increasingly sparse. The effects of the credit crunch may cause a shift back downwards.

August Equity's core market is the lower mid-market of around £10-50m (€13-64m). "It tends to be the unloved parts of large corporates that want to divest, or privately owned businesses where the owners are retiring," explains Green. "We do deals where growth is the main driving factor. That is what has driven substantial growth and a record number of exits in recent years, so we are now managing the smallest portfolio we have had for 20 years."

When it comes to adding value, the focus is on operational improvement, Green says. "Financial engineering went out 10 years ago. You can't make money by buying a company, increasing gearing and then selling it. You need growth, both organic and acquisitive. We focus on areas such as improvements in operations and basic buying, and can introduce people to get greater performance who can be full time or from our network of specialists in finance, sales, marketing HR and recruitment. We always put in place a non-executive chairman with a background in the industry."

Going even further down the capitalisation spectrum in the mid-market sector, Shadbolt argues that the most under-served area is the non-technology segment of the market requiring less than €13m of equity. For example, 3i has dismantled its UK regional network.

The cost of undertaking smaller deals is relatively expensive for a portfolio manager. Beamreach has developed a tailored model to make the economics work for investments in smaller businesses with a relatively conservative risk-return profile. "We are very unlikely to make 20 times on any investment but we aim to make at least two times on every one," Shadbolt says.

Venture capital markets have been a disappointment in Europe for some time. Even in the US the huge dispersion of returns makes it a highly risky sector to enter if you are not able to get into the so-called fortress funds, such as Kleiner Perkins or Sequoia that are virtually closed to new investors.

USS does not currently have a venture programme. "The key issue for us is whether we can deploy sufficient capital to the top-decile managers in order for the venture capital programme to make any material contribution to the overall private equity portfolio and justify the required amount of internal resource to fund the programme," says Powell. "This issue is particularly important for venture given the concentration of superior returns in a very small number of managers whose capital capacity is constrained by the nature of the strategy and their previous success."

"Venture is not what I would call a core investment focus, Bader says. "We do invest in venture firms if they are clear leaders in their space. It is not a segment that we have a lot in and it represents 15% of the total portfolio."

For Bader, the other winners of the credit crunch should be mezzanine funds. "In good times, mezzanine gets squeezed out of deals as it is more expensive than bank debt. But now that banks are not lending mezzanine becomes an alternative. So for the next 12-18 months, mezzanine funds will be in a nice negotiating position. Their attraction will fall when banks begin lending again."

USS has taken advantage of this situation. "During the summer of 2007 we also committed to a large mezzanine manager as we felt the unfolding credit crisis was presenting some compelling opportunities in mezzanine and subordinated debt," says Powell.

"It is a shame that private equity has had a bad press," says Shadbol. "I got into private equity because I genuinely thought it was the acceptable face of capitalism. I am slightly less naïve now, but it is attractive to be in a business that can create value and sustainable employment. Its role as a positive agent for change still hasn't been communicated properly."

However, for private equity to remain an attractive asset class the industry needs to ensure that its message is communicated effectively before politicians scent easy electoral points through aggressive legislation that may end up being more detrimental to the economy than any supposed swarm of locusts.