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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

OCTOBER 2009
NUMBER 267b

Chicago Fed Letter
When Worlds Collide: The Altered State of Private Equity—
A conference summary
by William Mark, lead examiner, Supervision and Regulation, and head, Private Equity Merchant Banking Knowledge Center,
and Steven VanBever, lead supervision analyst, Supervision and Regulation

The Federal Reserve System’s Private Equity Merchant Banking Knowledge Center,
formed at the Chicago Fed in 2000 after the passage of the Gramm–Leach–Bliley Act,
sponsors an annual conference on new industry developments. This article summarizes
the ninth annual conference, held on June 25–26, 2009.

In his introduction, Carl Tannenbaum,

At last year’s conference,
no one could have foreseen
the dramatic changes ahead
for the financial system.

Federal Reserve Bank of Chicago, noted
what a difference a year had made. Speakers at last year’s conference had noted
the beginnings of financial dislocation
and a rapid increase in risk aversion.
However, no one could have foreseen
the subsequent near collapse of the financial system, the breathless succession
of dramatic market events, government
interventions on behalf of so many large
institutions, and the wide range of special
government programs. Despite these
events, private equity funds1 are still robust
and are playing a new role as part of the
recapitalization of the banking industry.
Charles Evans, Federal Reserve Bank of
Chicago, shared his thoughts as the bank’s
president and CEO on the macroeconomic environment and broader financial market developments, framing the
landscape facing the private equity industry. By most indications, the current
recession will match or exceed the downturns of the mid-1970s and early 1980s in
depth and duration. According to Evans,
financial markets, including the shortterm funding markets and longer-term
bond issuance, have improved since earlier this year. However, the volume of
commercial lending (a major source of
funding for private equity) has fallen off
sharply since the 2007 business cycle peak,

and credit standards for these loans remain tight. Evans said, overall, economic
activity is expected to bottom out and
then turn positive later in 2009 or early
in 2010.
State of the industry

Sanjeev Mehra, Goldman Sachs Group,
surveyed the current state of the private
equity industry. During the five-year period leading up to mid-2007, leveraged
buyout (LBO)2 activity increased, driven
by access to plentiful and low-cost credit.
Leverage3 ratios also increased, new leveraged loan4 issuance soared, and credit
quality declined. The availability of lowcost financing came to an abrupt end in
mid-2007, and buyout activity declined
significantly. The industry today faces a
wall of refinancing, and debt pricing has
not fully recovered. The recession has
caused default rates to increase, with further increases expected. Private equity
firms are responding to these changes by
focusing on managing existing portfolios,
refinancing and extending debt maturities, injecting new equity into target
firms, investing in new ways (e.g., distressed debt5), and waiting for the initial
public offering market to provide opportunities to exit and reduce leverage.
Despite the numerous challenges facing
the industry, Mehra argued that “reports

of the death of private equity are premature,” citing continued fundraising
and a significant “overhang” of money
from 2007 funds still available to invest.
Top LBO firms have consistently outperformed the public market by providing capital and high-quality resources
to target businesses, focusing on value
creation, aligning management and
investor incentives, and closely monitoring performance.
A panel led by Mark O’Hare, Prequin
Ltd., explored private equity valuations.
It featured William Franklin, Conversus
Asset Management; Thomas Goldstein,
formerly of Madison Dearborn Partners;
and Erin Hill, One Equity Partners. After

private equity professionals. Providing
assistance in this exercise were Thomas
Janes, Lincolnshire Management; Martin
Magida, of Carter Morse and Mathias; and
James Marra, Blue Point Capital Partners.
Topics addressed included trends in mergers and acquisitions (M&A), banking as
a target industry, private equity industry
metrics, and compensation. The most
telling trends about the current state
of private equity were the drastic decline
in M&A activity and sluggish fundraising
and deal flow.
The secondary market7 was analyzed
by a panel moderated by Stephen Can,
Credit Suisse Strategic Partners; it featured Ethan Falkove, of Neuberger

Presenters agreed that reports of the death of private equity
are premature.
years of highly superior performance,
private equity saw write-downs averaging
17% as of year-end 2008. Although significant, these write-downs were still much
lower than those in other asset classes,
most notably public equities.
Panelists concentrated on the impact of
recently introduced fair value accounting
rules.6 From a general partner (GP) perspective (see note 1), these rules have
created a need for a much broader approach to valuations, using a wide variety
of data points. Independent valuation
committees and outside auditors are
also becoming more actively involved.
Some GPs have questioned whether fair
value is appropriate for private equity
assets, with their long maturities. Limited
partners, or LPs (see note 1), note that
valuations of the same asset can vary widely across different funds. Valuations can
be useful to LPs in assessing the track
record of different GPs and in determining asset allocations. The panel concluded that, while valuations are by necessity
subjective, the most recent efforts to determine valuations do represent diligent
and honest attempts to arrive at fair value.
Steven Pinsky, of J. H. Cohn, moderated a panel examining current industry
trends, as well as perceptions, misconceptions, and predictions espoused by

Berman; Mark O’Hare; Carlo PirzioBiroli, Deutsche Bank Group; and Philip
Tsai, UBS Investment Bank. The global
secondary market grew rapidly from 2006
through 2008. Transaction flow slowed
down in the first half of 2009. Although
both supply and demand are strong, bid
and ask prices are far apart. On the seller
side, many LPs are facing a severe liquidity crunch, as their net cash flows (distributions less new capital calls) have
fallen significantly. Furthermore, for
many LPs, declines in the value of other
invested assets (such as public equities)
have caused the percentage of the overall investment portfolio allocated to private equity to exceed policy thresholds,
triggering mandated adjustments.8 On
the buyer side, the secondary market
prices buyers are willing to pay have declined sharply. Wary of “catching a falling
knife,” buyers are weighing the impact
of the fair value accounting rules and the
recession on portfolio company performance and GP valuations. In addition,
providers of leverage to secondary market
buyers have essentially closed for business,
further reducing investing activity.
GPs and LPs

GPs face the daunting task of determining optimal staffing to accommodate
the multiple demands they face. This

challenge is particularly acute in the
current stormy economic environment.
Kathleen Graham, HQ Search Inc.,
spoke on staffing issues facing the private
equity industry, from both the GP and
LP perspectives. The presentation, using
a nautical theme, centered on the mantra
of “Can Do”: Communicate clearly and
completely, Align sails (interests and
compensation), Navigate via better
decision-making, Do due diligence,
and Operate efficiently.
John Kim, Court Square Capital Partners,
led a panel of LP investors, made up
of Greg Davis, State of Indiana Public
Employees’ Retirement Fund; David
Fann, PCG Asset Management; and John
Morris, HarbourVest Partners. Panelists
indicated that current market conditions
have increased the influence that LPs
have in setting terms and conditions,
including the key area of fees paid to GPs.
In addition, long-term shifts in the types
of benefit plans administered by pension
plans and the trend of private equity
funds going public have altered the funding available to GPs. LPs are currently
interested in the secondary market, senior bank loans, distressed debt, mezzanine funds,9 energy, clean technology,
and emerging markets. Finally, although
(lagging) write-downs in private equity
valuations have helped some LPs stay
within investment policy limits, future
capital calls could once again challenge
their ability to adhere to these limits.
Leveraged loan market

Meredith Coffey, LSTA, surveyed short-,
medium-, and long-term trends in the
leveraged finance market. In the short
term, technical factors (increasing demand relative to supply) and fundamental
factors (soaring defaults and rating downgrades) are moving in opposite directions.
In the medium term, the massive amount
of leveraged loans issued during 2005–07
will need to be refinanced over the next
few years. Collateralized loan obligations
(CLOs)10 had played a key role in financing growth in leveraged lending during
the boom, but CLO issuance has essentially ceased. Loan modifications (“amend
and extends”) may lengthen maturities
for stronger companies and provide some
relief. In addition, some of this bank debt

may be refinanced in the high-yield bond
market, provided this market remains
open and relatively healthy. In the long
term, Coffey said, the leveraged loan market is expected to be less levered11 and
more expensive, but also more stable.

argued that the most important ingredient
for success is picking the right management team—one that has the experience
and fortitude it takes to successfully
run a bank in today’s environment.
More regulation on the horizon?

Distressed assets and the banking
sector

A panel on distressed asset investing
was moderated by Kenneth Yager, of
MorrisAnderson. Panelists were Clifford
Brokaw, Corsair Capital Partners; Navin
Nagrani, Hilco Real Estate; David Onion,
Chicago Capital Holdings; and David
Wirt, of Locke Lord Bissell & Liddell.
While depressed asset valuations provide
an incentive to invest, available capital
has declined, and investors will likely remain out of the market through the end
of 2009. In the financial sector, recently
concluded stress tests at the largest banks
were considered helpful in reducing
the uncertainty about capital needs.
Panelists judged that there was enough
private capital available to recapitalize
the entire U.S. banking industry, but that
mid-tier banks were the riskiest segment
in the long term and that rescues for
small-tier banks from private sources
would be extremely limited.
Richard Decker outlined how his firm,
Belvedere Capital Partners, which specializes in acquiring financial services
companies, views current opportunities
in the banking sector. Although the
financial services sector offers unprecedented opportunities for investors, until
recently, very little private equity money
has flowed into it. Private equity firms
face a dilemma of whether or not to become bank holding companies (BHCs).
BHCs face much greater regulatory scrutiny and generally may not own controlling interests in nonfinancial companies.
However, avoidance of BHC status would
require limitation of firms’ investment
in banks to relatively passive, noncontrolling stakes, with fewer of the control
features (such as board seats) investors
would normally require. In addition, the
banking industry faces major challenges
at present, including restoring sound
credit fundamentals, improving capital
and liquidity management, and building a “fortress balance sheet.” Decker

The prospects for private equity regulation were discussed by Michael Tokarz,
MVC Capital, as interviewed by Edward
Hortick, VCFA Group. Tokarz provided
a long-term perspective on this issue.
Previously, as a member of Kohlberg,
Kravis, Roberts, and Co., he was involved
in the buyout wave of the 1980s and the
first attempts at regulating private equity,
which involved proposed tax changes
and the reporting of “highly leveraged
transactions.” Regarding the current
proposal to require registration of certain
hedge funds12 and private equity funds,
Tokarz stated that private equity generally does not pose systemic risk because,
in his opinion, systemic risk is largely
driven by liquidity issues, and private equity, on account of the long-term nature
of its assets and liabilities, does not pose
such issues. That said, he indicated that
certain hedge funds and other very large
financial institutions may warrant registration due to potential liquidity risks.
The venture capital model

Susan Boedy, Thunderbird Global Private
Equity Center, moderated a discussion
on global venture capital, with panelists
Jack Biddle, of Biddle Novak Venture
Partners; John Dominguez, SVB Capital;
Clare Fairfield, Venture Capital Institute;
and Randy Mitchell, U.S. Department of
Commerce. Based on the number of
funds, venture capital is the largest sector
of the private equity industry, with 31%
of the funds raised to date globally in
2009. However, it represented only 9%
of aggregate capital raised, compared
with 44% for buyout funds. Despite the
financial crisis and an extremely subdued
exit market, the amount of investment
in venture capital held up relatively
well in 2008 and so far in 2009.
Panelists stressed the need for a broader
“ecosystem” to support entrepreneurship, beyond the existence of funding
markets. The U.S. still leads the world
in this regard. They also cautioned that

proposals to increase the taxation of
venture capital could adversely affect
innovation and risk capital and, thus, the
broader economy. Among the sectors
projected to be the most active targets
of venture investing in the next three to
five years were clean technology, infrastructure, and biotechnology. The emerging markets of Brazil, China, India, and
Africa were mentioned as highly attractive
regions for investment.
A long-term, global view

Adnan Hassan, Mecasa Advisors, provided a wide-angle perspective on conference issues. He indicated that sovereign
wealth funds13 serve their sponsoring
governments by reducing volatility in
revenues, building up savings, supporting
strategic planning, and diversifying earnings streams. While these funds benefit
markets through quick decision-making,
ample liquidity provision, and protection
of the privacy of investees, they have
raised concerns because of a lack of
transparency, possible political agendas,
and placement of assets into foreign
hands. Hassan pointed out that “Islamic”
finance is a small but rapidly growing
market niche that is essentially a form of
socially responsible or “ethical” finance,
based on risk sharing and personal ties
between partners in a transaction.

Charles L. Evans, President; Daniel G. Sullivan, Senior
Vice President and Director of Research; Douglas D. Evanoff,
Vice President, financial studies; Jonas D. M. Fisher,
Vice President, macroeconomic policy research; Daniel
Aaronson, Vice President, microeconomic policy research;
William A. Testa, Vice President, regional programs,
and Economics Editor; Helen O’D. Koshy and
Han Y. Choi, Editors; Rita Molloy and Julia Baker,
Production Editors.
Chicago Fed Letter is published by the Economic
Research Department of the Federal Reserve Bank
of Chicago. The views expressed are the authors’
and do not necessarily reflect the views of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2009 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
whole or in part, provided the articles are not
reproduced or distributed for commercial gain
and provided the source is appropriately credited.
Prior written permission must be obtained for
any other reproduction, distribution, republication, or creation of derivative works of Chicago Fed
Letter articles. To request permission, please contact
Helen Koshy, senior editor, at 312-322-5830 or
email Helen.Koshy@chi.frb.org. Chicago Fed
Letter and other Bank publications are available
at www.chicagofed.org.
ISSN 0895-0164

Policymakers, confronted with traumatic
events such as the collapse of the housing giants Fannie Mae and Freddie Mac,
are trying to prevent a global depression
while facing financial risks of uncertain
magnitude. In addition, state capitalism
(whether in Washington, Beijing, or
Abu Dhabi) is trumping freewheeling
markets—at least for now.

“Traditional” financial values and conservative banking are also returning, benefiting advocates of “Islamic” finance. Given
all of these factors, Hassan argued that
private equity, based more on long-term
relationships than on pure financial engineering, would remain an attractive
investment model.

Conclusion

1

4

8

This phenomenon is known as the “denominator effect.”

9

Mezzanine funds target debt instruments
that provide the layer of financing that has
intermediate priority (seniority) in the
capital structure of a company, demonstrating both debt and equity characteristics.

10

CLOs are structured credit securities
backed by whole commercial loans,
revolving credit facilities, or letters of
credit, where interests in the security are
divided into tranches with differing repayment and interest earning streams.

11

That is, less leverage in borrowers’ capital structures will be allowed than in the
recent past.

12

Hedge funds are investment pools that
face few restrictions on their portfolios
and transactions. Consequently, they are
free to use a variety of investment techniques to raise returns and risk.

13

Sovereign wealth funds are pools of funds
set up by sovereign governments to manage
funds not needed for short-term purposes.

Private equity funds are pools of capital
invested by a private equity partnership,
typically involving the purchase of majority stakes in companies (not listed on a
public stock exchange) and/or entire
business units to restructure their capital,
management, and organization. The
standard vehicle for investment in private
equity funds is the limited partnership.
The manager of the fund, the partnership’s general partner, makes, monitors,
and ultimately monetizes investments
for a return on behalf of the investors
(the limited partners). Limited partners
include pension funds, insurance companies, asset management firms, and
fund-of-fund investors.

2

Leveraged buyouts involve the acquisition
of a company using a significant level of
borrowing (through bonds or loans) to
meet the cost of acquisition. Usually, the
assets of the company being acquired
are used as collateral for the loans.

3

Commonly measured as the proportion
of debt to equity (also assets to equity and
assets to capital), leverage can be built up
by borrowing (on-balance-sheet leverage)
or by using off-balance-sheet transactions.

A leveraged loan is a bank loan that is
rated below investment grade (BB+ and
lower by S&P or Fitch, and Baa1 and
lower by Moody’s) to firms with a sizable
debt-to-EBITDA (earnings before interest,
taxes, depreciation, and amortization)
ratio, or it is one that trades at wide spreads
over Libor, or London interbank offered
rate (e.g., more than 150 basis points).

5

These are loans of companies undergoing (or expected to undergo) bankruptcy or restructuring in an effort to
avoid insolvency.

6

U.S. accounting rules that expand and
clarify the use of fair value (or “markto-market”) accounting went into effect
at year-end 2008 for most firms. Implementation of these rules has been controversial in the current environment,
where some market values are severely
depressed and may not represent true
economic values.

Presenters at the conference were in general agreement that, despite a dramatically altered financial landscape, private
equity’s long-term and well-documented
cyclical nature drives favorable expectations of survival and prosperity after
“worlds collide.”

7

A secondary market is a market where
an investor purchases an asset from another investor rather than from the
original issuer.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102