Private Equity's New Challenge

For more than two decades, buyout funds — or nonventure private equity funds — have been an important force in global corporate finance and restructuring. Top-quartile funds, in particular, have turned in consistently strong performances, generating attractive returns for their investors (see Exhibit 1). In the 1980s the sector led a revolution in value creation and corporate restructuring that continues to reenergize economies in the developed and, increasingly, the developing world. Viewed from corporate suites, buyout players have alternately been willing acquirers of underperforming businesses, formidable competitors, and, under the right circumstances, valued partners. Storied firms such as Clayton, Dubilier & Rice, Kohlberg Kravis Roberts, and The Blackstone Group may be emblematic of the sector, but its ranks also include many other private limited partnerships, investment banks, and public-investment vehicles that follow a similar business model.

That model, however, may soon look quite different. A convergence of market forces has altered the competitive landscape in which private equity firms have thrived. More and more, they are encountering heavier competition for opportunities to invest, often against new competitors. The rise of the auction sales process is eroding the buyout players' ability to gain privileged access to investments from their once-legendary networks of relationships. The creative financial-engineering skills once guarded by a few top practitioners have become commodities, and a tougher stock market has worked against players looking to purchase, restructure, and then quickly sell a company. Taken together, these changes threaten to lower median returns over the next five to ten years, compared with the public equity markets, and could make standout performance considerably more difficult.

Of course, as long as there are attractive buyout opportunities — and there will be, particularly in the European industries that are restructuring and in less financially developed markets — the top buyout fund managers will continue to generate attractive returns for investors. But the most successful fund managers will be those willing to change significantly their historical investment and value-creation models. For the rest, recent trends will likely lead to something of a shakeout as well as increasingly differentiated performance between top buyout funds and the median.

Diminished Advantages
Our research and work with clients highlight a series of changes in the landscape where private equity firms have thrived.

An excess supply of capital. Throughout the 1980s and most of the 1990s, well-positioned players could rapidly deploy their capital because the demand for private equity financing generally exceeded the available capital. That situation has reversed dramatically, however. In the late 1990s, buyout funds collectively raised as much as $50 billion to $60 billion per year. Yet by the early 2000s, annual deployment had fallen to the $30 billion to $40 billion range (in equity value), and today a significant pool of capital — some $90 billion in the United States and €39 billion in Europe — is awaiting deployment (see Exhibit 2). The result is more competition for each new investment opportunity, more marginal or high-priced deals, and greater pressure from institutional investors to return some previously invested capital.

Privileged access is less important. Discussions with fund managers and investors indicate that the privileged deal is a thing of the past. Historically, the relatively limited number of fund managers (primarily experienced investment bankers) had unique networks of relationships that provided access to investment opportunities that other, less well-connected buyers couldn't match. Indeed, fund managers could sometimes consummate buyouts without a competitive bid process.

This situation has changed gradually over the years; today there are many more well-networked participants with much better information. Almost all significant deals today are subject to a visible and public auction process as sellers seek the maximum price. In many large deals, the number of bidders, both alone and in consortia, can reach double digits. The recent auction of a U.S. newspaper publishing business, for example, attracted almost all of the large active U.S. buyout funds.

Commodity financial-engineering skills. For years, the ability to create value through financial engineering was important. At its simplest level, a buyout fund would restructure and increase the debt of companies with too much equity. In this way, the fund reduced the companies' exposure to corporate-income tax, used heavy interest payments to manage cash flows, and encouraged management performance with levered equity-based incentives.

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