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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.