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Private Equity's New Challenge

A changed competitive landscape calls for a different business model.
The McKinsey Quarterly, McKinsey & Co.
September 16, 2004

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.


Such skills remain important, but today they are broadly available. Vendors are beginning to use so-called stapled finance, where assets and businesses are auctioned with aggressive buyout leverage already in place or preapproved by the financing banks, for instance. Even the sales of businesses with lower leverage tend to attract multiple bidders, each with its own access to similar sources of debt through the financial sponsors' groups of large investment and commercial banks. Acquisition prices therefore tend to reflect most of the upside from leverage.

Cyclical difficulties in ensuring attractive exit. Particularly during the 1990s, strong equity markets frequently permitted buyout firms to use initial public offerings (IPOs) to divest their interests. Beginning in 2000 that became more difficult, as markets plummeted, and even today this approach is a harder sell. As a result, buyout firms increasingly are changing their divestment strategies. Some are selling via secondary buyouts, while others are holding onto their investments longer. Indeed, Initiative Europe has reported that average holding periods increased from 37 months in 2002 to 52 months in 2003. (Founded in 1988, Initiative Europe is a leading independent provider of specialist and in-depth information focused purely on European private equity and venture capital markets.)

While some will argue that the current situation merely reflects the cyclical nature of the IPO market, it may well signal a fundamental change in the way that investors, markets, and regulators think about the characteristics of an IPO as well as the track record necessary for a successful listing.

Emergence of new types of competitors. Several categories of new competitors have emerged, further complicating the buyout world. An increasing number of buyout firms now raise funds for each individual transaction from investors who can choose to participate on a case-by-case basis, for example. A few have used this model for years, but others are attempting to copy it. Such funds may be more flexible in responding to market conditions than those that engage in significant fund-raising activities only every few years and may feel less pressure to rapidly put money to work. Another example involves the accelerated IPO, whereby businesses being auctioned are offered a rapid route to IPO, circumventing the typical intermediate step of buyout-fund ownership for a three- to seven-year period. Undoubtedly, we will see additional categories of competitors, further increasing the competition for available transactions.

Fewer pull-through opportunities for banks. Buyout funds within financial institutions can create value both by earning a basic investment return and by creating opportunities to pull through fee-based business such as M&A advisory and underwriting fees. Indeed, much buyout activity has been carried out within broader corporate-form financial institutions (predominantly investment banks) using both their own capital and that of third-party investors. A number of such bank funds historically have been very strong performers, although investors, unlike those in partnership-form peers, have suffered from double taxation of fund returns.

Recent market conditions, however, have severely limited pull-through business: few significant IPOs have been completed, and the fees per deal related to debt financing have continued to fall. Hence, while some banks will likely continue to create value from buyout activity, it may be worthwhile for all banks to reconsider carefully how much of their own capital they must invest to optimize total returns — including the pull-through of fee-based business.

Changing the Model for Success
Some forward-thinking fund managers have already begun to respond to this dramatically changed environment, but so far few have embarked on a broader effort to redesign their historical investment and value-creation model.

In a new environment for private equity firms, a logical first step would be to begin investing more aggressively in due diligence. Funds traditionally have been reluctant to invest heavily up front to really understand what is needed to realize the upside potential in a proposed buyout. This pattern may be partially due to the incentive structure of most funds, where up-front investment in incomplete deals effectively reduces the cash available for the compensation of fund managers and other professionals. The likely result, however, is too many deals being taken too far through the process. Early, detailed, and rigorous transaction screening can yield significant dividends in the appropriate deployment of fund professionals' time and the ultimate success of each deal.

Another likely source of competitive advantage in this new landscape is the development of a more hands-on approach to ownership and management. Several buyout firms now recognize that they can create value (in conjunction with management teams) by participating more in managing the companies in their investment portfolio and by developing cross-industry functional skills — including marketing, pricing, lean manufacturing, and procurement and supply chain management.


To develop these sources of competitive advantage, fund managers must add to their teams more professionals with deep strategic and industry insight, operational-improvement expertise, and other functional skills. Several firms have begun to build groups of strategists, former operating executives, and turnaround specialists, while others have entered into alliances with third parties to provide such services. Success will require extending this effort further; to attract the highest-quality operating and strategic talent, leveraged-buyout firms will have to cast aside past practices and increasingly offer up a share of the carry to such professionals.

Some firms will want to focus on a limited number of industry segments. Truly superior strategic and operational insights and the development of potentially privileged networks for sourcing require deeper industry knowledge in today's environment. Firms that quickly develop their knowledge of a few narrowly defined industry segments and geographies will be better positioned to translate this expertise into a perspective on value-creation potential, transaction price, and potential returns.

Last, another competitive edge will likely come from the better sizing of funds to targeted investment opportunities. Successful fund managers have tended to raise funds as large as the market will allow. While there is nothing inherently wrong with large funds — some of the top performers have been large, and there are some deals that are so large that only a few funds can compete — size has several unfortunate and unintended consequences. First, in the United States and Europe, competition for big deals is often fierce, with multiple funds and consortia chasing most deals. Second, very large funds force buyout firms to "institutionalize" as organizations grow, and many fund managers feel a threat to their entrepreneurial culture — a key to success. Finally, as the size of deals increases with fund size, so does the difficulty of ensuring that fund managers have the appropriate skills to effect multidimensional change in organizations with substantial portfolios. Although large funds should not necessarily be avoided, fund managers should think carefully about their firm's focus and the nature and scale of its likely opportunities and then adjust their fund-raising accordingly.

Corporate Connections
The trends altering the private equity landscape can offer opportunities to CFOs and other corporate strategists. Because of the surplus of capital in the current market, corporations looking at acquisitions are seeing more and more competition from a broader set of financial buyers in addition to the anticipated strategic buyers. However, buyout firms are increasingly willing to partner with corporations that bring complementary industry knowledge and managerial and operating skills. These partnerships create new strategic opportunities for public companies — and might even reassure some shareholders that they are investing alongside smart money.

What's more, corporate buyers often bring assets that can be combined attractively with the target business. While preparing a bid for a technology company during a recent auction, one corporation was approached by four buyout funds, for example, each with varying complementary assets and strikingly different proposals for alternative forms of partnership.

Many buyout firms also have increased their interest in private investment in public equity (PIPE). These investments are typically minority equity or convertible stakes in public entities that can in some cases be linked to financing for specific acquisitions. PIPE investments can also be part of an attempt to broaden the available set of opportunities beyond private deals, to get ahead of the competition for privileged access to divestitures of nonstrategic assets, or even to involve leveraged buyouts of complete public entities. Corporations will increasingly see buyout firms positioning themselves as potential minority shareholders and strategic partners, but CEOs and CFOs should consider carefully the true cost of such capital infusions from these players compared with the alternatives.

Finally, corporate executives should be prepared to encounter more competition from buyout firms for top managerial talent. Not only will buyout fund managers seek to add operational and strategic expertise to their ever-broadening teams that evaluate, execute, and monitor investments but also to offer more compelling financial incentives for such talent to accept positions in the turnaround and ongoing management of portfolio companies.

Neil Harper is a principal in McKinsey's New York office, and Antoon Schneider is a consultant in the London office. The authors would like to thank Richard N. Foster and Andreas Beroutsos for their contribution to this article, which first published in the Summer 2004 issue of McKinsey on Finance.




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