Only a few months ago, European venture capitalists were becoming increasingly gloomy about the prospect of an economic upturn. The starkest evidence was provided in August in the UK in Deloitte & Touche’s third-quarter Private Equity Confidence Survey. Of the 770 venture capitalists surveyed, 80% of respondents expected the UK economic climate to decline over the next six months, an increase in pessimism from 55% in the previous quarter’s survey.
The survey also showed that 62% of respondents saw no hope of improvement for at least a year. Venture capitalists also harboured doubts over their ability to raise funds for investments, with 71% expecting this to become more difficult over the following six months.
And yet now, only a few months later we are being told that the private equity industry expects equity markets to bottom out towards the middle of next year. Private equity executives hope this will prompt a deluge of investment opportunities as corporates start selling non-core businesses.
So what has changed. It appears that 11 September increased the speed of the downturn. The effect on the market was to force valuations down and encourage companies to increase their divestment of non-core activities. I guess the faster valuations go down the faster they can be expected to recover.
Chris Ward, a partner in the Deloitte & Touche corporate finance team, is reported as saying there was a reasonable chance the private equity market would pick up as early as the second quarter of 2002. He said: “In the early 1990s private equity firms came charging out of the trap as soon as the markets hit the bottom.”
With many private equity funds having had they fingers burned by investing too heavily in the TMT sector in 1999 and 2000 no one is rushing to overpay any more.
Interesting. Private equity is one area where prospects look much rosier in Europe than in the US at the moment. First, Europe never quite had the extreme valuations seen in US markets and, second, private equity exposure among pension funds and insurance companies is still very small. Commitments to the asset class are, of course, increasing in Europe. In the US many institutions are actually over-committed and over-exposed to the sector. Of course, many funds that raised money in 2000 and earlier this year still have a large percentage of their capital left to invest. This is probably just as well, as many of the early investments are still under water.
I am told that not much business is currently being done. Companies want to sell, but future earnings forecasts are just too vague for private equity firms to price a business accurately. Business will get done, but not yet and not necessarily at prices vendors would like. It looks like 2002 will prove to be a buyers’ market. If this is true then it bodes well for private equity funds being set up now. They obviously won’t have the drag on their performance that comes from an exposure to last year’s bad deals and they can pick and choose new investments.
Private equity firms forecasting an upswing include Legal & General Ventures, Candover, Deloitte & Touche and BNP Paribas. They are all reported to have said that 2002 will be better for the industry than 2001.
Not everyone, however, is quite so optimistic that events will move so quickly. Cinven, the pan-European buy-out specialist, has conducted a survey of European investment banks with 51% expecting asset values to decrease. However, 92% of those bankers who foresee a fall in asset values believe that this presents buying opportunities for private equity firms. The difficulty is that, although valuations are coming down, it is difficult to predict when the market will hit the bottom. Despite the declining mergers and acquisition activity in Europe, 71% of the bankers surveyed expect to see increased participation from private equity firms in M&A deals – the lower level of deal flow being compensated by more sensible pricing.
The challenge for a lot of pension fund trustees is whether they can hold their nerve. Whilst a number of the more recent private equity funds are reporting bad news with write-downs of their portfolios the winners will come from those investors that can hold their nerve and continue to invest through the downturn.
Private equity has always been a case for regular steady investment. Those pension funds that try to catch up historic underinvestment in the sector over too short a time are likely to be very disappointed. A pension fund wishing to invest in the sector today from a zero exposure should set itself at least five years to reach their target exposure. The only way in which funds can sometimes be recommended to reach a target exposure earlier is to invest part of the account in secondary funds. This way a fund can build up exposure to funds of an earlier vintage. Fund managers are however, warning: avoid the 1999 and 2000 vintage funds at all costs! All the bad news may not yet be revealed.